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TOTAL COMPENSATION
A comprehensive total compensation program for executives, which the compensation committee designs and recommends, will have varying time frames for earnings and payments and involve both cash and equity awards. The mix of executive compensation packages continues to change. These include:
- Annual Compensation: base salary, annual cash incentive awards tied to annual performance goals, and certain limited perquisites and employee benefits
- Long-Term Compensation: equity-based long-term incentive awards, which can be full-value or appreciation awards
- Post-Employment Plans: benefits under qualified pension plans, retirement plans for senior executives, non-qualified deferred compensation plans, and employment and severance agreements
Annual Cash Compensation: This is the sum the executive receives in a year comprised of a fixed base salary and variable cash incentive, which may be a performance-based plan or a discretionary bonus.
The base salary of top executives is set relative to market data and modified by internal factors such as the nature of the job, company history, and the current performance of the executive. It is a fixed cost for the company and used as an index for computing other elements of the compensation package (e.g. bonus, pension etc.).
There are internal factors that need to be taken into account in setting the base salary:
- Current base compensation
- Individual performance
- Degree of match to the job description - a position may include relatively greater or fewer responsibilities in comparison to the peer group and this needs to be taken into account
- Organizational needs and strategy - compensation may be higher for executives pursuing riskier strategies
The annual cash incentives for executives are designed as short-term incentive plans covering a twelve-month measurement period with defined performance standards tied to the organizational and job-related goals. Long-term cash incentive plans are also used that span multiple years, but they are not as prevalent.
Each performance standard must be weighted when multiple criteria are used. Although profits may be the most popular organizational measure, there are a number of others such as:
| Common Financial Performance Criteria | |
|---|---|
| 1. | Earnings per share: The organization's net income divided by the average number of shares of common stock outstanding |
| 2. | Return on equity: The organization's net income divided by the average of shareholders' equity (common and preferred stock plus retained earnings) |
| 3. | Return on capital: The organization's net income, minus dividends, divided by its average capital (shareholders' equity plus outstanding loans) |
| 4. | Return on assets: The net income of the organization divided by the net assets of the organization |
| 5. | Free Cash Flow (non-GAAP measure): calculated as operating cash flow minus capital expenditures |
Payout formulas - most executive short-term incentives plans are indexed to the salary of the executive. Goals are established for each of the appropriate measures and each executive. If the organization achieves or exceeds the goal, the executives receive a percentage of a calculated payout indexed to base salary.
| Sample Payout Formula |
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ABC Enterprises wishes to maintain a minimum return on assets of 10%. It establishes a plan whereby the CEO may receive:
These calculations could be made for one measure or for a number of measures. Further, the measures could be independent, or any cash incentive at all could depend upon maintaining a minimum level of performance on all measures. Often these plans have maximums (such as 300%) placed on the percentage above 100% of base salary that can be earned. |
Memory Jogger
Discretionary bonuses are considered short-term because they: