Benchmarking executive compensation requires a holistic approach to feel like you are “getting it right.” Considering market reference points and other external factors is important, but it is also critical to not lose sight of internal factors. Most companies have an established methodology but, since factors can evolve from year to year, it is important to periodically review your approach to benchmarking.
Defining the Competitive Market
The first step to any compensation analysis is to define the competitive market and determine your compensation philosophy. Are you targeting median of the market or something else? Your compensation philosophy should align with and support your overall company strategy. It is important to review compensation decisions each year with that philosophy in mind, both for individual executives as well as across the entire group.
Defining the competitive market can be more nuanced, as there are several different approaches. The first step is to think about your main competitors for talent. What industries do they operate in? Are they public or private? This will help influence what the best primary reference point is for your executive team (note that benchmarking deeper in the organization may follow a consistent approach but with a slightly different methodology). Most organizations use proxy data, survey data or a combination of the two in order to give a robust picture of the market. The beauty of using proxy data for a defined public company peer group is that you can look at company-by-company detail and know exactly what pay levels are going into the summary statistics, and you have the greatest amount of control over the companies in your sample. However, proxy data also has its limitations, as companies only disclose compensation data for the five highest paid executives. While it is valuable for your top five executives, particularly for the CEO and CFO, it may not be as helpful for other members of your executive team. For these executives, you will more likely have to rely on survey data.
Survey data is also a great reference point, as you can get functional matches for nearly all your roles, whereas you may only be able to get proxy data for certain roles or may need to match executives based on pay rank. However, for survey data, there is more ambiguity as to which companies are in your sample (you typically only have access to the full participant list). There are instances where it may be helpful to do a custom cut of the survey with specific participants, but this can limit the robustness of the data. Survey data is also a great resource for general industry data or data that is in related broader industries. Peer groups typically focus on companies in your industry; however, general industry data may be appropriate for roles where knowledge is transferable across industries and your available talent pool is much wider.
Whether using peer group proxy data or survey data, you must consider the quality of the market data. You want to ensure that each data cut you use is robust and has a reasonable number of incumbents, usually at least ten for proxy data and more for survey data. Therefore, in some instances, you may not have a functional match for every role. Additionally, for those with more unique responsibilities, it may be difficult to find a “perfect” benchmark match. In those instances, use the best available market match, but recognize you may need to consider other factors in setting compensation for such a role. The important thing to remember is that you want to establish a credible set of market reference points so that the compensation committee feels comfortable and believes it is an accurate representation of the market.
Other External Considerations
Beyond defining the competitive market, there are several other external factors to consider when making pay decisions. Recent market trends and industry outlook can have a significant impact on decision-making. Market data typically lags current levels by at least one year. This means that there can be a delay in the market data “catching up” to current market trends, both those driving up, as well as slowing down, changes in compensation. For example, we saw large equity grants in the technology industry one year, slowing the next year given recent stock market performance in the industry, and market data took a couple years to catch up.
Other external factors for consideration include recent company performance and investor expectations. If company performance has been weaker in recent years, investors will expect to see target compensation be flat or modestly increase, particularly for the CEO and other senior leaders. If performance has been strong, investors will expect to see more significant increases accompanied by robust disclosure explaining the rationale for such increases.
It is also important to consider the pay for performance relationship to confirm that your pay programs are working as intended. If investors are seeing weaker financial performance with payouts above target or large pay increases or stronger financial targets with payouts below target or modest increases, investors may question if you are using your compensation program and strategy as an effective tool.
Internal Considerations
There are several factors from an internal perspective that are important to consider when setting pay levels. The main one that connects to your external market reference point is determining what your pay philosophy is as an organization. Most companies target pay levels within a competitive range of market median. A competitive range means positioning executives within a range above or below median (usually ±10%). You will need to consider several factors, including individual performance, internal equity, historical practice and retention risk to determine where to position each executive relative to this competitive range.
These internal considerations are both organization-focused as well as related to individual circumstances. Historically speaking, are individuals or certain roles positioned similarly versus market over time or has positioning changed? There may be a good reason for positioning to change over time, but it is an important check and balance. Internal equity across the team is also important. While market data is one input, individuals who are valued the same internally should be paid similarly. It is important to review the executive team in order of target total direct compensation to confirm that pay levels make sense relative to each other internally as individuals may have more or less responsibility than the market role, so market data is only one input.
Individual tenure, performance and retention risk are also key to understanding market positioning and determining pay levels. Is the individual new to the role or a seasoned executive? Do you pay the market rate for doing the job or bring a new incumbent to market over time? Additionally, there may be special consideration to pay levels if an individual is a retention risk — you may want to pay more competitively versus your market philosophy to prevent an untimely transition.
Additionally, with any pay-related decisions, the final check is affordability; that is, can the company afford the recommended changes (from both a cash and accounting perspective)?
More Than Just Market Data
Ultimately, market data should inform but not be the sole factor in determining executive compensation levels and design. When focusing on individual pay decisions, you need to look at all the external and internal considerations together. Looking at either external or internal factors in a vacuum may not give you the full picture and may make it difficult for the compensation committee as a whole to feel comfortable with the pay decisions.
Regardless of the approach you take, consistency is key, and each benchmarking assessment should be conducted in a consistent manner. Promoted employees and external hires should be benchmarked in line with your standard approach; that is, you should consider all the internal and external factors and, in particular, pay equity to ensure that all employees are paid equitably and not treated differently given the timing.
Finally, continue to monitor your pay program over time. Consider how the performance outcomes and actual pay impacts positioning versus the market; for example, is above-median performance resulting in above-target pay if your pay philosophy targets the median? If there is a consistent disconnect between the two, it may be time to reevaluate your compensation philosophy or the structure of your incentive plan design. Additionally, consider how employees in the same role are positioned over time versus the market. As they continue to gain experience — assuming the individual is a high performer — is their positioning getting stronger versus market? If it is not, is that a result of large swings in the market data year-over-year or some other internal factor? Benchmarking executive pay requires a holistic approach — you may not always get it right, but a well-rounded approach can mitigate any concerns about how pay decisions are made.