Does executive compensation today create the best win-win scenario for both employers and employees?

Every day at MBS we are honoured to meet with many diverse candidates, each with a unique narrative, set of achievements and ambitions for the future. However, one area of surprising commonality in our conversations with candidates is in their attitude to their overall compensation package – and how they value the different aspects of executive pay.

Most companies and their remuneration consultants view remuneration as simply a logical measure of “total compensation” – i.e. the sum of base salary, short-term bonuses, LTIPs, pension, car allowances etc. However, as headhunters it is clear to us that candidates often don’t have this logical, unemotive view of pay. Rather, candidates ascribe a different weighting to each aspect of compensation, valuing certain aspects of their package more highly than others.

So, what do candidates really value – and why? For us, it is clear that candidates prioritise two aspects of compensation: base salary, as well as longer-term “life changing” wealth creation opportunities.

Unsurprisingly, above all else, candidates often place disproportionate value on their base salary. For example, in the John Lewis Partnership, executives have significantly higher pay than their peer group – yet have much lower total potential compensation, primarily because there is no LTIP and the annual bonus is the same across the Partnership (which last year paid out at 6% for all ‘partners’). The philosophy here is great: on bonus, everyone in the partnership is rewarded equally, proportionate to their base earnings, for the collective success of the business.

To attract and retain the right senior executives, John Lewis is therefore paying higher base salaries than many of its competitors – yet has a much lower cost of total annual compensation (even when you take into account a very generous pension scheme). This model of paying a higher base with lower variable costs John Lewis considerably less overall on a cash basis – and it works! John Lewis has been able to attract and retain some phenomenally talented senior leaders over many years. Aldi and Lidl, both newer to the UK, adopt similar base-heavy compensation strategies and likewise, are succeeding in attracting and retaining some of the best retailers.

Other candidates attribute most value to elements of their package that have the potential to create significant wealth, such as within a private equity management deal or through an equity grant in an emerging tech company. In such a scenario candidates are wholly aligned to the corporate goal, with real clarity of singular and team mission – and a clear sense that their personal actions will lead to the end-prize. That being said, candidates know there is never any guarantee of “wealth creation”. However, even with this uncertainly, they are often willing to back themselves to achieve the wealth-creation event – including sacrificing elements of their compensation (not least base pay) to be a part of the deal. The potential of a significant prize, and the related tax benefits, for certain candidates often trumps other elements of pay.

On the flip-side, we at MBS are often surprised by how little value candidates anecdotally appear to place on other variable aspects of their package. No more so than with bonuses and LTIPs, which on the surface makes little sense given that the upside potential can be substantial (sometimes up to 200% of base pay for both bonuses and LTIPs).

This is where the psychology of pay comes in again, and it is interesting to analyse why candidates appear to ascribe less value to bonuses. To me, there are three key drivers. Firstly, within consumer industries over the last 10 years, bonuses and LTIPs have not consistently paid out – indeed in some businesses a significant pay-out has certainly been the exception rather than the rule. Candidates therefore have a healthy dose of scepticism about all aspects of variable pay. Secondly, more often than not, a significant element of a bonus or LTIP pay-out relates to overall company performance – not individual or individual business unit. Whilst having bonuses based on overall company performance is certainly the right metric for the main board, divisional CEOs and divisional boards, particularly in a large global business, feel somewhat disempowered to significantly change the dial on their bonus potential. Thirdly, the criteria of bonus schemes change somewhat regularly and therefore it is hard to establish a record of historic pay-outs, and consequently predict future streams.

Lastly, I am continually surprised by how little value UK candidates place on company contribution to their pension. Candidates rarely mention their pension when describing their overall package to me and when prompted, many candidates can’t remember the actual contribution their company makes. Before the recent caps on pensions were imposed, company contributions could be significant – varying wildly from 1% all the way through to 25% of base (and in some cases, even final salary schemes) – and therefore it is somewhat surprising that candidates don’t consider their pension to be a hugely material aspect of compensation. Of course, many executives within our sectors have now maxed out on their lifetime pension contributions. For the others, the short-term elements of pay seem to be prioritised over longer-term aspects.

The psychology of executive compensation is of interest to us all here at The MBS Group as we strive to achieve the best possible outcomes for both clients and candidates. If nothing else, understanding how candidates think about their package is an important first step for companies in building strong and lasting relationships with new employees.

Our observation is that just possibly, businesses are spending more than they need to on total compensation – without necessarily aligning the reward-mix to optimise both performance and longevity of employment. Indeed, Professor Alexander Pepper at the London School of Economics found in his 2015 book The Economic Psychology of Incentives – New Design Principles for Executive Pay that a majority of executives prefer “a clear pay package” that they can understand and control, as opposed to a more ambiguous package offering potentially higher rewards.

Given the scrutiny executive compensation is under at plc AGMs on a weekly basis at the moment, we suspect that change may well be in the offing that will affect the balance, composition – and possibly total quantum – of overall pay packages. Taking a fresh look at the make-up of the executive compensation proposition might be both timely and effective. | @TheMBSGroup | The MBS Group