Governance Best Practices

How to Create a CEO Compensation Package

Good governance and well-established policies that align closely with the corporation’s overall goals and objectives lay the groundwork for a sound executive compensation program. Most Americans believe that CEOs are grossly overpaid, according to the 2016 Public Perception Survey on CEO Compensation. About 74% of the survey respondents said that they felt CEO compensation was out of proportion as compared with compensation for average workers.

The public may have misperceptions on CEO pay because they may not be considering that the bulk of a CEO’s pay is contingent on their performance. CEOs usually get an annual salary along with performance rewards based on other parameters, such as company performance, company growth and shareholder value.

Components of a CEO Compensation Package

There are six basic components of a CEO compensation package — base salary, short-term incentives, long-term incentives, employee benefits, perquisites and severance. Here’s a brief description of each of them:

Base Salary

Base salaries for CEOs vary substantially, depending on the type of industry, the CEO’s years of experience and other factors. Typically, boards of directors will form an executive compensation committee that sets a base annual salary to be paid monthly or biweekly.

The 1993 federal tax law limits the amount that companies can deduct for cash compensation for tax purposes to $1 million. The law holds an exception for certain performance-based compensation, which was repealed under the 2017 Tax Cuts and Jobs Act. Currently, companies must cap compensation for base salaries to $1 million for the CEO, the CFO and the three other highest-paid executives, whether it’s performance-based or not. The cap also applies to payments that executives receive after they retire or terminate their employment.

Short-Term Incentives

As part of strategic planning, board directors set a number of short-term goals for CEOs to achieve. The intent of the base salary is to compensate CEOs for achieving their short-term business goals. Boards set their goals based on many different factors, depending on the type of business and other conditions. Some examples of short-term goals for CEOs include: increasing revenue or profit margins, increasing market share and expanding to new markets. Boards may also set goals for operations, such as implementing a new corporate strategy, developing new products or meeting critical project deadlines.

Most boards pay their CEOs the base salary in cash. The base salary may have a two-tier structure with a certain payout for the normal expected performance. As an incentive for CEOs to achieve extraordinary results, boards may also add a “stretch component” that rewards CEOs for superior results. The bar for stretch rewards is typically fairly high, so it’s usually challenging for CEOs to meet the threshold.

Long-Term Incentives

Long-term incentives comprise the largest part of CEO compensation plans. As indicated by the name, long-term incentives are rewards for CEO performance over a three- to five-year period. Compensation committees often set up long-term incentives with target and stretch incentives just like with short-term incentives.

Long-term incentives provide the most shareholder value, which is why companies are increasingly compensating their executives according to their performance. The Hay Group says that 31% of the total direct CEO compensation is based on performance, which is up 6% since 2009. Boards usually structure long-term incentives so that they’re paid out in some form of stock-based compensation, such as stocks, stock options, restricted stock or performance-vested stock.

Most boards structure their long-term incentives based on total returns to shareholders, earnings per share, return on assets or similar benchmarks. CEOs usually receive compensation for long-term incentives at the end of their stated performance periods.

Employee Benefits

Employee benefits for CEOs are usually somewhat similar to those of other salaried employees within the company. CEOs can expect such benefits as Social Security, Medicare, workers’ compensation, unemployment insurance, paid vacation, paid holidays, and additional time off for sick pay or personal sabbaticals. In addition, companies may offer CEOs programs for health insurance, life insurance and special retirement plans. Special retirement plans may not be subject to protective federal tax and pension rules, which places those funds at risk if the company goes bankrupt.

Perquisites

The word “perks” stems from the word “perquisites,” which refers to additional compensation for executives that isn’t available to other salaried employees. Perquisites are designed to compensate executives for extra demands on their time. Perks may come in the form of hired drivers or the use of private planes. Other benefits may include special parking privileges, communications systems in their homes, and security for executives at home or at work.

Severance Packages

Severance packages provide CEOs with payments in the event of voluntary or involuntary termination. Severance pay can be instrumental in recruiting and retaining CEOs.

Nominating and governance committees may use severance packages as incentives in recruiting talented CEOs. Severance pay is a benefit that may entice a CEO candidate who’s on the fence about leaving a long-time employer in fear that the move might not pan out.

CEOs have a fiduciary duty to put the best interests of the company before their own interests. While this is a well-known concept called the Duty of Care, the notion becomes challenging when a merger or acquisition is on the horizon that might put the CEO’s job in jeopardy as a new administration takes over. Some benefits packages include a change-in-control agreement, which is also commonly called a golden parachute. This provision compensates executives if they should lose their jobs due to a merger or acquisition in which the purchasing company replaces them with their own leaders. Golden parachutes allow CEOs to continue working for the good of the company without worrying about losing their main source of income.

Digital Tools Assist Boards in Evaluating CEO Performance

Since the financial crisis of 2008, shareholders have been quite vocal about their expectations for boards to align CEO performance with pay. Executive compensation plans are complex and have multiple components. Board portals are a valuable tool for tracking short- and long-term progress against goals and objectives. Diligent Boards incorporates Governance Cloud, a suite of digital tools for boards that support board applications, such as board self-evaluations, to helps board evaluate CEO performance against their achievements.

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