Granting what's at stake, each compensation committee has to approach the executive compensation package design with utmost care. This is especially so since according to the 2021-2022 FW Cook report executive pay generally hits astronomical levels, yet it's quite differentiated across the globe.

The United States leads the way with the highest median total compensation packages that average around $17.7 mln a year, while for the rest of the world numbers are significantly lower. The median for Europe and Australia oscillates around $6.8 mln; Canada, the UK, and Hong Kong at $8 mln, while most Asian countries trail behind - Japan at $2.9 mln and China only $109 000.

Nevertheless, those are powerful numbers that not only affect the companies' budgets and relations with shareholders but often attract the media attention and stir the emotions of the general public. Therefore, the choice of particular elements is critical, with each carefully weighed against the pros and cons, well thought out in the context of the firm's strategic objectives, and most importantly transparent and clearly communicated to the stakeholders and the general public alike.

In this step-by-step guide, I cover the types and elements of a typical executive compensation plan as well as considerations associated with the design itself.

What is an executive compensation package?

An executive package is the total compensation a C-suite member receives for their work.

Most executive compensation plans are a combination of:

• annual base salary,
• short-term bonuses,
• long-term incentive plans usually tied to performance,
• and benefits, including: health, retirement, and special executive perks.

The overall goal of many executive compensation packages is to motivate the people in the top management positions to make choices that will benefit the company in the long run.

This is done through the selection of incentives tied to the achievement of particular targets, and making them the largest components of the executive pay. In fact, performance-based incentives in form of annual bonuses and LTIs comprise 92% of the total direct compensation of an American CEO. For his Asian and European colleagues the numbers are only slightly lower - 77% and 70% respectively.

Tying executive pay to a company's success is a worldwide trend. Learn more about current developments in human resources field in 2022 HR Trends article.

Compensation committee

Most company boards designate an executive compensation committee that is responsible for the design, creation, and supervision of the whole process associated with the executive compensation plan. Typically the members come from different departments within the organization itself (tax, legal, accounting, etc.), although many companies also hire outside consultants and proxy advisory firms to help out in the process.

What elements should you consider in the executive compensation package?

The factors that determine choices for the executive compensation plans depend on a number of aspects the compensation committee should take into consideration.

First, at the most basic level, the packages vary with respect to the size of the company, region, and corporate culture.

Next, you should consider the firm's strategic goals. Most publicly traded companies aim to align the stakeholder's interests with those of shareholders. Then, it's important to ask:

• In what stage of the business lifecycle is the company currently?
• Is it going through a transformation or turnaround?
• Is it a private company that wants to compete with public entities?
• What are the main goals: profits improvement, revenue growth, or maybe a change in the ownership structure, talent retention, or corporate governance?

Below I describe 6 basic components of the executive compensation plans that critically affect the recipient's actions.

Types of executive compensation:

1. Fixed vs variable pay

Every executive compensation plan consists of a fixed base salary that is paid in cash every month as well as bonuses, rewards, and short and long-term incentives known as variable pay, granted upon the achievement of preset targets. The ratio of variable to base pay varies depending on the region, market cap, and industry.

And so, American CEO compensation tends to be largely based on variable pay, with base salary accounting for only 8% of the total remuneration, while their Asian and European colleagues receive respectively 23%, and 30% fixed cash compensation. An extreme case in point here is Tesla, where Elon Musk's base salary in 2018 amounted to $56 380, while his performance-based option grant totaled $2 283 988 504. This means that 99,9975% of his total direct compensation came in form of variable pay.

For other senior executives such as CFO, CTO, and COO, etc., the proportions are similar, with the fixed pay slightly higher than for the CEOs. With respect to market cap, the tendency is for the smaller companies to grant a smaller amount in form of the variable compensation with 69% of the total direct pay, compared to the large-cap firms, where the variable pay amounts to 87%. The fixed and variable components also vary slightly according to the sector. Utilities, finance, and materials tend to grant a larger base salary compared to IT, energy, and real estate.

2. Short-term incentives vs long-term incentive compensation

Short and long-term incentives are another basic element of executive compensation plans. Short-term incentives are generally paid out as cash the same year the recipient hits the targets.

Long-term incentives are granted in form of long-term incentive plans (LTIPs). Typically long-term incentives are deferred for an average period of 3 to 5 years (vesting period) once the goals are achieved. The long-term compensation is usually paid out as equity in form of stocks, stock options, or performance shares. Companies that want to emphasize long-term profitable growth tend to reward executives with larger long-term incentive compensation. Those trying to effect fast change, for example, the ones experiencing transformation, grant more annual bonuses and short-term incentives in cash.

According to FW Cook report C-suite receives 28% of their variable pay in the first year it's granted, and the rest in the future. Yet again, much depends on the sector as well. Financials offer 60% of the variable compensation as a long-term incentive, while for Health Care and IT LTIs comprise as much as 82% of the variable pay.

3. Cash vs equity

The third dimension a compensation committee has to consider is the form of a payout. The options generally are cash or some form of company stock. These include actual shares as stock plans such as employee stock ownership plan (ESOP), employee stock purchase plan (ESPP), restricted stock (RSUs), and stock options such as incentive stock options plan (ISOP). Some organizations also choose to grant phantom shares, which track the price of the company stock and pay the award in cash based on the price readings. A study by Boris Groysberg et al. found that 59% of executive packages are equity compensation and 41% cash. The ratios also depend on the sector, market cap, maturity, and company strategy.

Young companies such as start-ups tend to attract talent by granting generous amounts of equity. Similarly, companies with large market caps reward the executive team with more equity compensation. And again, IT, Telecommunications, and Health Care also favor the payouts in stock ownership. For example, at United Health Group the CEO Andrew Witty's total remuneration is 24% cash.

4. Group vs individual rewards

Other key elements in compensation design are whether you reward the group or individual performance. The average pay package comes in at 29% for individual executives' performance and 71% for groups.

Yet, this very much depends on the company culture. The product-oriented businesses commonly focused on manufacturing, or coming from Industrials, Technology, Consumer - Staples, and Discretionary - sectors prefer group rewards based on company performance.

On the other hand, competitive companies that favor individual performance and achievement endow individual rewards. In service-driven firms such as consulting, law, real, estate, and investment banking, where employees are able to influence the results, most of the awards are based on individual performance targets.

5. Financial vs non-financial performance metrics

All the packages meant to drive performance have to be based on some form of metrics. The right choice of those performance metrics is a critical decision for compensation committees.

Currently, all CEO compensation plans use some form of financial metrics, but non-financial ones have been steadily gaining popularity and nowadays occur in 70% of the packages.

Financial metrics

According to FW Cook, 73% of public companies use at least two metrics. Depending on company goals and sector these can vary widely. Most commonly used is the total shareholder return (TSR), found in most companies' plans, followed by profits, and, revenue.

For example, 100% of companies in Utilities and 90% in Energy use TSR for long-term incentives metrics, while 81% of Consumer Staples base their targets on profit. On the other hand, none of the organizations in Energy, Materials, and Utilities rely on revenue. Consumer Staples and Industrials are the only sectors where at least one-third of the companies use cash flow as one of the metrics.

ESG and other non-financial metrics

Non-financial metrics can take many forms, yet as of now they appear in 64% of the executive compensation plans as environmental, social, and governance (ESG) goals. ESG metrics are most prevalent among the Energy (100%) and Utilities (92%) companies. Most of those organizations use some form of environment and sustainability, and health and safety metic.

On the other hand, sectors that most sparingly rely on ESG metrics are Consumer Discretionary, IT (each 54%), and Communication Services and Industrials (each 50%).

The most popular across all sectors are human capital and culture at 45%, and diversity and inclusion at 43%, which saw the biggest year-to-year increase in prevalence. Non-financial performance metrics don't necessarily have to imply ESG. These can also come in form of individual objectives such as succession planning or hitting a certain number of acquisitions over the year.

6. External competitiveness vs internal equity

This is not an actual element of a compensation package, but an important factor to consider. In order to make an appropriate salary proposition, the compensation committee has to base their suggestions on the available data.

External Benchmarking

Benchmarking against other companies is a must to stay competitive and retain key employees. You need to know how the executive compensation at your company compares to other comparable firms on the market. Geographical location, sector, size of the company, and the stage in the business lifecycle will help you determine the right peer group to benchmark against.

Managing the internal equity

Similarly, it's crucial to conduct an internal salary review as well. Making sure that the C-suite is paid fairly according to their grade, seniority, and type of work done helps to build a positive corporate culture and achieve the company goals. This does not mean that the compensation packages have to be equal. Certain functions in a given company's situation may be more important than others.

For example, if a young private company is in a process of developing a line of products or services crucial to the future success of the organization, it may be worth hiring an experienced top-talent CTO and offering them compensation comparable to those granted in the public companies, much higher than other executives at that company. In this way, the compensation committee can use the remuneration budget to achieve goals and steer the organization's development in a particular direction.

Regional Differentiation in Compensation Packages

Executive compensation plans vary according to the region. Overall pay levels in the United States are much higher compared to other areas, yet this is not due to base pay that is generally lower compared to Europe and Australia, but to the size of performance-based long-term incentive compensation packages.

In Europe and Australia, the base salary and annual incentives are typically on par with those in the Americas, and higher than in other regions. The average total executive compensation plan is significantly lower than in the US, however, due to the more modest LTI grants.

Asian executives' total compensation package is significantly lower than those in other areas, with the exception of Hong-Kong, whose total direct compensation is on par or higher than that of other highly paid executives in Canada, UK, EU, and Australia.

The more humble compensation for Asian executives is largely due to many of the Chinese companies being state-owned. The state-owned businesses adhere to strict pay regulations and generally don't provide any long-term incentives. And those few that actually do, typically offer them as stock options.

Retirement Executive Compensation Packages

Another major element of the compensation package is the executive retirement plan. Upon retiring from the company executives receive retirement benefits. These customarily include:

• standard 401(k) in case of the US or other qualified plans elsewhere,
• health insurance,
• and possibly a Supplemental Executive Retirement Plan (SERP).

SERP is an additional plan available to key executives. Companies offer it primarily to attract and incentivize their top managers, since as a non-qualified plan, SERP does not require IRS approval and needs to be only minimally reported.

One of the caveats to watch out for in the executive retirement plans are so-called golden parachutes - lucrative severance payments compensating the executive upon termination regardless of the company's results. Such payments are often the cause of unwanted media attention and public outrage, therefore the compensation committee should take utmost care to make sure all the decisions are transparent and backed by impartial data.

Executive perks and fringe benefits

In addition to standard retirement plans, health insurance, and employee benefits, top executives receive also a number of perks unavailable to other employees. These may include access to a private jet, club memberships, travel reimbursements, and even outrageous fringe benefits such as subsidized birthday parties.

Smaller organizations and businesses operating on the brink of revenue margins, with low savings, should particularly watch out for such gratuities since these may actually cause deficits and drive the company down. Not to mention that they easily ruin the image of any firm.

In fact, in light of many controversies stirred by the excessive executive perks and flamboyant lifestyle of some CEOs more and more firms resign entirely from offering any fringe benefits.

Adapting executive compensation to current market conditions

As we have slowly started to shake off the Covid-19 -related crisis, now the specter of a recession looms on the horizon. With the war in the Ukraine, broken supply chains, the disintegration of a global network, rising energy prices, and overall inflation, the outlook is bleak. S&P 500, Nasdaq, Dow Jones, and pretty much all the indices worldwide have been falling continuously for the last 6 months.

It is hard to imagine, therefore, that all of the targets set out in the incentive plans couple years ago are attainable. Granting the current economic environment and state of the market, most of the financial goals may not be achievable, rendering many of the executive compensation plans ineffective.

In light of this, companies need to reconsider their assumptions and explore a possible range of moves. Some may need to change absolute metrics to relative, others may have to reexamine the peer groups, revise annual incentive goals, adjust the payout curve, or change payouts based on performance shares to cash.

The bottom line is that the executive compensation plan plays a significant role in every company's growth and future success. Carefully designed compensation package, periodically reevaluated and adjusted to current market conditions, will inevitably lead to the achievement of strategic objectives leading to prosperity.

Check out my analysis of the actual executive compensation packages at the top publicly traded companies.