Fair Pay Fair Play - Book Summary

Unlocking the secret of balancing executive remuneration.

Have you ever come across the term 'aligned pay'? If you haven't, then let’s delve into this integral component of corporate compensation.

Aligned pay revolves around the amount of remuneration a company provides its top executives. This compensation, which may include stocks, bonuses or other benefits, should essentially be just and equitable.

But here lies the crux of the matter - what does 'fair' truly mean? In the course of this summary, we will walk you through the complexities of setting executive pay. The goal? Guiding you on how to level out your company's pay structure to reflect true fairness.

Through this journey, you will discover:

- The tipping point where a lavish compensation package starts doing more harm than good,

- The factors that should weigh heavily when determining executive pay, and

- Why, for ambitious executives, cash rewards are just one slice of the comprehensive compensation pie.

Considering CEO performance and industry benchmarks are key to a fair executive remuneration plan.

Picture this: You are a hardworking account manager in a team of three, giving it your all day in and day out. One day, you discover that despite equal effort, your two colleagues earn more than you do.

Wouldn’t you label such a situation as downright unfair?

This analogy mirrors the reality of executive compensation today – often overly generous, with scant regard for CEO performance.

Take, for instance, John Chambers, the CEO of Cisco Systems – a heavyweight in the global telecom landscape. In addition to his salary of three hundred thousand dollars, Chambers took home five to six million dollars in stock options and a bonus of four hundred thousand dollars each year.

In all honesty, that's an overwhelming amount of money – one might argue that no executive can truly merit such compensation. But performance isn't the only factor to keep in mind for a fair remuneration plan. Another key component is understanding and aligning with the compensation landscape within the same industry.

It's common knowledge that industry standards vary greatly, with each industry being influenced by unique external factors. Take, for example, the energy sector, which ebbs and flows with oil prices, or the tech industry, which is heavily impacted by the IT supply chain's inventory levels.

These external dynamics can significantly sway any executive's performance, making it essential for CEO pay to mirror the remuneration standards within the same industry.

This approach ensures that the CEO of an energy company won't be unfairly penalized in their compensation if an oil crisis inflates prices and dampens company returns. Simply put, even if a CEO's performance is beyond reproach, basing their pay on that of a flourishing tech sector CEO wouldn't be a fair approach.

Adherence to pre-established agreements and overall business strategy is key to fair compensation.

We all have those moments of spontaneity when we make impulsive decisions, setting goals we later realize we cannot maintain. Consequently, these goals are discarded without a second thought. This very pattern can be observed in the distortion of executive compensation frameworks.

Random decisions that deviate from original plans can profoundly undercut fair pay strategies. Here's how it works.

Executive remuneration should ideally be dictated by a predetermined plan that lays out how the pay scale will fluctuate based on specific future scenarios — for instance, a company merger. Even though these plans are set in place well ahead of time, unforeseen events or arbitrary decisions can easily disrupt their solid foundation.

Imagine a CEO who, after serving the company for 20 years, decides to retire. Her contract had already laid out a specific plan for retirement, but the company board, on a whim, decides to grant additional stock options, resulting in a disproportionately generous compensation plan!

Similarly, adjusting compensation in response to economic events without regard for the company's long-term business strategy can also result in unfair remuneration.

This is why companies should refrain from knee-jerk reactions to external circumstances and changes in plans. Instead, they should remain steadfast in their adherence to the initially established plan and the overarching corporate strategy.

Here's an illustrative example. A certain company shifted its executive pay scheme from a lavish package of base salary, bonuses, and stock, to a plan solely composed of stock. The result was a drastic reduction in total compensation.

Why this abrupt change? The decision was made in 2008, amidst the global financial crisis. The executives were reacting to external events, completely bypassing the long-term business strategy.

The lesson here is clear – deviate from your pre-set plan, and your compensation scheme is bound to suffer.

CEO compensation plans often act as shields against missteps or short-term risks.

Are you familiar with the term 'illusory superiority'? It's a psychological phenomenon where an individual ascribes their successes to their own efforts but blames external factors for their failures.

This mindset is not confined to individuals and can often infiltrate corporations. Companies frequently operate under the impression that their top brass is smarter, more competent, and generally superior to lower-level employees. This belief materializes in executive paychecks that far outweigh their true value.

Consequently, when an economy is thriving, even a company with lackluster management can prosper. The executives in such a situation are still rewarded with bonuses, further inflating their already bloated paychecks. However, any struggles the company might face are chalked up to external variables like an economic downturn, never attributed to the company leadership!

Yet another faulty assumption underpinning executive remuneration is the adoption of a one-size-fits-all approach to compensation models.

This was a glaring issue during the 1990s and 2000s when many American firms believed that the pay scale for executives of publicly traded companies should match that of managers at top-tier private equity firms.

This assumption was deeply flawed; public and private firms have inherently different dynamics. The valuation of a public company, for instance, is constantly reassessed in the open market. Executives of public firms need to cater to the demands of shareholders over a prolonged period, regardless of when they bought their stocks.

Private companies, in contrast, grant executives a portion of company equity upon their appointment, which they can sell at a later date.

Overlooking this key distinction resulted in gross overcompensation of executives in publicly traded companies. They were reaping the benefits of a compensation model designed for short-term (the private firms) when their pay should have been governed by the long-term strategy typical to public firms.

Executive overcompensation is a common tactic to retain talent, but money isn't always the best motivator.

We often succumb to the belief that money can overcome any challenge, particularly when it comes to compensation. The notion persists that if a person is paid handsomely, they are bound to perform spectacularly — no exceptions.

This belief compels executive committees to overcompensate executives to keep them within the company, even at the risk of sparking financial turmoil.

A glaring example was the 2008 financial meltdown when some companies, fearful of losing their executives, refused to scale down exorbitant executive salaries, even as the company revenue took a nosedive.

Moreover, several companies offered their executives attractive stock option packages to retain them, despite the substantial financial strain it could impose on the company.

Such decisions are fundamentally flawed, as they trigger a misappropriation of resources. The funds allocated for executive compensation could have been diverted to more productive pursuits, such as research and development.

The truth is, monetary compensation doesn't hold the sway companies assume it does when it comes to retaining top-tier talent.

Even though many companies cling to the belief that compensation is the ultimate motivator, it is but one aspect that contributes to an executive's job satisfaction. Other considerations include the level of challenge the position offers, the opportunity for professional growth, and the potential for enhancing their reputation.

In reality, those who are tapped for top-tier positions are rarely interested in just the paycheck. More often than not, these executives are attracted by the company's mission, its vision, its team, and the potential they see to fortify the company's standing in the industry.

Therefore, job transitions among executives are seldom driven by a desire for a heftier paycheck. Instead, when they do move on, it's typically to ascend another rung on the career ladder.

Implementing a few strategies can help level executive remuneration and ensure its fairness.

It's clear that the realm of executive remuneration is riddled with fairness issues. So, what's the solution?

A navigation map provides you with directions to your destination, and similarly, an alignment report serves as a compass guiding your executive compensation decisions. This report aids in deciphering whether the proposed pay is in "alignment" with the overall value the executive brings to the table.

An alignment report outlines the value an executive adds to the company and calculates what they should be compensated relative to their industry counterparts.

Imagine a hypothetical comparison between two auto companies, Company X and Company Y.

In 2015, Company X flourished under dynamic leadership, boosting its revenue by 23 percent, and the CEO drew a salary of $180,000.

Conversely, in the same year, Company Y, a company comparable to Company X in size and market share, didn't fare as well. The revenue only grew by 8 percent, but the CEO pocketed $175,000.

By juxtaposing their performances and industry, it becomes evident that the CEO of Company Y was overcompensated.

The alignment report also exposes whether the compensation model in place is equitable. Compensation model refers to the method a company uses to determine its executive pay, be it through bonus systems, stock grants, or a mix of both.

In order to uphold fairness, a compensation model should calibrate executive remuneration according to their performance in comparison with other executives within the same field.

Therefore, if most CEOs within the competition are compensated with a fixed monthly salary, your CEO may be overpaid if they receive a regular monthly bonus in addition to their salary, granted that they are contributing the same amount of value as other CEOs in the same industry.

To put it succinctly, in order to gauge the fairness of executive compensation, contrast the value added by your executives with that provided by the executives of rival firms.

Wrapping up

The central theme of this book:

The issue of skyrocketing executive compensation needs immediate attention. For the remuneration of top-tier executives to be justifiable, it should be performance-oriented and benchmarked against the compensation of executives in comparable roles, at similar companies, operating in similar markets.