|
Background. “Internal Equity” has become one of the hottest catch
phrases in executive compensation. More than ever, compensation committees
today are asking about what internal equity is and how to implement it as
part of a well-designed executive pay process. Major organizations such as
PepsiCo, ConocoPhillips, and Kroger among others, have described internal
equity in their proxy statements.
The concept of internal equity has been around for a considerable time.
However, the discussion of internal equity today – which focuses on pay
relationships between executives – has become dangerously oversimplified.
Focusing on pay relationships between executive roles without understanding
how those roles are different can yield information that is not only
meaningless, but potentially dangerous to the health of an executive
compensation program.
External Benchmarking. We all know how quickly the landscape for
executive compensation has changed – and is still changing. Shareholders and
compensation committees have become proactive in challenging the
externally-focused, peer group-driven approach in benchmarking executive
pay. Many have complained that an over-reliance on external market data from
peer group or survey has led to a “ratcheting” effect, where the same group
of comparator organizations benchmark against each other’s pay levels to
find that what was a 75th percentile marketing positioning two or three
years ago is a 50th percentile positioning today.
Market comparisons encourage the lower paid companies to accelerate their
pay increases to meet the market. The result has been an ever-increasing
executive pay structure that compensates based not on the actual demands of
the role or its performance, but rather on a mindset that an organization’s
executives need to be compensated at least at the market median. As a
result, the need for a true internal equity-based approach – one that helps
compensation committees understand the market but be driven by internal
fairness – has never been more apparent.
What is Internal Equity? Current debates and discussions on internal
equity are likely to narrowly define the term as the pay relationships
between different positions at different levels in a single organization.
This approach looks to understand whether executives in that organization
are paid appropriately relative to each other, in addition to the external
market. The concept of internal equity also should examine pay differences
as a function of organization structure, job size, and incumbent
performance. While some may consider internal equity to mean the
relationship of the CEO’s pay to the next level of executive reporting to
the CEO, that view may be overly simplistic.
In managing the concept of internal equity, companies have been encouraged
by some commentators to use “pay multiples” to manage it. This concept has
been promoted by Ed Woolard, former CEO of DuPont, who suggested that the
CEO should be paid at a level that is no more than two times key executives
reporting to the CEO. Building on this questionable approach, some companies
use “pay multiples” (i.e., one position is targeted at roughly “X” times
another position) to manage pay fairness between executives. The use of such
“rules of thumb” ensures that an employer’s pay relationships are linked to
each other, rather than to the external market (which may lead to a greater
– or in some cases smaller – multiple). While the internal fairness of
executive pay is very important, a simplistic approach that does not
consider other relevant factors is misguided.
The Problem with Multiples. The problem with a multiple approach is
that top organization structures are not the same within a peer group and,
as a result, not all executive roles at a given organization level are equal
in value. Some organizations have a narrow span of control, and possibly a
COO is the top position reporting to the CEO. Another organization may
operate as a holding company with group heads reporting to the CEO. Still
others may have a more integrated structure with either vertical or
horizontal integration of business units. In short, not all organizations –
and therefore – not all executive roles – are created equally. Therefore, a
pay multiple that is appropriate for one employer may be entirely
meaningless for another due to differences in structure.
Additionally, an individual executive’s pay is a function of the background
of what the incumbent brought to the job as well as the incumbent’s
sustained performance and potential. A CEO recruited from the outside in a
company that is in a turnaround situation will likely be paid more than an
incumbent in a less troubled organization that has been promoted from
within.
A More Balanced Approach. The answer is to look not only at titles
and the size of the organization, but also at the jobs – how big and complex
they are, and how they impact the organization. In other words, the answer
is to understand the size of each role. In addition, incumbent experience,
performance, and prior compensation history should be considered. Job sizing
allows a more informed snapshot into the internal equity of pay practices.
Simply put, it focuses on the design of each job and essentially looks to
rank (or score) jobs based on their content and complexity.
There are various ways to size jobs. One approach is grounded in the common
sense view that most compensation committees should understand their
executive roles well enough to know which are materially bigger or smaller,
and thus be able to group them into different levels. At the Penicle Group,
we take a more precise approach by applying our proprietary job evaluation
methodology, which “size” each role while examining three factors:
- Knowledge, Experience & Skills – the total of every kind of
knowledge and skill required for acceptable job performance.
- Decision-Making & Problem Resolution – the intensity of the
mental process which employs knowledge to identify, define, and resolve
problems.
- Responsibility for Results - the impact of the position and
the nature of the impact on end results.
In the case of senior executives, Responsibility for Results is likely
the most highly weighted factor, while in the case of lower management
positions, a different weighting is likely appropriate. Using the Penicle
Group’s methodology, the weighting for the CEO position has approximately
half of the total job value in Responsibility for Results, with
Knowledge-Experience-Skills and Decision-Making & Problem Resolution
splitting the remaining half.
However job sizing is done, what results is a ranking (or score) that
represents the size of each role relative to other executive jobs; this
allows us to examine the relationship between their size and their pay. With
this information we can see whether or not the organization’s bigger jobs
are paid more than the smaller jobs, which is a critical test for the
internal equitability of pay practices.
Balancing Market Data and Internal Fairness. Taking an internal
equity approach absolutely doesn’t mean that a company should avoid also
incorporating external benchmarking into the process. However, the market
should be viewed as research and a point of reference, not a mandate on how
a position should precisely be paid. Before making a decision on pay,
market data should be balanced against the internal perspective.
Balancing internal equity with external benchmarking can be done in a myriad
of ways. In its simplest form, compensation committees can consider internal
equity alongside external market competitiveness, balancing the need to pay
executives at a certain level of competitiveness with the need to pay
executives appropriately relative to other roles and incumbent factors. Pay
levels for executives should be a function of:
- organization structure
- incumbent experience and demonstrated performance
- potential – will current pay keep other interested employers at bay?
- succession – can pay for increased responsibility be managed
effectively?
- internal equity – will pay be viewed as fair, all factors
considered?
Summary. However it is done, integrating internal equity into the
compensation benchmarking process will move pay governance forward, as it
adds another important dimension to looking at executive pay. That said,
there is danger in examining internal equity in a vacuum – using only a
blind application of a pay multiple approach – as it can lead to recruitment
and retention issues for some executives, and overpayment for others.
Neither of these outcomes should be acceptable to stakeholders.
For these reasons, it is clear that both the relative size of an
organization’s executive jobs and the “going rate” matter. Using internal
equity in pay decisions forces a company to account for how their executive
roles are unique. Compensation committees that consider internal equity
alongside external competitiveness are able to create an executive
compensation program that balances fairness and competitiveness with what
jobs actually do – and that will help ensure that compensation decisions
aren’t at the mercy of the market but make sense, all factors considered.
|
