After nearly three decades of advising companies on executive pay issues, I have seen an evolution of compensation design. When I began consulting in the mid-1990s, the typical executive pay package included base salary, annual incentives and a grant of plain-vanilla stock options. The technology industry, the strength of the dot-com stock market, and the lack of accounting expenses on option grants all had a direct influence on the attraction of options.
After the dot-com bubble burst and options attracted accounting expenses, companies began to experiment with executive pay packages and incentive plan designs. We saw companies introduce discounted options, indexed options, truncating options, reload options, career shares, market-leveraged stock units and many other incentive designs.
That era of invention and innovation ended relatively quickly, and in the past 20 or so years many companies have settled into a third modern era of pay design that is largely characterized by pay design monotony and a considerable reduction in pay design variety. This has largely been driven by a fear of straying too far from “market practice.”
With the widespread influence of proxy advisors, a concentration of share ownership among large institutional investors and the adoption of required say-on-pay votes, many executive teams and board members are rightly concerned with ensuring that their pay practices are approved by increasingly powerful and involved stakeholders.
When innovative practices are properly applied, they are crafted to fit the organization’s exact needs and circumstances. This means that different practices are not always necessary; if typical pay practices and pay levels perfectly fit the organization’s needs, then nothing unusual or extraordinary is needed.
However, after working with hundreds of companies in my career, I have found few – if any – that will say they are perfectly typical and have all the same problems, good fortunes, obstacles and advantages as their peers.
In effect, we see the application of creativity and innovation in pay practices borne from a desire to move from “market practice” and even beyond “best practice” on to “best fit,” which refers to the optimal solution to address a specific problem or accomplish a set of objectives. The best fit solution maximizes the return on investment for that specific problem or set of objectives. On a plot of market practices, the best fit solution often cannot be plotted (Figure 1).
Note: “Best fit” is the optimal solution for a specific case, maximizing ROI for that single case. Best fit practices cannot be plotted in this type of graph because they are unique.
When best practice is used as a copy-paste solution, through repetition it becomes market practice which, by definition, is not as good as best practice. This happens because the competitive environment and associated challenges change over time and new, innovative solutions appear that can eventually define best practice.
As best practice becomes common and becomes market practice, it becomes an unfit or suboptimal solution for most companies. This forces development and innovation of new ideas and practices – and creation of new best fit practices. Through refinement and adaptation into more organizations, these best fit practices then become recognized as best practice and the process continues (Figure 2).
In this process of developing a best fit solution, companies should neither adopt nor avoid unusual features simply because they are unusual. A carefully designed and customized plan that addresses the organization’s particular circumstances, business strategy and HR objectives is still a best fit solution regardless of what it looks like. The process – not the result – determines if the design is a best fit solution.
Despite the reluctance of many organizations to adopt innovative best fit solutions, there are many examples of creative plan designs in the marketplace. These include offering only base salary and stock options with no short-term incentives (STIs) (Netflix), setting significantly wider performance ranges in incentive plans (Spectrum Brands), offering a choice of pay devices (Iron Mountain, Tapestry, Netflix) and the granting of career shares (Lear).
When applied properly, unique pay practices do not result in negative stakeholder reactions. For instance, the most recent say-on-pay resolutions for the five aforementioned companies were approved by 92% of shareholders, on average (Table 1).
| Approach | Other objectives and/or considerations | Examples | Most recent say on pay approval |
|---|---|---|---|
| Replace STI entirely with additional LTI |
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| Career shares that vest upon retirement |
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| Widen payout ranges (e.g., threshold payout at zero) |
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| Employee choice: cash vs. shares, fixed vs. variable, stock options vs. restricted stock units |
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Most people are familiar with the concept of brainstorming to generate new ideas and concepts. However, you can take a more disciplined approach to ensuring innovation is regularly embedded in your organization’s reward and HR programs. Table 2 describes a more formal process for discovering best fit solutions.
| Saturation |
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| Incubation |
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| Insight/evaluation |
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| Verification |
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Based on the article “How to think creatively” by Tony Schwartz, Harvard Business Review.
Within the overall process, the saturation stage may be the most important, as the success of the innovation process requires both a clear definition of the problem or opportunity as well as a deep understanding of all related aspects.
Within the context of rewards, the innovation process requires full knowledge of the organization, including its:
The process also requires an understanding of the dynamics of the relevant labor market, where talent is sourced, where it is lost and what motivates it. Finally, it requires expertise in rewards programs and incentive design including the universe of possible solutions and all related advantages and disadvantages (e.g., plan outcomes in both expected and unlikely conditions, accounting treatment, share use, perceived value, administrative complexity, tax ramifications) as well as relevant factors such as the regulatory environment and likely stakeholder reactions.
When thinking about introducing innovation and creativity into your executive incentive programs, there are a few key tips to remember:
Ensure that the business and HR strategies and lifecycle stage – not market practice – drive the performance framework.
Let your performance framework determine incentive pay delivery, not the other way around.
Avoid tinkering. Allow your program design to work as intended.
Revisit and level-set your framework annually.
When an expansive body of knowledge and experience is applied to a problem definition, we can – and should – move beyond market practice and even best practice. Instead, compensation leaders should generate truly innovative solutions that represent the best fit for the organization and its unique strategy, lifecycle stage, culture and objectives. Thankfully, evidence supports the idea that when we generate best fit solutions, we have permission from stakeholders to adopt them.
A version of this article appeared in Workspan on August 15, 2024. All rights reserved, reprinted with permission.
