REWARDS AND COMPENSATION MANAGEMENT

UNIT-4
EXECUTIVE COMPENSATION

Executive compensation definition

Executive compensation, also known as executive pay, refers to remuneration packages

specifically designed for business leaders, senior management and executive-level employees
of a company.

Executive compensation includes benefits such as salaries, perks, incentives, insurances etc.

Importance of executive compensation

Senior management and executive-level employees play a crucial role in the company as
they're the ones making the strategies, taking importance decisions etc. In order to keep them
motivated and satisfied it's important to set the right benefits package.

This type of compensation is negotiable between the employer and potential executive and
can defy the organizational norms on compensation to regular employees.

COMPONENTS OF EXECUTIVE COMPENSATION

Main Components of Executive Compensation Programme are as follows:

The executive’s total compensation package consists of four main components basic salary,
short-term incentives, long-term incentives and perquisites

Basic salary
Base salary is the regular annual salary of the executive. While job evaluation is typically
used to set employee pay in organizations, executive base salary levels are often more
influenced by the opinion of the compensation committee (which consists of some or all of
the members of the company's board of directors), which is often dependent on information
from salary surveys of similar companies. Typically, pay of CEOs and other executives is set
to be competitive with other executive salaries in the market and thus may be very high in
comparison to the pay of employees in their own company
.
Executive Bonuses
In the base salary of executives, most receive variable pay, a compensation that fluctuates
according to some level of performance. The use of compensation beyond base salary is
intended to motivate executives to reach certain organizational performance goals, for
example, specific profit levels, and reward them for reaching these goals. One very popular
type of variable pay is the executive bonus, which is a one-time payment tied to some short-
term performance goal.
Long term Incentives
In recent years, incentives have become important for rewarding the performance of
executives, and now make up about one half of total executive compensation. Incentives are
rewards that are linked to >specific long-term goals of the organization. The most common
long-term incentive is the stock option, which either gives the executive free company stock,
or allows him or her to purchase company stock at a reduced price for a period of time. These
stocks become more valuable as the company improves financially, and therefore, ownership
of stock is intended to encourage the executive to make the organization more profitable
Benefits/Perquisites
The last component of an executive’s total compensation package consists of a wide variety
of benefits and perquisites. It is difficult to quantify benefits due to lack of reliability of data.
These benefits include company cars, club membership, spouse travel, housing
accommodation etc.’

Theories of Executive compensation plan

Important theories that can explain executive compensation are as follows:

1. Marginal Productivity Theory

Marginal productivity theory is mainly concerned with predicting the pay levels of
executives. Many of its propositions about executive compensation are made with a context
of analysing the firm’s ability to generate profits and maximise productive output.  The size
of the executive pay package reflects the firm’s net profits. At this point the firm maximises
its profits and the executive maximises his compensation which is equivalent to the profits of
the firm.

 2.Governance Theory
It is held that executives should pursue strategies that will create long- term shareholder value
and that they should receive closely related rewards. Advocates of this theory believe that a
hired executive will act in the best interests of the owners if he has a personal ownership
stake. Many contemporary executive compensation programmes are structured to reflect this
theory by paying substantial amounts of compensation in the form of stock options.

3.Managerialism
The separation of ownership and control in organisations can lead to executive pay decisions
that benefit the executive regardless of what the organisational outcomes and effects might be
on shareholders. In other words, an executive in such a firm is more likely to have a pay
package that will increase when firm performance is good and remain at the same level even
when the firm performance is poor.

4.Agency Theory
Agency theory may be considered as a theoretical extension of managerialism. A firm’s
owners are called the principals and the hired executives are called the agents. Owing to
widely dispersed ownership, the agent may pursue activities that benefit him rather than the
firm’s owners.

This represents an “agency cost” to firm owners which is the difference between net profits
of the firm had the owners been the managers and the net profits under the agent’s
stewardship. Agency theorists hold that agency costs are a necessary evil that comes with the
advantages of modern corporations

5. Structural Theory
Structural theory examines executive compensation at the firm level. Structural theory
focuses on the “social standards” of pay at different hierarchical levels. According to this
theory, organisations attempt to maintain particular salary differentials between the
management and subordinate levels to comply with cultural norms of proportionality.

6.Symbolism Theories
The symbolism theories of executive compensation held that the executive’s power and
political influence are the primary determinants of his pay level. Power and politics are of
more direct importance to those who make executive pay decisions than the economic
elements of firm performance and executive productivity.

How to design an executive compensation plan

Designing an executive compensation plan is a lengthy and complex process that involves
company introspection and data analysis. Here is a step-by-step guide for how to design an
executive compensation plan:
1. Decide who may develop the plan
Many organizational boards create a compensation committee to be in charge of the creation
of executive compensation plans. They may create a budget for the committee and hire
consultants to give non-biased professional opinions. They may also design a long-term plan
for the yearly review and revisal of the executive compensation plan. This can help to ensure
that they may adjust the compensation plans as the financial wellbeing and company goals
shift over time.
2. Collect and analyze market data
A useful first step in the process of creating an executive compensation plan is to acquire
market data. Learn about typical base pay, short-term incentives and long-term incentive
plans for organizations or a comparable size. Data about similar competitor organizations and
their executive plans may be particularly useful. You can also craft studies around CEO
responsibilities and the labor market to determine how easy or challenging be to fill an
executive opening. This can impact how competitive or generous the compensation plan may
need to be.
3. Think about company goals
An executive compensation is a key element of executive motivation. This means that it may
directly impact what those executives achieve, therefore influencing the company
accomplishments. For this reason, it can be useful to think carefully about company goals
when crafting executive composition packages. For example, you can consider long versus
short term financial focus or specific monetary goals to help guide the creation of the
compensation plan.
It may be useful to remember that an executive package that contains a large salary and few
performance-based incentives may be more likely to produce executives who defend the
status quo. A package with a smaller salary and larger performance-based incentives may
produce executives who want to push the company forwards at all costs. This means that one
goal to consider is the desire to innovate and expand versus the desire to maintain a steady
existence.
4. Develop a plan and revise
Once you collect all the data and set your goals, the compensation committee may create an
initial proposal for the executive compensation plan. They may then give their proposal to the
board, the executive in question or an outside consultant for review. The process of
developing or revising an executive compensation package may take months. It may involve
multiple rounds of planning, revisal and negotiation with executives. Therefore, it may be
useful to plan for a lengthy creation and rollout process.
FIXED AND VARIABLE PAY
What is Fixed Pay?
Fixed pay is the in-hand salary that an employee gets at the end of the month. This includes
basic pay, conveyance allowance, house rent allowance,

What is Variable Pay?

Variable pay is a kind of performance-based incentive that is paid to an employee on a
quarterly or annual basis. 

Features of Fixed Pay:-

 It is a fixed amount that an employee would receive regardless of their performance.

 The only scenario where an employee does not receive his fixed pay is if they have
taken unpaid leaves or has done some sort of damage to the company (broken any
appliance or lead to some sort of loss for the company).
 This amount is guaranteed for the employee and gives them a sense of security that
they will be earning this much at least.
 Fixed pay at times can lead to demotivated employees. Under fixed pay, both good
performers and bad performers are paid their base salary.
 This leads to good performers not wanting to put in extra work as they are not
rewarded for it. 
 In the same way, bad performers are not going to improve their performance because
they are not losing anything.
 The fixed pay system leads to employees looking for higher-payment

Features of Variable Pay:-

 It is an incentive that employees get depending on their performance.

 This is variable, with the amount directly based on whether or not the employee met
their targets and how much profit they made for the company.
 In India, sales job has the highest variable pay system. Where the ratio of fixed pay to
variable pay is 60:40.
 For non-sale jobs, the ratio of fixed pay to variable pay is 80:20. 
 Variable pay leads to a highly motivated employee, as their performance will directly
lead to their incentive being higher.
 However, variable pay then leads to unhealthy competition. This leads to a toxic work
environment where everyone is trying to sabotage each other. 
 Often, to meet their targets an employee can undertake unfair means.
  For example, in a sales job just to make a sale, the employee can advertise false
information to their customers. This can damage the brand reputation of the company
and also strain their relationship with the customers.
 Variable pay affects employee retention. If the company is not making a profit then
this would affect the variable pay and employees then start looking for other avenues.

Types of Variable Compensation

There are 3 most common forms of variable pay plans that are in use today are mentioned
below:

1. Bonuses

A bonus is a one-time payment to the employee that is not built into his or her pay rate. The
basis of the bonus may be any performance desired by the organization, and the payment
schedule can be designed like that of the standard hour or measured day work. Some
organizations have adapted their merit pay plan to a bonus plan. The base pay of all
employees stays the same or increases by a cost-of-living factor. Then the results of the merit
pay plan are converted into bonuses that are distributed in various ways, from a lump sum to
add to each paycheck. The point, however, is that the bonus is just for the current period and
not built into the base pay. 

Besides performance bonuses, there are other types of bonuses that are used by the
organizations: Hiring Bonus, Referral Bonus, Spot Bonus, Retention Bonus, Discretionary
Bonus, Spot Bonuses, and more.

2. Gain Sharing

This approach rewards outcomes that are direct measures of the success of the organization as
opposed to the success of an individual employee. A gain-sharing plan is a popular type of
organization-wide variable pay plan. The purpose of gainsharing is to tie the employee to the
performance measures. Although clear performance-reward connections can be made in these
circumstances, it is difficult to make a performance-effort connection.

3. Profit Sharing
A further option for tying employees to the economic success of the organization is by
granting them a share of the profits of the organization. This type of incentive is useful only
in a profit-based organization. Profit-sharing may be the oldest form of an organization-wide
variable pay plan. They were installed to deal with employee’s grievances over low salaries
and to combat the feelings that organizations made huge profits but paid workers very little of
the gains. Later the idea of aligning worker and management goals appeared. 

Sales Compensation Plan – 

A sale compensation plan refers to the determination of the right compensation schemes and
application of it to the sales force to bring a balance between compensation and the sales
force performance. The basic purpose of the plan is to establish an equitable and fair
distribution of salaries or wages, and other incentives amongst working personnel in a way
that maintains equity between proportionate performance contribution of an employee and
compensation received. 
 Methods of SCP
Basically, the remuneration that is given to salesmen is justified on two factors, viz. – (1) the
amount of sales made and (2) the amount of time spent on this job of selling. Based on these
two factors, different plans are designed. There are three fundamental methods of sales
compensation plan  (1) Straight-salary method, (2) Straight-commission method, (3) Mixed
method. Apart from these three, we have two more incentive plans, viz. – (1) Bonus and (2)
Profit-sharing.

1.Straight Salary Method:

This method is based on the time-spent on the job. Under this method, salesman is paid a
predetermined amount by way of his salary at the close of every month. Salary paid to him is
irrespective of sales performance during the month.

2.Straight-Commission Method:
The salesman is paid on the basis of performance of a job. Productivity is given top priority
than the time consumed. Commission is the remuneration worked out as a percentage of sales
volume. The percentage of commission varies from concern to concern, and case to case. It
may be differential rate, i.e., a lower percentage up to the standard work and higher
percentage over and above the standard performance in terms of value or volume as accepted.

.3. Mixed Method (Combination of Salary and Commission Methods):

The fundamental objective of the use of combination of salary and commission scheme is to
do away with limitations of both straight-salary and straight-commission methods, while
retaining the chief advantages of each of the two methods. Under this method, each salesman
is guaranteed a minimum salary at the end of each month. Over and above the guaranteed
amount, he receives certain commission on his sales. Thus, a salesman has the security of
income to the extent of the guaranteed amount of monthly payment.

Steps in developing a compensation plan

Step # 1. Review Job Description:
Analysing job description is the starting point of developing a compensation plan. Careful
analysis of the features of job description helps a company decide the pay level of the
salespeople holding the job title mentioned in the job description. A job description gives a
clear picture of the characteristics of the primary and secondary job responsibilities.
The company should decide the compensation level for the salespeople considering the
importance and volume of the jobs listed in the job description.
Step # 2. Establish Compensation Objectives:
The basic objective of compensation is to bring equity in the apportionment of remunerations
amongst salespeople. Compensation objectives are, in fact, the outcomes of the sales
compensation plans. Objectives need to be categorically stated to make the compensation
scheme comprehensible to both the salespeople and the management. While setting
compensation objectives, the company should include the provisions for experience, skill,
merit, seniority, etc
Step # 3. Establish Compensation Levels:
Establishing the compensation level is the third step in the compensation plan. The objective
of this is to establish a right compensation level for a group of salespeople belonging to a
common rank. Rank and compensation level, therefore, have a strong association. The
management should be careful to fix an appropriate compensation level for senior and junior
salespeople, sales trainees and salespeople, sales executives and sales representatives, etc.
But at the same time, one should also review the plan so that a wide discrimination, between
the seniors and the juniors, does not intrude the compensation plan.
Step # 4. Methods of Compensation:
Direct compensation is a major part of the compensation plan.
A company can choose from the following compensation plans to match compensation levels
for salespeople:
i. Straight salary.
ii. Straight commission.
Step # 5. Deciding Indirect Monetary Compensation:
The indirect monetary compensation is a monetary reward that is not direct such as -salary or
commission. It includes retirement pension, gratuity, payment from insurance plans (e.g.,
medical insurance, group life insurance, disability compensations, thrift savings plan, paid
holiday, paid vacations).
Step # 6 Implementation of the Plan:

Here, the crucial decision that the company has to take is whether it will implement it for all
salespeople such as – executives, juniors, seniors, trainees, commission agents, etc. or for a
selected group as a test case. The company takes a decision to implement it for salespeople
working in two/three territories and if successful makes it operational for all salespeople.
Once introduced, it must continue for a long term and effectively use contingency plans in
case of urgency.
International Compensation management 

International Compensation management can be defined as the provisions of monetary

and non-monetary rewards, including base salary, benefits, perquisites, long and short-term
incentives, valued by employees following their relative contributions to MNC performance.
Its broad HRM purpose is to attract, retain and motivate the personnel required throughout
the MNC currently and in the future. Job evaluation is how internal relatives and
compensable factors, those elements an individual’s work role in the MNC and contribute to
its performance are determined.

Components of International compensation

1. Base salary:
For expatriates, the term base salary means the primary component of a package of
allowances which are:

(a) Foreign service premium,

(b) Cost-of-living allowance,

(c) Housing and utility allowance,

(d) Basis for in-service benefits and pension contributions.

Base salary may be paid in home or local currency or in some hard currency like pound or
dollar.

2. Foreign Service inducement/hardship premium:

Parent-country nationals often receive a salary premium as an inducement to accept a foreign
assignment or as compensation for any hardship caused by the transfer. Such payments vary
depending upon the assignment, actual hardship, tax paid to foreign governments and length
of the assignment.

3. Allowances:
Various allowances are paid to expatriates depending upon the assignment. They include:

(a) The cost-of-living allowance (COLA):

It involves a payment to compensate the differences in expenditures between the home
country and the foreign country.

(b) Housing allowance:

Implies that employees should be entitled to maintain their home-country living standards
(or, in some cases, receive accommodations)

(c) Home leaves and travel allowances:

Is given to cover the expense of trips (usually once in a year) back home. These trips allow
the expatriates the opportunity to renew family and business ties, thereby helping them to
avoid adjustment problems when they are repatriated.

4. Education Allowances for Children:

Education allowances are given towards fees for the education of expatriates’ children.
Education allowances include items such as tuition, language class tuition, books,
transportation and uniforms.

5. Relocation Allowances and Moving:

Relocation allowances usually cover moving, shipping; temporary living expenses, and down
payments or lease-related charges.

6. Tax Equalisation Payments:

Many international compensation plans attempt to protect the expatriate from negative tax
consequences by using a tax equalisation plan. Under this plan, the company adjusts an
employee’s base income so that the expatriates will not pay any more or less tax than if they
had stayed in the home country.
7. Spouse Assistance:
To help guard against or offset income lost by an expatriate’s spouse as a result of relocating
abroad. Multinationals generally pay allowances in order to encourage employees to take up
international assignments.

Importance of International Compensations

1. Attracting and Retaining Personnel: Most to attract and retain staff in the areas
where the multinational has the greatest needs and opportunities, hence must be
competitive and recognize factors such as the incentive for Foreign Services, tax
equalization, and reimbursement for reasonable costs.
2. Optimizing Cost of Compensation: It is to facilitate the transfer of international
employees in the most cost-effective manner for the firm. Compensation management
aims at optimizing the cost of compensation by establishing some kind of linkage
with performance and compensation. A higher level of wages and salaries doesn’t
need to bring higher performance automatically but depends on the kind of linkage
that is established between performance and wages and salaries.
3. Consistency in Compensation: It means to be consistent with the overall strategy,
structure, and business needs of the multinational. Compensation management tries to
achieve consistency-both internal and external – in compensating employees. Internal
consistency involves payment of the basis of the criticality of jobs and employees’
performance on jobs. Thus higher compensation is attached to higher-level jobs.
Similarly, higher compensation is attached to higher performers in the same job.
External consistency involves similar compensation for a job in all organizations.
Though there are many factors involved in the determination of wage and salary
structure for a job in an organization which may result in some kind of disparity in the
compensation of a particular job as compared to other organizations, compensation
management tries to reduce this disparity.
4. Motivating Personnel: Compensation management aims at motivating personnel for
higher productivity. Monetary compensation has its limitations in motivating people
for superior performance.