LESSON 3

Role of Compensation and Rewards in the Organization

Chapter 1: Introduction to framework of Compensation Policy

Learning Objective

• Introduction to the concept of Framework

• Understanding the Framework of a Compensation Policy

Introduction to the concept of Framework

A compensation framework that supports a long term strategic vision for compensation
and implements new initiatives, will provide the needed direction, changes will involve
moving towards solving special salary problems using innovative concepts.

The way we do compensation is undergoing major change towards a more flexible and
timely corporate compensation systems. The new system will have increased delegation
to managers and will be driven by the business needs of Government and ministries. It
will be faster, more efficient and eliminate duplication, focus on a long term approach to
compensation management.

Move from being highly centralized to a decentralized approach whereby deputy

ministers and senior mangers will have increased authority to make decisions.
Integrate compensation with the other areas of human resource management. And
Emphasize transparency, monitoring, reporting and accountability.

The vision for compensation will assist the pubic service in attracting and retaining key
employees.

Managers will have more accountability for the compensation of their employees, and
will be profiled with the required tools, systems and support. Senior mangers will
approve, within the framework, exceptional compensation changes, based on sound
business decisions. Senior managers will also have authority to approve the classification
levels of pre-identified jobs within their organization.

Framework of a Compensation Policy

Employee motivation and performance management depend on good systems that offer
both financial and non-financial rewards (non-monetary rewards). This performance
management article applies to all organisations.

Constant change and high expectations are taking their toll in some organisations, as well
as in industry and government generally. Sometimes this is shown in employee turnover.
Sometimes it is hidden because of job insecurity. Many employees make a New Year's
resolution to seek other employment. Many are also seeking more balance in their life.
Rewards and remuneration must be scrutinised. Employee motivation and performance
are critical. Non-monetary rewards can be as important as monetary rewards.

In some organisations, a multitude of different salary and pay arrangements exist. It is

time to bring these different systems into a new framework. Employees at all levels need
to have confidence in the salary administration system. Employees want the rewards to be
shared fairly and equitably. If they are not, dissatisfaction can cause severe morale and
performance problems.

If they haven't done so already, leading organisations will need to establish an improved
salary administration structure.

It is possible to develop a simple structure that overcomes the difficulties of the past, yet
is simple enough for everyone in the organisation to understand. This structure can be
tied to a completely new performance management approach, including better
performance appraisal mechanisms.

Some industry's remuneration systems have been dominated by the industrial relations
system. Enterprise bargaining and local area work agreements, individual performance
based contracts, and the effect of competition on organisational structures, have had a big
impact.

A good rewards and remuneration system ensures that each person receives appropriate
financial and nonfinancial recognition to account for the personal contribution they are
making and the overall value of their position to the organisation.

This includes:

Creating and maintaining an organisational structure and culture that facilitates both
employee and organisational performance.

Recognising and rewarding individual and team performance, financially and

otherwise, in relation to the overall contribution made.

Implementing compensation systems that fairly treat and recognise all employees,

regardless of their level within the organisation. This is the equity issue. It involves
matching remuneration with the contribution made, particularly where job requirements
can change rapidly.

The best performance appraisal system in the world will not work if it is linked to a
rewards and remuneration system that employees do not trust or support.
A motivated employee will achieve a great deal. A demotivated employee will be slow,
prone to error and not likely to achieve.

Motivation influences performance. It also suggests that the 'lack of', 'promise of', or
receipt of either financial or non-financial rewards may also influence motivation. A
feedback loop between motivation and performance exists, with each potentially
impacting the other.

Remuneration is a component of both financial and non-financial reward; financially, in

terms of cash and benefits received; non-financially in terms of recognition, status and
esteem, e.g. the status of full private use of a motor vehicle.

Job evaluation is a process to determine the contribution of a position to an organisation.

It needs to be seen by both the employee and organisation as fair and equitable.

Good salary administration requires that employees should receive financial recognition
for the contribution that they make, and that positions of equal value should be entitled to
equal compensation. If organisations handle this incorrectly, or manipulate it in some
way, the impact on the employee is significant.

Past pay systems often paid little attention to incentives. It is only in recent years that
some systems have provided for differentiation based on performance. The concept of
fair incentives should be on the agenda. An integrated system is required such as the
following diagram represents.
Perception is the reality. If the current system is not working as intended, then the
organisation has a real problem.

Some key questions:

Does the documentation give a full, comprehensive description of each position?

 Is the evaluation system used soundly based and rigorously applied?

Is consideration given to market competitiveness in setting the remuneration range?

Is the performance appraisal system well designed and accepted by all employees?

Is the review process conducted fairly and within agreed time limits? As well as
checking goal achievement, does the review reconsider the job and changes that may
have occurred?

Are non-financial rewards considered along with financial rewards?

The system should not be bureaucratic, but it has to be perceived as fair. It also has to be
actually administered fairly.

Where do you rate your system on a scale of 1 to 10?

1 Employees are showing their total disenchantment by leaving as quickly as they can.
Morale and motivation are non-existent.

2 Employees are unhappy and grumble frequently about the non-existence of a

remuneration system. They openly talk about the problems instead of getting on with
their work.

3 Employees are unhappy and comment frequently about the remuneration system that is
supposed to be in place but doesn't work. However, a work ethic exists and they do some
work.

4 Employees believe that 'management' controls and manipulates the system. They
continue on regardless, but they do not like it.

5 Employees are aware of a remuneration system but do not see it working for them. It
causes some dissatisfaction.

6 Employees believe the remuneration system only works for 'management'.

7 Some employees believe the remuneration system is working, others believe it could be
better targeted to their particular situation.

8 A comprehensive system is in place. Position value and remuneration is fairly evaluated

and most are well compensated. Areas for improvement are recognising individual and
team contributions fairly. The system is reviewed regularly.

9 A comprehensive system is in place. Position value and remuneration is fairly evaluated

and nearly all are well compensated. Individual and team contributions are recognised.
Higher achievement will come from better implementation.
10 Everyone from the CEO down believes that the remuneration system is working well
and being equitably administered. Individual and team contributions are recognised and
rewarded accordingly. Although some would like more pay, no one is unhappy with the
system. They are motivated and productive.

Tutorial Activity 1.1

Let us study the case below the framework of compensation policy at University at
Minnesota.

Approved by the : Faculty Senate on February 18, 1993

Accepted and Implemented by the: Administration on April 26, 1993

Action by the: Board of Regents - no approval required

Faculty Compensation Policy

Background on Compensation at the University Of Minnesota

Faculty are compensated for their contributions to teaching and advising, research and
scholarship, and service to the institution and the state/region/nation/other nations, as
well as their professions. Total compensation includes annual base salary plus fringe
benefits, including retirement, health and dental coverage, and life and disability
insurance. In some instances, annual base salary is augmented through internal sources,
such as overload teaching, or from external sources in the case of approved external
consulting.

Initial annual base salary is negotiated at the time of hire, with floors establish for the
instructor and assistant professor ranks only. Increases to annual base salary for faculty
occur in the following ways: through annually determined merit increases; through
acceptance of a retention offer that includes an increase; in conjunction with a promotion
in rank and/or the awarding of indefinite tenure; through an augmentation attached to an
administrative title or a set of administrative duties.

For many faculty, annual base salary is supplemented with summer school or other
internal summer employment, such as grant research. Annual base salary may also be
supplemented internally during one's contract period through means such as extension
teaching. Normally, new salaries go into effect for A base faculty on July 1 and for B
base faculty on September 16 of each year.
The salary determination process must provide an objective unbiased evaluation of each
faculty member following a thorough review of his/her work. The process must
encourage continued good or improved performance, which in turn, should be rewarded
by the compensation system.

Criteria for Annual Salary Increases and Promotion

Any salary determination process at the University of Minnesota must be

nondiscriminatory. Initial salary offers, periodic increases, and retention offers may not
be based on considerations related to the race, color, creed, religion, national origin, sex,
sexual preference, marital status, public assistance status, veteran status, or age of the
person being considered.

The criteria for determining salary increases must be similar to those used for promotion
and tenure. The tenure and promotion regulations of the University, adopted in 1985,
provide the following instructions which form the framework within which salary
decisions must be made:

7.11 General Criteria

The basis for awarding indefinite tenure is the determination that the achievements of an
individual have demonstrated the individual's potential to continue to contribute
significantly to the mission of the University and to its programs of teaching, research,
and service over the course of the faculty member's academic career.

The primary criteria for demonstrating this potential are effectiveness in teaching and
professional distinction in research; outstanding discipline-related service contributions
will also be taken into account where they are an integral part of the mission of the
academic unit. The relative importance of the criteria may vary in different academic
units, but each of the criteria must be considered in every decision.

Faculty Involvement

Faculty input into the discussions surrounding criteria and procedures for salary increase
determination is essential to maintaining an equitable and collegial environment. With the
administrator of each unit, the faculty must have the opportunity to develop the criteria
for, and the format of, the process through which annual salary increases are determined.
The documents that describe these criteria, formats, and processes shall be shared with
the college dean, the appropriate vice president, and finally the Senior Vice President for
Academic Affairs.

This process must include the provision that the department chair (unit leader) meet with
each faculty member individually, at least once per year, to review his or her
performance. The sessions shall review the past year's performance and offer suggestions
for enhancing productivity, where appropriate. Units may choose to conduct more in
depth evaluations on a periodic basis (e.g. 4 or 5 years) that would include outside
evaluations.

Allocation Format

Each year the annual salary increase pool for meritorious performance received by the
unit will be distributed based on the criteria specified in the University's Regulations
Concerning Faculty Tenure and appropriate departmental faculty evaluation documents.
Unsatisfactory performance, which shall be documented and communicated to the
individual involved, shall serve as justification for withholding an individual's increase.

Promotion Increases

Beginning with the 1993-94 salary year, promotion from assistant professor to associate
professor will be accompanied by an extraordinary $1,500 increase in base salary and
promotion from associate professor to professor will be accompanied by an extraordinary
$2,000 increase in base salary. It is intended that these promotional increments will be in
addition to the annual salary increase award related to meritorious performance.

The dean will set aside, from those funds provided to his/her unit for salary increase
distribution, sufficient funds to cover these promotional increments. It is understood that
the dean may also set aside funds from this overall pool to address special merit or
retention purposes. It is intended that this promotion increment will receive inflation-
related increases in future years.

Other Recommendations

A standing administrative and faculty compensation committee (including representatives

of the Senate Faculty Affairs Committee) will examine and make recommendations on
policies such as salary levels in the University as a whole, salary disparity among units,
minimum salary levels for associate and full professors, and salary compression.

Tutorial Activity 1.4

CALIPERS”

Let us analyse the Executive Compensation Framework policy with regard to the
organization CALIPERS’.

Company Background:

The purpose of CalPERS' policies on executive compensation is to raise the level of

accountability of Boards and Compensation Committees to shareowners. CalPERS feels
it will benefit shareowners in the long-term if shareowners can provide an enhanced level
of oversight in relation to Compensation Committee actions. This results in more
shareowner friendly compensation programs.
Compensation programs are one of the most powerful tools available to companies to
attract, retain and motivate key employees, as well as align their interests with those of
shareowners. Poorly designed compensation packages may have disastrous impacts on
the company and its shareowners by incentivising short-term oriented and self -interested
behavior.

Conversely, well-designed compensation packages may help align management with

owners and drive long-term superior performance. Since equity owners have a strong
interest in long-term performance and are the party whose interests are diluted by stock
option plans, CalPERS believes shareowners should provide stronger oversight of
executive compensation programs.

In recognition of this, CalPERS' believes that companies should formulate executive

compensation policies and seek shareowner approval for those policies on a periodic
basis. Since SEC's Release #34-48108, adopted on June 30, 2003 as listing standards, for
the NYSE and NASDAQ, companies must give shareowners the opportunity to vote on
all equity compensation plans and material revisions (with limited exemptions). The
ability to vote on these plans provides the checks and balances on the potential dilution
resulting from earmarking shares for equity-based awards.

With this in mind companies should design executive compensation policies to be

comprehensive enough to provide shareowners with oversight of how the company will
design and implement compensation programs, yet broad enough to permit the
Compensation Committee flexibility in implementing the policy. CalPERS does not
believe that it is optimal for shareowners to approve individual contracts at the company
specific level.

CalPERS developed a model policy guideline designed to assist companies in

formulating executive compensation policies. This also provides a framework by which
interested parties may gauge the quality of company specific executive compensation
programs and practices.
General Policy Guidelines.

This also provides a framework by which interested parties may gauge the quality of
company specific executive compensation programs and practices.

General Policy Guidelines

Executive compensation programs should be designed and implemented to ensure

alignment of interest of management with the long-term interest of shareowners.
Executive compensation should be comprised of a combination of cash and equity-based
compensation. Direct ownership should be strongly encouraged.

Executive compensation policies should be transparent to shareowners. The policies

should contain, at a minimum, compensation philosophy, the targeted mix of base
compensation and "at risk" compensation, key methodologies to ensure alignment of
interest, and parameters for guidance of employment contract provisions, including
severance packages.

Companies under new SEC guidelines must provide shareowners the opportunity to vote
on any material revisions to these plans.

Executive contracts should be fully disclosed, with adequate information to judge the
"drivers" of incentive components of compensation packages.

Executive Compensation Policies

In particular, executive compensation policies should contain, at a minimum, the

following components:

1. The company's desired mix of base, bonus and long-term incentive compensation

This section should include adequate detail to shareowners regarding the company's
philosophy of base pay components versus "pay at risk" components of the program.
Details should include reasonable ranges based on total compensation within which the
company will target base salary as well as other components of total compensation.
Overall targets of total compensation should also be provided.

This section should also provide an overview of how the company intends to structure the
compensation program, such as how much of overall compensation is based on peer
relative analysis and how much of it is based on other criteria. The policy should clearly
articulate how the company ensures optimal alignment of interests with shareowners
through the design and implementation of its executive compensation program.

2. The company's intended forms of incentive and bonus compensation, including what
types of measures will be used to drive incentive compensation.

In addition to the relative mix of base salary and any form of incentive compensation, the
company should provide a breakdown of the types of incentive compensation and
reasonable ranges based on total compensation targets for each type of incentive
compensation within the program.

The policy should include the company's philosophy related to the major components of
incentive compensation, including the strengths and weaknesses of each and how the
overall incentive component of the plan provides optimal alignment of interests with
shareowners.

CalPERS believes that in the case of option plans and restricted stock, a significant
portion of the overall program should consist of performance-based plans. These include

index-based options, premium-priced options and performance targets tied to company-

specific metrics.
Performance-based plans should be constructed to reward true out-performance, and
should include provisions by which options will not vest if hurdles are not obtained.
Time-accelerated vesting is not considered a meaningful performance-based hurdle.

The policy should include the specific drivers the company will use in constructing the
performance-based components of the plan. CalPERS suggests using metrics such as
Return on Invested Capital (ROIC), Return on Assets (ROA), and Return on Equity
(ROE), and the relative mix of how performance metrics will be weighted.

CalPERS believes that optimal plan design will utilize multiple performance metrics in a
fashion that will tie small portions of vesting to individual metrics or larger portions of
vesting to multiple metrics.

CalPERS believes that if metrics are used in combination, the plan should require that
each component be satisfied to achieve vesting as opposed to one of several that must be
achieved.

3. The company's intended distribution of equity-based compensation

The policy should include the company's philosophy related to how equity-based
compensation will be distributed within various levels of the company.

In the event that the company uses equity-based tools in its compensation program, the
policy should articulate how the company will address the issue of dilution. For example,
the company should provide a detailed plan with each option program addressing the
intended life of the plan and the yearly run rate.

If the company intends to repurchase equity in response to the issue of dilution, the plan
should clearly articulate how the repurchase decision is made in relation to other capital
allocation alternatives. CalPERS does not favorably view repurchase plans that are

4. The company's philosophy relating to the dilution of existing equity owners

simply targeted to mitigate and obfuscate dilution caused by stock option plans.

5. The parameters by which the company will use severance packages, if at all.

6. The parameters by which the company will utilize "other" forms of compensation, if at
all.

The policy should provide broad guidelines by which the company will use alternative
forms of compensation, and the relative weight in relation to overall compensation if
"other" forms of compensation will be utilized.

The term and length for "other" forms of compensation should be disclosed. Other forms
of compensation include but are not limited to pension benefits, deferred pay, perquisites
and loans. In some cases, other forms of compensation can provide significant value to
executives which are not readily comparable to more basic forms of compensation such
as salary, bonus and incentive.

Other forms of compensation are also more likely to be perceived by shareowners as not
providing meaningful alignment of interests or incentive value. To the degree that the
company will provide other forms of compensation, it should clearly articulate its
philosophy for utilizing these tools with specific treatment of how shareowners should
expect to realize value from including these forms of compensation

Executive compensation programs should be designed and implemented to ensure

alignment of interest of management with the long-term interest of shareowners.
Executive compensation should be comprised of a combination of cash and equity-based
compensation. Direct ownership should be strongly encouraged.

Executive compensation policies should be transparent to shareowners. The policies

should contain, at a minimum, compensation philosophy, the targeted mix of base
compensation and "at risk" compensation, key methodologies to ensure alignment of
interest, and parameters for guidance of employment contract provisions, including
severance packages. Companies under new SEC guidelines must provide shareowners the
opportunity to vote on any material revisions to these plans.

Executive contracts should be fully disclosed, with adequate information to judge the
"drivers" of incentive components of compensation packages.

In addition to the relative mix of base salary and any form of incentive compensation, the
company should provide a breakdown of the types of incentive compensation and
reasonable ranges based on total compensation targets for each type of incentive
compensation within the program.

The policy should include the company's philosophy related to the major components of
incentive compensation, including the strengths and weaknesses of each and how the
overall incentive component of the plan provides optimal alignment of interests with
shareowners.

CalPERS believes that in the case of option plans and restricted stock, a significant
portion of the overall program should consist of performance-based plans. These include
index-based options, premium-priced options and performance targets tied to company-
specific metrics.

Performance-based plans should be constructed to reward true out-performance, and

should include provisions by which options will not vest if hurdles are not obtained.
Time-accelerated vesting is not considered a meaningful performance-based hurdle.

The policy should include the specific drivers the company will use in constructing the
performance-based components of the plan. CalPERS suggests using metrics such as
Return on Invested Capital (ROIC), Return on Assets (ROA), and Return on Equity
(ROE), and the relative mix of how performance metrics will be weighted. CalPERS
believes that optimal plan design will utilize multiple performance metrics in a fashion
that will tie small portions of vesting to individual metrics or larger portions of vesting to
multiple metrics.

CalPERS believes that if metrics are used in combination, the plan should require that
each component be satisfied to achieve vesting as opposed to one of several that must be
achieved.

Answer the questions below based on the above case study:

• What is the purpose behind CalPERS' policies on executive compensation?

• Based on the above case study how can you say that compensation programs are
one of the most powerful tools available to companies?

• Discuss the components of executive compensation.