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3Q | 2014

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Anil Agarwal I American Express

Todd Allen, CCP, SPHR I Wells Fargo Insurance Services

Barbara Anderson, CCP I Wal-Mart Stores Inc

Jacqueline Barry, CCP I The Warranty Group

Jean Bayuk, CCP, GPHR I Elliott Co.

Deborah Beany I ROI Consulting

William A. Blagmon I GlaxoSmithKline

Gayle Brocksmith I The Sports Authority

Richard Burtner, CCP I American Express

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Leah Davis, CCP, SPHR I The Guardian Life Insurance Co.

Jerry Edge, CCP I RMC Consultants

David Engelman, CCP I AJAE Consulting

Tricia Eusebio I KBR

Myrna Hellerman, CCP I Sibson Consulting

Todd Henderson, CCP, SPHR I HSBC North America

Todd Henke, CCP I Longnecker and Associates

Angela Keller, CCP, CSCP, SPHR I Sophic Partners LLC

Jennifer Mackin, CCP, CBP I Ferro Corp.

William McPeck, WLCP

Michael Newman, CCP I Macom

Michael Oubre, CCP, CBP, GRP I KBR Inc.

Rosa Perez

H. Robert Sanders, CPA, CCP I Centene Corp.

Theresa Schnelle, CCP, CBP I Lockton Co.

Ashley Thomalla, CCP, GRP

Robert Tursky, CCP, CEBS, SPHR I Volvo Business Services NA

Michiel Van Duin, GRP I Novartis Pharma AG

Douglas Van Tornhout I Purdue Pharma LP

Michel Voigt, CCP, SPHR I Galderma Labs

Patrick Wagner

Carolyn Wiley, Ph.D., SPHR I Roosevelt University

Paul Wilson, CCP, GRP I Edison International

Kurt Wolfer, CCP I Stanley Black & Decker

Executive SummariesThird Quarter 2014 | Volume 23 | No. 3

Culture: The Missing Link Between Remuneration and MotivationBy Linda Herkenhoff, Ph.D., CCP, CBP, St. Mary’s College

Culturally tuned remuneration can provide employers with a competitive edge over

those organizations that do not look beyond a traditional approach to remuneration

design. A large global survey conducted by the author over several years suggests that

employees prefer remuneration that aligns with their cultural values. In other words,

certain forms of pay and benefits have different values within different cultures. This

article highlights how national culture can provide the missing link between remunera-

tion and motivation. The Cultural Remuneration Behavior model (CRB) is provided as a

managerial tool in better understanding the relationships among remuneration, motiva-

tion and culture in designing local-national remuneration plans.

Direct Salesforce Versus Independent Representatives: A Strategic Choice Across a Business Life CycleBy Pankaj M. Madhani, Ph.D., ICFAI Business School

While organizations devote considerable time and money to manage their salesforces,

few give much thought to the roles that internal (or direct) and external (independent

representatives) salesforces play over the life cycle of a business. This article presents

research on the economic and non-economic factors to be considered when deter-

mining a salesforce structure throughout a business’s life cycle.

The X-Factor: Which LTI Measures Drive Corporate Performance?By James F. Reda and David M. Schmidt, Arthur J. Gallagher & Co.

This article presents an analysis of long-term incentive (LTI) plans for top executives

in 200 of the largest U.S. companies. The authors studied three measures – total

shareholder return, earnings per share and capital efficiencies – for performance-based

grants. The study found that for all measures, the effectiveness of LTIs in influencing

company performance increases when a plan is administered consistently over a five-

year period.

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© 2014 WorldatWork. All Rights Reserved. For information about reprints/re-use, email [email protected] | www.worldatwork.org | 877-951-9191

Third Quarter 2014

5 Third Quarter | 2014

Pay for Performance: Getting it Right Throughout the OrganizationBy Don Delves, Emory Todd, Lori Wisper, Towers Watson

While pay for performance is certainly not a new topic, it remains an issue that many

companies struggle to address. In recent years, much attention has been paid to

executive pay for performance and in particular, generous CEO pay packages. However,

executive compensation is more sensitive to company performance and stock price

performance than it’s ever been. In fact, while executive compensation remains high,

CEO and executive pay is generally fairly closely aligned with performance these days.

In contrast, typical worker pay is not. Budgets for merit pay have shrunk and incen-

tive pools are often funded below target levels making it difficult to drive and reward

employee performance. This article explores the considerations that organizations

must consider to strike the right balance in pay for performance through all levels of

the workforce.

Designing an Effective Corporate Health and Wellness StrategyBy Celina Pagani-Tousignant, Normisur International and Asako Tsumagari, Mevident Inc.

The next few years are critical for employers to take drastic action in their health

and wellness strategy. However, a company’s business focus, not regulatory changes,

should drive health and wellness strategy. By understanding and connecting the

company’s business focus with key HR metrics, the HR manager will ascertain what

is required of the health and wellness strategy. HR managers can develop their health

and wellness strategy, evaluate programs, determine new programs and guide senior

executives without being entrenched in tactical and operational matters.

Executive Pay Disclosure: Realized and Realizable PayBy Eric Hosken, Michael Keebaugh and Kyle Eastman, Compensation Advisory Partners (CAP)

The alignment of pay with performance continues to draw the attention of companies,

investors, shareholder advisory firms, and compensation professionals. Traditional defi-

nitions of pay included in regulatory filings have the potential to provide a misleading

picture of compensation when viewed in the context of performance. In an attempt to

communicate a more accurate and meaningful account of the compensation that is

delivered to executives, companies have begun to include realized and/or realizable

pay disclosure in their annual proxy statement. In many situations, this disclosure is

essential for the illustration of a pay-for-performance link. However, these definitions

of pay are far from perfect. In this article, the authors provide an overview of realized

and realizable pay, which includes the advantages and disadvantages of each relative

to traditional pay definitions and the prevalence of disclosure among Fortune 250

companies, in an attempt to determine which definition – if either – is preferred.

Published Research in Total Rewards

Executive SummariesThird Quarter 2014 | Volume 23 | No. 3

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Linda Herkenhoff, Ph.D.,

CCP, CBPSt. Mary’s College

Culture: The Missing Link Between Remuneration and Motivation

There are many excellent academic papers on the

topic of global pay, but not all provide managerial

implications. In contrast, this article is specifically

written with a practitioner focus while still being based

on robust research and analysis. How can pay and

benefits be designed to go beyond just welfare tools?

Can higher levels of employee motivation be gained

with better designed pay and benefits? Are there easy-

to-use tools that can help with the design of global pay

programs for local nationals?

This article provides a practical example of the impor-

tance of understanding culture while managing local

employee preferences. Culturally tuned pay and benefits

can be important tools in managing a global workforce.

REMUNERATION, MOTIVATION, CULTURE

Remuneration

There are many terms in the literature to describe pay,

rewards and benefits. “Wages” is used interchangeably

with “base pay” and “pay.” “Compensation” includes

direct payments (i.e., base pay) and indirect payments

(i.e., bonuses). Many businesses use the term “total

compensation” to capture all forms of pay and benefits.

This study will defer to the definition of “remunera-

tion” that encompasses “the sum of the financial and


Third Quarter 2014


nonfinancial value to the employee of all the elements in the employment package

(i.e., salary, incentives, benefits, perquisites, job satisfaction, organizational affili-

ation, status, etc.) and any other intrinsic or extrinsic rewards of the employment

exchange that the employee values” (WorldatWork 2014).

Management often thinks of remuneration as little more than the sum total

of hygiene factors within a legally mandated framework. However upon closer

examination, there are many opportunities for flexibility in remuneration design

and delivery. Remuneration elements can be selected that are relevant within each

country of operation by understanding the cultural values of that country.

Although it may represent the largest component of total operating costs, remu-

neration should be considered as more than a business cost, especially in the

global marketplace where multinational corporations often compete with lower

labor costs than they face in industrialized countries. Remuneration practices

can directly influence the decisions an employee makes about whether to join

an organization, when to quit, whether to come to work and how hard to work.

Remuneration should be treated as an integral component of a corporation’s busi-

ness strategy in order to achieve a competitive advantage over corporate rivals.

Competitive advantage requires looking beyond the fine-tuning and enhancement

of current remuneration packages offered by others, and actually establishing a

new remuneration paradigm that takes into consideration national cultural data.

In the area of strategic management, the ultimate interest of managers in different

national cultures and rewards systems should go beyond descriptive understanding

and explanation to prediction and control. Accurate prediction requires an accurate

contextual lens within the country of operation. In a recent situation experienced

by the author in Tonga, an American hotel owner wanted to provide perquisites

as a performance motivator for his four management-level employees. He chose to

provide company cars. He noticed the cars were usually missing even though the

managers were at work. He later discovered that all employees from the cleaning

crew upward borrowed the cars as needed. Tongan culture does not embrace

hierarchy in business in the same way as the United States. Although Tongans have

a hierarchical political structure that includes a king, prime minister and village

chiefs, their day-to-day functional existence embraces an egalitarian notion that

one can borrow from a neighbor without asking for permission if that person’s

need is greater at that moment. This mindset limits crimes associated with stealing

because Tongans are just borrowing and will return the item in good time, even

if it is their neighbor’s prize pig. In this case, the overseas manager replaced the

criteria of position-based cars with simply company cars.

Motivation

Research of the late 1980s and early 1990s more clearly established the motiva-

tional impact of remuneration on employees, specifically that behavior-based

compensation programs can be effectively used as tools to motivate and manage

8 WorldatWork Journal

desired employee performance. (O’Dell and McAdams 1987; Lawler 1990; and

McCoy 1992). The motivational aspect of remuneration within human resource

management (HRM) theory is well documented in case studies of North American

companies but is conspicuously absent within the global framework.

Management practices that reinforce national culture are more likely to yield

predictable behavior, self-efficacy and high performance. An example experienced

by the author occurred in Indonesia with safety bonuses. The multinational company

wanted to motivate local employees to improve their safety record in the field so

the business offered a financial bonus to the field crew for every month without any

safety incidents. The crew understood that the field crew supervisor would have to

report these results to the area manager. On the surface, it seemed like the model

worked because safety incidents decreased, which was the predicted behavior. But

what actually was happening was the field employees were saving face for their

area manager by simply not reporting many of the incidents. In a hierarchical

culture such as Indonesia, great respect is paid to those at the top of the hierarchy.

Certainly this was an unpredicted behavior that did not improve performance and

was subsequently corrected through removal of the bonus program.

All of the integrated models recognize that motivation affects choice, action and

performance of the employee. Motivational practices are managerial practices that

aim at increasing employee willingness to allocate physical and mental resources to

the work. However, managerial practices, such as those associated with some form

of remuneration that motivate employees in one culture, may not be motivating when

applied within a different culture. For example, employees in Eastern cultures are

not induced to work purely because of calculative and instrumental considerations.

Culture

This article highlights that culture can provide the link between remuneration

and employee motivation. Although it focuses on national culture, the manage-

rial implications and processes described here can be applied to corporate and

professional cultures.

National culture can play an important role in transforming remuneration from

a hygiene factor to an asset. Although the research focus has expanded from

expatriate compensation to international compensation, organizations still have

few culturally tuned remuneration practices.

Often the national culture of a local overseas office can prevent acceptance

of a foreign or important corporate practice. One example recently experienced

by the author occurred in Zanzibar, where the practice of implementing a piece

rate for pay versus hourly wages turned out to be more complex than originally

anticipated. The Swiss mother company wanted to provide payment for each unit

of seaweed that the workers harvested. More pay for more work seemed to be

a basic motivational tool to the overseas management. However in a collectivist

culture such as Zanzibar, the workers wanted an hourly rate, so all could earn


the same amount. The concept of pay for performance was incongruent with

their national value. Their work-around was that each week they would pool their

wages and divide them up equally, thereby defeating the motivational model that

the parent company had introduced to improve productivity. Social awareness of

cultural values and beliefs allows remuneration to be fine-tuned to better fit with

what motivates local nationals. Being intelligent about the market-based aspect

of pay and benefits is not enough. Understanding the human cultural side of

remuneration is also important.

FINDINGS

A large global survey conducted by the author over several years suggests that

employees prefer remuneration that aligns with their cultural values (Herkenhoff

2000). In other words, certain forms of pay and benefits have different valences

within different cultures.

The Hofstede (1980) model provides the analytic framework for culture in this

article. (See Table 1.) Hofstede’s research is of critical importance in attempting

to position motivational analysis into a global framework. Hofstede’s impressive

database and subsequent detailed quantitative analysis of the data allowed him

to postulate that national cultural norms can influence motivation. Subsequent

to Hofstede’s work, House et al. (2004) provided a rich database that explores

the relationship of culture to the concepts of leadership, resulting in some of the

same dimensions as Hofstede. Both databases of country indices are very useful

to practitioners who decide to culturally tune their remuneration practices.

Remuneration elements and their associated culture indices were analyzed using

structural equation modeling techniques. (See Table 2.)

The remuneration elements were correlated in Spearman Rank Order analysis

with the national culture values across the following countries: Australia, Angola,

Brazil, Canada, France, Great Britain, India, Indonesia, Japan, Netherlands, Papua

New Guinea, Singapore, Saudi Arabia, Thailand, United States and Venezuela.

Some of the significant analytical results include:

z As the PDI increases, employees show greater preference for hierarchical-based

remuneration such as bonuses and perquisites.

For example, the author was hired to work in India, a high PDI country, on a

project involving adding more job levels within the client’s existing organizational

structure. Employees in these types of hierarchies desire perquisites (position-

based remuneration elements), the more visible of which become status symbols

of success. These can be as simple as an increase in lunch allowance or receiving

a paid subscription to the Financial Times. By contrast, in the United States where

more restrictive definitions of wage discrimination exist, perquisites have faced

diminished popularity at all but executive levels.

z As the LTO increases, employees show greater preference for pension benefits

than base-pay increases.


For example, in Angola where ongoing political unrest promulgates uncertainty

(low LTO), employees indicate a preference for increases in current pay in lieu of

counting on receiving the money as a future payment by way of a pension plan.

z As the UAI decreases, there is marginal support to suggest employees show

greater preference for at-risk gainsharing than for add-on gainsharing. This rela-

tionship warrants further study.

z As the MAS decreases, employees show greater preference for obtaining family

welfare benefits.

Table 1 Hofstede Dimensions

Power Distance Index (PDI)

This refers to the degree to which power d i f fe rences are accepted and sanc-

tioned by society. A high PDI describes a society that believes there should be a

well-defined order in which everyone has a rightful place. A low PDI is associated with the

prevalent belief that all people should have equal rights and the opportunity to change their

position in the society. All societies are unequal but some are more unequal than others.

Long-term Orientation (LTO)

This stands for a society fostering vir tues oriented toward future rewards, in par tic-

ular perseverance and thr i f t . Long-term or ientation stands for a society foster ing

vir tues related to the future. Shor t term per tains to the past and present, in par tic-

ular respect for tradit ion, “preservation of face” and ful f i l l ing socia l obl igat ions.

Uncertainty Avoidance Index (UAI)

This refers to the degree to which a society is willing to accept and deal with uncertainty. A high

UAI score suggests a culture that seeks certainty and security and wishes to avoid uncertainty.

A low UAI score reflects the society is comfortable with a high degree of uncertainty and is

open to the unknown. A high UAI culture tries to minimize the possibility of unexpected events

occurring by adopting strict codes of behavior. Cultures with high UAI are active, aggressive,

and emotional and show a low tolerance for behavior and viewpoints different from their own.

High UAI countries show a need for comprehensive rules and regulations, a belief in the power

of experts and a search for absolute truths and values.

Masculinity (MAS)

This refers to the degree to which traditional male values are important to society. For example,

male values would include assertiveness, performance, ambition achievement and material

possessions, whereas some of the feminine values would include quality of life, environment,

nurturing, and concern for the less fortunate countries. A high MAS would have clearly differenti-

ated gender roles with men being dominant. In a low MAS culture, the gender roles are more

fluid and there is a predominance of feminine values.

Individualism (IDV)

This refers to the degree to which individual decision making and action are accepted and encour-

aged by society. A high IDV score depicts a society that emphasizes the role of the individual.

Conversely, a low IDV emphasizes a societal emphasis on the importance of the group model. It

describes the relationship between individuals and groups and the extent to which the individual is

integrated into the group. In high IDV countries, the links between individuals are loose. People are

expected to look after their own interests and, at the most, the interests of their immediate family.


In other words, as feminine values such as nurturing become more domi-

nant in lower MAS cultures, remuneration that helps other family members

becomes more highly valued. In many cases, access to group plans, even

without company subsidy, is highly valued because individual coverage does

not exist or is prohibitively costly. This is an example of a high-value benefit

that has minimum to no cost to the employer.

z As the IDV decreases, employees show greater preference for team-perfor-

mance-based pay and for all team members to receive equal pay.

Although in the United States teams have been popularized in the workplace,

very few team-based remuneration examples exist. Some companies use team-

based bonuses. Few if any organizations base an employee’s base pay on team

outcomes and performance, in part because of laws protecting employee pay.

Data were also collected on individual characteristics such as age and gender

to better understand their influence on employee preference. But on average,

the relationships are influenced more by national culture values (80%) than by

individual characteristics of the employees (20%). These results are based on

TABLE 2 REMUNERATION ELEMENTS

PDI

Hierarchical bonus refers to bonus payments that relate the magnitude of the bonus to the

employees’ level in the organizational hierarchy.

Perquisites are benefits that vary by grade level, for example, the use of company cars

LTO

Pension plans or superannuation schemes replace income during permanent discontinuation

of employment due to retirement

UAI

At-risk gain-sharing is a variable pay plan that is usually tied to achievement of very specific

organizational goals such as productivity. If these goals are achieved, then the group shares

part of the resulting monetary gains. A certain part of base pay may be put at-risk, dependent

on the organizational performance. A risk option typically offers lower guaranteed earnings if the

organization does not perform well, but higher earnings if the company does perform well. If the

company performs well, the employees may earn their entire base pay plus a substantial bonus.

Job security is the surety of remaining an employee of an organization.

MAS

Shorter working hours refers to time off without pay – working fewer hours for reduced pay.

Family welfare benefits represent the opportunity for employees to acquire welfare benefits for

dependents at a discounted group rate through their organization. Normally the purchase prices

for such benefits as an individual rather than as a group are substantially higher.

IDV

Team pay refers to pay that is based on some form of team performance.

Team pay allocation refers to all team members receiving equal pay.


structural equation modeling and hierarchical linear modeling techniques (HLM)

(Herkenhoff 2000; Herkenhoff 2009b).

CRB MODEL

A general model is provided in Figure 1 to help practitioners apply the principles of

culturally tuned remuneration. The Cultural Remuneration Behavior (CRB) model

connects how much an employee values various remuneration choices being

offered through the lenses of national culture, professional culture, corporate

culture and individual characteristics. The subsequent behavior outcome can lead

to improved performance when managed correctly.

This research has focused on national culture as it dominates the other two

cultures as well as the individual characteristics. Organizational culture and profes-

sional culture have an ongoing battle in terms of which influences employee values

the most. But regardless of which ends up dominate in a given organization, their

influence is much less than that of national culture. Individual characteristics

are also secondary influences compared to stronger national cultural influences.

Therefore, focusing on national culture provides a reasonable platform for practitio-

ners to predict employee remuneration preferences. The secondary influences may

enrich the analysis but are not required to gain important managerial insights from

the model. The national culture indices can be obtained from either the Hofstede

or House published databases, thereby eliminating the need for companies to

collect their own employee national values.

Figure 1 | Cultural Remuneration Behavior Model (CRB)

IndividualValue

REMUNERATIONPREFERENCES

• Age

• Level

• Gender

• Education

• Dependents

• $ Satisfaction

• Spousal Benefits

• Intrinsic Job Level

Individual Characteristics(I)

National Culture (N)

Hofstede Indices:

PDI, LTO, UAI, MAS, IDVBehavior in Organization

PERFORMANCE

IMPROVEMENT

Corporate Culture (C)

Professional Culture (P)

• Pension

• Security

• Team pay

• Work hours

• Dependent welfare

• At-risk gainsharing

• Team member and equity


Certain categories of employees may have overriding compensation design issues

that limit the potential of applying the CRB model. The model is more effectively

applied to nonexecutive, nonunion, full-time, local national employees. With some

of the other employee groups, remuneration design options may be limited for a

variety of reasons.

Executive remuneration typically has a more complex structure and greater

variance in remuneration elements on a global basis requiring a different type of

analysis. Union employee remuneration is often restricted by contractual guidelines

that limit design options. Part-time or contract employees do not have the same

remuneration elements available to them as do full-time employees. Local nationals

represent the national culture of the country in which they work. However, expa-

triates and third-country nationals import their own national culture values and,

therefore, are typically not representative of the local national culture of the

country in which they work.

Although the CRB model suggests a causal outcome with performance improve-

ment, more research is required to fully quantify that relationship.

RECOMMENDATIONS

There are several culture-based remuneration strategies and specific managerial

recommendations that evolved from the quantitative findings of this study for

local nationals.

Power Distance (PDI)

z In high PDI countries, use hierarchical-based remuneration with minimal to no

overlap between levels.

z In low PDI countries, avoid remuneration based on hierarchical position within

the organization. There should be more focus in these countries on performance

rather than job level.

Time Orientation (LTO)

z In high LTO countries, the local remuneration package should include a

pension plan.

z In low LTO countries, avoid using pension plans. Remember these employees

do not have a future focus.

Uncertainty Avoidance (UAI)

z In high UAI countries, avoid at-risk gain-sharing plans.

z In low UAI countries, at-risk gain-sharing plans should be part of the remunera-

tion strategy.

It is a no-win proposition to force risk-adverse employees to welcome the notion

that some of their pay/benefits may be reduced if pre-determined goals are not

achieved, regardless of the potential upside.


Gender Values (MAS)

z In high MAS cultures, employees in general prefer receiving remuneration in forms

other than as benefits for dependents. The cultural values in this scenario welcome

more focus on take-home pay and other more immediate forms of payment.

z In low MAS countries, an optional welfare package for dependents should be

made available to employees. When MAS values are lower, employees seem to

value access to company-sponsored family welfare plans that as individuals they

cannot access. Of course, in addition to access, company subsidies are always

appreciated but often not expected.

Individualism (IDV)

z In high IDV countries, avoid team-performance base pay. Although there may be

a team bonus, it is usually separate from individually earned pay.

z In low IDV countries, team-performance pay should be part of the remuneration

strategy. We know that in more collectivist cultures, employees are more comfort-

able with team pay. In some countries and industries, this may also include a

small component for individual performance.

z In high IDV countries, if team pay exists, pay team members based on their

individual contributions to the team.

z In low IDV countries, if team pay exists, pay all team members an equal amount.

CONCLUSIONS

From a practical perspective, this study provides the type of national culture

information that companies should be considering in preparing the groundwork

for strategic reforms within their global remuneration programs for local national

employees.

The remuneration paradox recognizes that the global strategy and corporate

culture it drives may conflict with the practices and perceptions in specific national

cultures. The global/local reward paradox suggests that when organizations think

globally, they need to apply their practices locally. In other words, remuneration

practices should be relevant for each national culture in which they are applied.

Culturally tuned remuneration can provide employers with a competitive edge

over those organizations that do not look beyond a traditional approach to remu-

neration design. z


AUTHOR

Linda Herkenhoff, Ph.D., CCP, CBP ([email protected]) is the Director of the Transglobal MBA Program and Professor in Analytics/ Organizational Behavior/Global Business at Saint Mary’s College in California.

REFERENCES

Herkenhoff, Linda. 2009a. “A Socially Intelligent Approach to Global Remuneration.” World Journal of Management 1(1): 118-140.

Herkenhoff, Linda. 2009b. “Hierarchical Linear Modeling of National Culture Within a Remuneration Framework.” Global Journal of Management: International Review of Business Research Papers 5(2): 173-193.

Herkenhoff, Linda. 2000. Using Cultural Values to Untangle the Web of Global Pay. Boca Raton, FL: Universal Publishers.

Hofstede, Geert. 1993. “Cultural Constraints in Management Theories.” Academy of Management Executive 7: 81-94.

Hofstede, Geert. 1980. Culture’s Consequences: International Differences in Work Related Values. Beverly Hills, CA: Sage Publications.

House, Robert, Paul Hanges, Mansour Javidan, Peter Dorfman, and Vipin Gupta, eds. 2004. Leadership, Culture and Organizations: The GLOBE Study of 62 Societies. Thousand Oaks, CA: Sage Publications.

Lawler, Edward E. 1990. Strategic Pay. San Francisco: Jossey-Bass.

McCoy, Thomas. 1992. Compensation and Motivation. New York: Amacom.

Nicholls, Michelle. 2012. “Relationship Between Occupational Culture, Occupational Groups and Reward Preferences.” University of Johannesburg, Doornfontein Campus, South Africa. Viewed: April 2, 2014. http://www.worldcat.org/title/relationship-between-occupational-culture-occupational-groups-and-reward-pref-erences/oclc/846890377.

O’Dell, Carla and Jerry McAdams. 1987. People, Performance and Pay. Houston: American Productivity Center Publications.

WorldatWork. 2014. Glossary. Viewed: April 2, 2014. http://www.worldatwork.org/waw/Glossary.

http://www.worldcat.org/title/relationship-between-occupational-culture-occupational-groups-and-reward-preferences/oclc/846890377



Pankaj M. Madhani, Ph.D. ICFAI Business School

Direct Salesforce Versus Independent Representatives: A Strategic Choice Across a Business Life Cycle

The salesforce represents a significant investment for

most organizations. U.S. companies alone spend an

estimated $800 billion on their salesforces each year

(Zoltners, Sinha, and Lorimer 2008). To improve profit-

ability, many organizations have begun to scrutinize the

role of their salesforces and their overall compensation

costs. In properly designing a pay structure, the HR/

compensation manager, in consultation with the sales

manager, must determine how much pay should be

fixed (salary) and how much variable (commission).

The structure and composition of a salesforce varies

widely from one organization to another. The orga-

nization must adjust its overall systems to fit with

changing external and internal environments (Madhani

2010a). The salesforce compensation strategy should be

adjusted to support the organization’s changing busi-

ness life cycle and structure as well as external factors

such as customers, territory and competitive response.

Rebalancing of fixed and variable pay in the compen-

sation structure offers HR managers enough flexibility

to deal with market variability and organizational

changes. Business life cycle stages are likely to be a


Third Quarter 2014


key determinant of compensation strategies and their effectiveness in achieving

organizational goals.

A salesforce structure of an organization must be well organized if it is to

effectively sell the products and services and satisfy customer needs. Salesforce

structure decisions influence how customers see the organization and affect the

selling skills and knowledge level required of salespeople. That, in turn, affects

the recruitment, training and compensation structure of the salesforce. Each orga-

nization must structure its salesforce to fit the unique needs of the organization

and its management (Aspley 1956). If the salesforce structure is adaptive, the sales

organization can react quickly to market dynamics without a major structural over-

haul and disruption of the selling process. Salesforce structuring is considered an

art, as organizations do not have scientifically developed algorithms for optimal

salesforce structure decisions (Madhani 2012).

DIRECT SALESFORCE VERSUE INDEPENDENT REPS

Sales outsourcing refers to shifting an organization’s sales activities in part or as

a whole to an independent third party (Ross, Dalsace, and Anderson 2005). By

outsourcing a sales function, an organization uses external resources to limit its

risk exposure. Turning fixed costs of a sales organization into variable costs is

one of the most important reasons why organizations outsource the sales func-

tion. Sales employees who contract their services are called an indirect salesforce,

manufacturers’ representatives or independent reps; those who are employees of

the organization are generally called an in-house or direct salesforce. They can

be further classified as inside or outside sales reps. Inside reps almost always

operate from within the company premises, performing sales calls and support

functions. Conversely, outside reps perform their duties outside the company,

which involves traveling and visiting customers. Independent reps will have a

portfolio of products that are complementary, but not competitive. Independent

reps or agents represent almost 50% of the business-to-business and upper-channel

sales (Barrett 1986) and more than 37% of all customer contacts by manufacturers

(Churchill, Ford, and Walker 1997).

Organizations with complex, heterogeneous, high-margin products and long

sales cycles are more efficient with direct salesforces. Similarly, a large number of

geographically distributed and widely dispersed customers, frequently ordering

small quantities, may be more efficiently served by several independent reps

than by a direct salesforce. Since independent reps carry multiple products and

are known in their territory, they are frequently able to penetrate a geographical

market quicker.

The use of direct salesforces is associated with large organizations, larger average

orders, more complex products requiring technical service and less standard prod-

ucts (Anderson 1985). If the product is of low unit value, standard, well-accepted in

the market, ordered in small quantities and/or frequently re-ordered, independent


reps may be the best choice (Powers 1991). The independent reps are a better

choice when the product is new and has no established demand, or the product

is infrequently purchased (Hawes, Strong, and Winick 1996). There is a consider-

able debate on reconsideration of direct salesforce vis-à-vis independent reps in a

salesforce structure (Taylor 1981). Hence, this research looks into this aspect and

studies the impact of a business life cycle on the choice of salesforce structure.

SALESFORCE STRUCTURE ACROSS A BUSINESS LIFE CYCLE:

AN INTRODUCTION

Choosing the proper salesforce structure of direct salesforce versus independent

reps depends on customer or product characteristics as well as stages of a business

life cycle. The more influence a salesperson has on the sale, the more important

is a direct salesforce for the organization.

As shown in Figure 1, the startup and decline stages of the business life cycle

are characterized by low growth and profit potential while growth and maturity

stages of the life cycle are characterized by high growth and profit potential.

Accordingly, independent reps are preferred in startup and decline stages while

Growth StageHigh

Maturity Stage

Decline Stage

Startup Stage

Independent Reps

Gro

wth

an

d P

rofi

t P

ote

nti

al

Low

Figure 1 | Growth Potential and Salesforce Structure Across a Business Life Cycle

Direct Salesforce

Source: Matrix developed by author

Sales Structure


direct salesforces are preferred in growth and maturity stages. In the startup stage

of a business life cycle, there is a lot of uncertainty and business risk. Business

risk is a central determinant of an organization’s value in terms of the present

value of the risk-adjusted future profit. It is affected by various parameters such

as price, variable costs, operating costs and the stability of demand (Halil and

Hodgin 2003). Business risk has a negative impact on the operation or profitability

of an organization. A business risk can be the result of internal conditions, such

as high fixed operating costs, and external conditions, like a change in demand

for an organization’s goods and services (Madhani 2010b).

As business risk is high during the startup and decline stages of a business life

cycle, sales organizations should keep low operating leverage. (See Figure 2.) The

degree of operating leverage (DOL) is a function of the organization’s cost structure

in terms of the relationship between fixed costs and total costs. An organization

that has high operating leverage will also have higher variability in earnings than

a similar organization with low operating leverage. The more operating leverage

(fixed costs/total costs), the more profits will vary with changing sales revenue.

Figure 2 | Relationship of Business Risk and Operating Leverage Across a Business Life Cycle

Salesforce Structure

Independent Reps

Growth Stage

Maturity Stage

Decline Stage

Startup Stage

Sales Revenue

Bu

sin

ess

Ris

k

High

High

Low

Low

Op

era

ting

Leve

rag

e

High

Low

Direct Salesforce



In the growth stage, an organization’s operating income is increasing while

uncertainty and business risk are moderating. Similarly during the maturity stage,

uncertainty and business risk are low. While in the decline stage, uncertainty

and business risk are high again. Hence, during a period of low business risk,

high operating leverage is preferred while during a period of high business risk,

low operating leverage is preferred. Accordingly, independent reps are preferred

in startup and decline stages while direct salesforces are preferred in growth

and maturity stages of the business life cycle. Deployment of independent reps

will decrease operating leverage for an organization because they work on a

commission-only basis. Because a direct salesforce represents fixed costs for an

organization, its deployment will increase operating leverage.

By reducing the business risk, the cost of capital of the organization is also

reduced, thus increasing the economic value of the business (Madhani 2009).

Therefore, the independent reps are most preferred choice for the sales organiza-

tion in an uncertain environment (Williamson 1979).

TYPES OF SALES ROLES: GENERALIST VERSUS SPECIALIST

Effective salesforce structure design involves finding the right balance between

generalized and specialized sales roles. Generalist salesforce structures are typi-

cally deployed in organizations that are either in their startup stage of the life

cycle, establishing their presence in the market, or in the decline phase, trying to

cut costs. During the startup stage, the independent reps have a strong influence

on the sales. However, for large accounts that buy on contract, independent reps

are usually less effective than a direct salesforce (Anderson and Trinkle 2005).

Organizations may employ a small in-house direct salesforce to service very large

or key sales accounts while permitting smaller accounts to be serviced by inde-

pendent reps. Most startup salesforces structures are generalist, comprised of a

relatively small number of direct salesforce members who sell a narrow product

line to a limited number of target market segments along with a larger proportion

of independent reps. (See Figure 3.)

Similarly, during a decline stage of a life cycle, products are more efficiently

handled by independent reps or channel partners since their costs are lower and

less fixed. During the growth and maturity stages of a life cycle, a direct sales-

force is preferred. As a business expands during the growth stage of a life cycle,

the salesforce has to call on prospects in a broader set of markets as the product

portfolio expands. This presents organizations with two challenges related to a

salesforce: specialization and size.

In a generalist sales organization, each representative or account manager sells an

organization’s entire, but usually limited, product line to customers who typically

are all in the same industry, thus providing a single point of business contact to

customers. Salespeople are expected to engage in all types of sales activities for all

of the products and sell to all customers. While in a specialist salesforce structure,


salespeople are expected to engage in a limited set of selling activities for only a

portion of the organization’s products and sell to only a certain group of customers.

Salesforces specialize in different ways such as by product, customer, geog-

raphy or function within the sales process and vertical market, in which goods or

services are offered within a specific industry or specialized market. Specialization

by vertical market is recommended when a salesforce with deep industry knowl-

edge represents a competitive advantage over a generalist salesforce. When an

organization plans to specialize, the choice of appropriate methods should be

dictated by overall sales strategy and stages of business life cycle.

Customer specialization makes salesforce structure more market driven and

focused on a select group of customers. Specialization by geography is the least

complicated. Salesforce specialization by function is illustrated by the delineation

between the “Hunter” and “Farmer” roles of the salesforce. Hunters typically focus

on new sales, while farmers cultivate current customer relationships. Depending

on stages of business life cycle, a salesforce structure may contain a mixture of

generalist and specialist roles.

Figure 3 | Salesforce Structure and Sales Roles Across a Business Life Cycle

Salesforce Structure

Independent Reps

Growth Stage

Maturity Stage

Decline Stage

Startup Stage

Sales Roles

Sa

les

Rev

en

ue

Big

Small

SpecialistGeneralist

Sa

lesfo

rce S

ize

Direct Salesforce

Big

Small



SALESFORCE STRUCTURE DURING VARIOUS STAGES OF A BUSINESS

LIFE CYCLE

Startup Stage

In this stage, the primary responsibilities of the salesperson is to overcome initial

customer resistance to the new product and focus on communicating product

performance. A higher level of product knowledge is required to explain the

benefits of the product to customers (Madhani 2011). When product demand is

uncertain, employing a direct salesforce is a risk. Deployment of independent

reps can help organizations better manage business risks because if they do not

perform as expected, their compensation in the form of commission is minimal.

A product launch always carries a certain level of business risk as profitability

projections are low and liquidity positions are strained. By engaging independent

reps for a product introduction, organizations can obtain a trained salesforce imme-

diately and with virtually no fixed cost. Sales organizations in the startup stage of

a business life cycle are challenged to grow the business, yet often have limited

funding and face considerable uncertainty about the future. In this stage, outsourcing

is the preferred option. Independent reps are likely to be more effective than a direct

salesforce because they are skilled, experienced and create synergy for customers as

they offer multiple product lines. Independent reps visit a wide range of customers

to get them more interested in the product and are responsible for looking at the

early adopters. Independent reps can afford to call on small accounts because they

have multiple lines, thereby absorbing travel time between accounts.

Independent reps are a better option for small, seasonal or volatile products

and sparse territories where high travel costs may not warrant a direct sales-

force. Startup sales organizations can enter markets rapidly by working alongside

independent reps who have sales expertise, influence over sales channels and

relationships with potential customers, which the startup sales organization cannot

replicate quickly enough with a direct salesforce. Deployment of independent

reps also helps the startup sales organization learn about the market in order to

successfully build its own direct salesforce.

Growth Stage

The growth stage is characterized by an organization rapidly expanding its niche

in the market. By this stage, the organization has achieved a degree of success,

largely overcome the previous concern for survival, and is exploiting expansion

opportunities. During the growth stage, the organization focuses on selling and

increasing product demand and market share. Large new investment is likely in

this period as the organization is growing in products, customers, sales volume,

geographic contact and number of sales employees.

In a growth stage, a direct salesforce is preferred when sales volume is high

enough that its overall costs are less than independent reps. As products are


established in the market, repeat sales become a larger proportion of overall

sales and customers require service and support, adding to salesforce’s workloads.

As such selling and supporting tasks grow beyond the salespeople’s capacity to

perform their jobs, their companies need to set up specialist salesforces (Zoltners,

Sinha, and Lorimer 2006).

Maturity Stage

Direct salesforces classically are used by mature sales organizations with great

effectiveness because they are most efficient at selling compatible products to

one market. Hence, sales organizations are frequently structured into autonomous

divisions or profit centers, each with its own line of products and often its own

direct salesforce, responsible only for its product line. However, if such profit

centers simply cannot afford the fixed costs of a direct salesforce to provide

the necessary market coverage for introducing new products, they may deploy

independent reps. As the size and complexity of an organization increases, it

needs multifaceted, versatile and high-performing sales employees to face a more

competitive environment (Chen and Hsieh 2005). Such an organization may opt

for a direct salesforce if it can attract and hold salesforce talents, the market is

highly concentrated geographically, and it has very few customers or the sales

volume is large enough (Novick 2000).

The maturity stage is the relatively flat period in the business life cycle that follows

the rapid growth period. An organization at the maturity stage is experiencing

slower but more consistent growth in its market. In this stage, organizations have

stability and efficiency as their goals. As organizations mature, they focus more

on defending their existing market niches as products and services start to lose

their advantage, competition intensifies and profit margins erode. Organizations

emphasize retaining customers, serving existing segments and increasing the effi-

ciency and effectiveness of the salesforce. During this period, the organization has

achieved the greatest economies of scale in its life cycle and is able to generate

steady and predictable profits. The environment becomes more stable and predict-

able in comparison with the growth stage.

Decline Stage

Although the maturity stage can be extended through proper management, internal

and external factors may, at any time, drive the organization into the decline stage

(Whetten 1980). During this stage, the organization begins to stagnate as markets

dry up and product demand decreases. The decline stage of the business life cycle

is characterized by a decrease in an organization’s resource base. In this stage, orga-

nizations are experiencing reductions in market share, reduced product demand and

even financial losses because of a variety of reasons, such as ineffective management

practices, changes in market environments and stiff competition. At this stage, organi-

zations’ strategies emphasize retaining and serving existing customers and segments.


When a revival is not likely and further decline is inevitable, a sales organizations

can only ensure that it remains profitable for as long as possible. Organizations

should use their salespeople to service the most profitable, loyal and strategically

important customers while discarding unprofitable product lines or territories.

In this stage, the size of the sales organization’s direct salesforce is generally

reduced substantially. The remaining salesforce should move from a specialist to

generalist focus, emphasizing value-based selling to large, profitable and stra-

tegically important customers or product lines. By using less expensive selling

resources, sales organizations can continue selling efficiently to some customer

segments. To preserve profitability, organizations should utilize independent reps

or selling partners to cover some market segments at less cost. Improving the

efficiency of a salesforce is critical. Organizations should use a generalist salesforce

structure when repeat sales are not the major portion of sales.

A DIRECT SALESFORCE VERSUS INDEPENDENT REPS:

An Economic Analysis

Using independent reps avoids the significant fixed capital costs and ongoing

costs of building and running a direct salesforce. A direct salesforce is difficult

to set up, slow to get up to speed and is predominantly a fixed cost comprised

of salespeople, sales managers and information systems. The cost of the direct

salesforce includes base salaries, 401(k)s, stock options, taxes and other fringe

benefits such as vacations, medical coverage and life insurance, training costs,

travel and other selling expenses and sales management overhead. On the other

hand, independent reps represent a variable cost since they are paid commission

on realized sales. Thus, if the product doesn’t sell, costs are minimal.

The decision whether to engage a direct salesforce or independent reps is gener-

ally influenced by the cost of serving the same level of sales. The convergence

of direct salesforce cost and commission paid to independent reps should play

an important role in the initial decision to use a direct salesforce or independent

reps. Such convergence is viewed in the terms of selling cost and sales revenue

and is stated by following formula:

Where:

OHd = Overhead cost of the direct salesforce

Cd = Variable pay (commission) of direct salesforce

Cr = Commission of independent reps

S = Sales revenue during life cycle of a business


As shown in Figure 4, sales revenue changes across the life cycle of a business.

During the startup as well as decline stages, sales revenue (Ss or Sd) remains on

the lower side. During the growth and maturity stages, sales revenue (Sg or Sm)

remains on the higher side. Sales revenue during growth and maturity stages is

considerably higher compared to the startup and decline stages of the business

life cycle (Sm > Sg > Sd > Ss).

When this relationship is diagrammed in Figure 5, it can be seen that the cost of

independent reps (Cr) rises in direct proportion to increases in sales (S) because

sales costs of independent reps are primarily in the form of commissions (Cr).

Figure 5 represents the convergence of direct salesforce cost and commission of

independent reps for a mixed pay plan (variable pay along with base salary) of

a direct salesforce. In a mixed pay plan, the cost of a direct salesforce includes

sales overhead, such as base salaries and costs of sales support (OHd) as well

as commission (Cd) paid to the direct salesforce. The two cost lines converge at

point O, where the cost of the two salesforce strategies are equal (OHd + Cd =

Cr). Point O is also called the indifference point or break point and represents the

equilibrium of the sales commission (variable pay) paid to the independent reps

versus selling costs associated with a direct salesforce.

Therefore, based on a purely economic decision, during periods of low sales

such as in the startup or decline stages of a business life cycle, organizations

should use independent reps to gain sales at a lower cost as denoted by line

Figure 4 | Typical Stages of a Business Life Cycle

Where

Sm = Sales during maturity stage

Sg = Sales during growth stage

Sd = Sales during decline stage

Ss = Sales during startup stageSource: Chart developed by author

Time

Sa

les

Rev

en

ue

(S)

Business Life Cycle Stages

Growth Maturity Decline

Sm

Ss

Sg

Sd

Startup


RO and continue using them as long as their commission costs (Cr) remain

lower than the costs associated with a direct salesforce (OHd + Cd). As shown

in Figure 5, the least cost paths are RO and OD where the cost of a direct

salesforce is OHd + Cd.

Once the organization’s sales volume is high enough in the growth and matu-

rity stages that the commission or variable pay paid to the independent reps

(Cr) is greater than the estimated total fixed cost and variable costs (OHd + Cd),

the organization should switch to a direct salesforce. If sales exceeded point

O, then the sales organization should convert to a direct salesforce to maintain

the lower costs as denoted by line OD. When sales revenue is low (as in the

startup and decline stages) and below the indifference point, independent reps

should be used.

This single evaluation, however, reflects only the economic aspect of the deci-

sion. Organizations should not choose a direct salesforce or independent reps

based only on these criteria. Other important non-economic factors in selection

of a salesforce structure are their relative performance in sales coverage/sales

generation and the costs/revenue effects during the process of switching from

independent reps to direct salesforce and vice versa.

Figure 5 | Salesforce Structure and Compensation Cost Across Business Life Cycle Stages

(Low Sales Revenue) (High Sales Revenue)

R

Cr

Ss Sd S SmSg

D

Cd

OHd

Sa

les

Co

mp

en

sati

on

($

)

Sales Revenue ($)

Where

Sm = Sales during maturity stage

Sg = Sales during growth stage

Sd = Sales during decline stage

Ss = Sales during startup stage

= Least cost path

Source: Chart developed by author

Indifference Point

O


DIRECT SALESFORCE VERSUS INDEPENDENT REPS

An Optimal Scenario

As calculated in Table 1, considering independent reps instead of a direct

salesforce results in an increase in variable costs. It also results in decreases

in fixed costs, operating leverage and break-even point (BEP). BEP is a no

-loss, no-profit situation. Since using independent reps helps reduce BEP,

the organization can reach profitability faster. Table 1 demonstrates how

the break-even quantity and operating leverage will be lower for the sales

organization that has used independent reps instead of a direct salesforce.

If cost of coordination with independent reps is not considered, then fixed

costs will be zero and subsequently BEP will also be zero.

Table 1 illustrates the impact of employing a direct salesforce or indepen-

dent reps on operating leverage and BEP. In the direct salesforce option, the

organization employs internal sales employees on a mixed pay plan (fixed

pay: $22,000, commission: 2%) while in the independent reps option, the

organization pays commission only at 13.94% of sales. The indifference, or

break point occurs at the sales volume of 60,000 units. At this point, the

costs of the direct salesforce and independent reps are equal (Scenario 1).

Below the indifference point, the cost of the direct salesforce will be higher

(Scenario 2) while above indifference point, the cost of independent reps

will be higher (Scenario 3). In comparison to a direct salesforce, the inde-

pendent reps option offers a sales organization a lower degree of operating

leverage (DOL), lower market risk and its profits vary less with changes in

sales volume.

A critical requirement of such economic analysis is a complete and precise

estimation of the total fixed costs associated with the direct salesforce as well

as accurate forecasting of sales revenue. In the earlier illustration, certain

assumptions are made. It is assumed that a direct salesforce can achieve

an increase in sales volume with no increase in the number of salespeople.

Such analysis is a cost-based steady-state analysis. It means that the orga-

nization had either considerable slack resources at the beginning or there

was a large improvement in the organization’s selling efficiency over time. It

is also assumed that fixed costs associated with independent reps are zero.

However, some minimal fixed costs are still incurred with independent reps.

In reality, the cost curve will not vary directly with sales volume as consid-

ered in the illustration. Essentially, fixed costs of sales will increase with

increase in sales. Fixed costs are not fixed at a given level in perpetuity

(Guiltinan 1974). In fact, those costs are fixed within a range of relevant

factors such as sales volume or the number of customers. As the relevant

factor increases or decreases, the associated fixed cost changes as investment

must be made or reduced and is fixed again at the new higher or lower level.


A Strategic Choice at Indifference Point

As calculated in Table 1, at indifference point there is no difference in choice

of direct salesforce or independent reps because the cost-to-sales ratios are the

same. However, magnitude and timing of cash flow will have major impact on

the liquidity position of the company. Independent reps usually bear all sales

expenses and are the manufacturer’s exclusive salespeople for a defined set of

StepNo.

Senario 1

Sales Organization (At Indifference Point)

Senario 2

Sales Organization (Below Indifference Point)

Senario 3

Sales Organization (Above Indifference Point)

Direct Salesforce

Independent Reps

Direct Salesforce

Independent Reps

Direct Salesforce

Independent Reps

1 Unit sales (Monthly) 60,000 60,000 30,000 30,000 120,000 120,000

2 Unit selling price ($) 24 24 24 24 24 24

3 Unit variable cost ($)

12 12 12 12 12 12

4 Fixed pay (salary) ($)

22,000 0 22,000 0 22,000 0

5 Selling overhead ($) 150,000 0 150,000 0 150,000 0

6 Total Fixed cost = (4) + (5) ($)

172,000 0 172,000 0 172,000 0

7 Variable pay (%) 2 13.94 2 13.94 2 13.94

8 Variable pay = (1) x (2) x (7) ($)

28,800 200,800 14,400 100,400 57,600 401,601

9 Variable pay/unit = (8)/(1) ($)

0.48 3.35 0.48 3.35 0.48 3.35

10 Total variable cost/unit = (3) + (9) ($)

12.48 15.35 12.48 15.35 12.48 15.35

11 Unit contribution Margin = (2) – (10)

($)

11.52 8.65 11.52 8.65 11.52 8.65

12 Contribution margin = (1) x (11) ($)

691,200 519,200 345,600 259,600 1382,400 1038,399

Calculation

Sales- force Structure

Table 1 | Salesforce Structure and Financial Performance: Various Scenarios


customers (Anderson and Schmittlein 1984) and usually do not take title or

possession of the product, which is usually shipped directly to the buyer or user

by each manufacturer (Heide and John 1988). Also, they are not paid when they

receive the sales order but are normally paid their commission when the product

is shipped or when the organization is paid.

On the other hand, direct salesforces are generally paid every month in base

StepNo.

Senario 1


Senario 2


Senario 3


Direct Salesforce

Independent Reps

Direct Salesforce

Independent Reps

Direct Salesforce

Independent Reps

1 Unit sales (Monthly) 60,000 60,000 30,000 30,000 120,000 120,000

2 Unit selling price ($) 24 24 24 24 24 24

3 Unit variable cost ($)

12 12 12 12 12 12

4 Fixed pay (salary) ($)

22,000 0 22,000 0 22,000 0

5 Selling overhead ($) 150,000 0 150,000 0 150,000 0

6 Total Fixed cost = (4) + (5) ($)

172,000 0 172,000 0 172,000 0

7 Variable pay (%) 2 13.94 2 13.94 2 13.94

8 Variable pay = (1) x (2) x (7) ($)

28,800 200,800 14,400 100,400 57,600 401,601

9 Variable pay/unit = (8)/(1) ($)

0.48 3.35 0.48 3.35 0.48 3.35

10 Total variable cost/unit = (3) + (9) ($)

12.48 15.35 12.48 15.35 12.48 15.35

11 Unit contribution Margin = (2) – (10)

($)

11.52 8.65 11.52 8.65 11.52 8.65

12 Contribution margin = (1) x (11) ($)

691,200 519,200 345,600 259,600 1382,400 1038,399

Source: Calculated by author

StepNo.

Senario 1


Senario 2


Senario 3


Direct Salesforce

Independent Reps

Direct Salesforce

Independent Reps

Direct Salesforce

Independent Reps

13 Contribution margin ratio =

(11)/(2)

0.48 0.36 0.48 0.36 0.48 0.36

14 Total variable cost = (1) x (10)

($)

748,800 920,800 374,400 460,400 1497,600 1841,601

15 Total cost = (6) + (14) ($)

920,800 920,800 546,400 460,400 1669,600 1841,601

16 Total revenue = (1) x (2) ($)

1440,000 1440,000 720,000 720,000 2880,000 2880,000

17 EBIT (earnings before interest

and tax) = (16) - (15) ($)

519,200 519,200 173,600 259,600 1210,400 1038,399

18 DOL (Degree of operating leverage) =

(12)/(17)

1.33 1.00 1.99 1.00 1.14 1.00

19 Decline in EBIT on 20 %

decrease in Sales = 20 x (18) (%)

26.63 20.00 39.82 20.00 22.84 20.00

20 BEP (Break Even Point) = (6)/(13)

($)

358,333 0 358,333 0 358,333 0

21 Cost to sales ratio = (15)/(16)

(%)

0.639 0.639 0.759 0.639 0.580 0.639

22 Strategic Choice Depends on Magnitude and Timing of Cash Flow

Independent Reps Direct Salesforce

Sales- force Structure

Calculation


salary and commissions on pending sales. Therefore, deployment of independent

reps sharply improves the cash flow position of the company compared to a direct

salesforce. Especially for a long selling cycle, this can be a significant difference for

a sales organization with a direct salesforce since those employees are paid before

the sale is actually finalized. In reality, these amounts of commission and salary

paid during different time intervals are not the same, given the time value of money.

Figure 6 illustrates how these opportunity costs result in a decrease in cash

flow for an organization deploying a direct salesforce. An organization is selling

a complex, technology-intensive, big-ticket item to a government agency. The

selling cycle for this product is long and it takes eight months to close the sale.

The selling price of a product package is $500,000. The organization is evaluating

Figure 6 | Decrease in Cash Flow Caused by Using a Direct Salesforce

Option D

Time-line

A A A A A A A A AA A

0 1 2 3 4 5 6 7 8 9

iPV = A x

(1 - (1/ (1 + i ) n ))x (1 + i)

(1 + i ) nPV =

FV

0 1 2 3 4 5 6 7 8 9

$50,000Option I

PV = $45,052

PV = $47,483

Where A = Annuity

= $60,000 /12

= $5,000 (paid to salesforce as a salary in the beginning of each month)

Present value (PV) of this cash flow (annuity due) is given by following formula:

Where i = 0.14/12

= 0.01167

and n = 10

Hence, PV = $47,483

Where FV (Future value) = $50,000

i = 0.01167

and n = 9

Hence, PV = $45,042


the options of a direct salesforce (D) versus independent reps (I). In option D,

the organization is hiring sales employees at an annual salary of $60,000. While

in option I, 10% commission is paid to independent reps on realized sales. The

weighted average cost of capital (WACC) for the sales organization is 14%.

Because the independent rep is paid the commission 30 days after the sale is

completed, that payment comes nine months after the sale was initiated. However

with the direct salesforce, this amount is paid as salary at the beginning of every

month, before the sale actually concludes eight months later. The difference in the

cash flow in this simplified example is $2,441 ($47,483 - $45,042), a 5.42% differ-

ence. Although the organization spends the same $50,000 amount, the payment

timing is different and causes a different cash flow. The lesson here is that all

dollars paid out are not the same; their value depends also on when they are

paid out.

An Ethical Perspective

Salespeople are recognized as the element of organizational function most likely

to find themselves in ethical dilemmas (McClaren 2000). If an independent rep

working on a commission-only basis takes a short-term view of sales by putting in

little effort while working dishonestly or unethically, he/she will be solely guided

by quick sales and will not be interested in building long-term relationships and

customer loyalty.

In this situation, the value of the business decreases as future cash flow and

profitability decline because of lack of repeat sales and decline in customer loyalty.

This situation is represented by Quadrant I in Figure 7. Quadrant I represents

dishonest or unethical behavior by a sales employee and is characterized by low

customer loyalty, low firm value and a higher proportion of variable pay. This is

also a reflection of low-level effort by sales employees as they focus on short-term

sales objectives for quick gains.

In the 1990s, incentive compensation inflicted great harm on the reputation and

integrity of Sears, Roebuck and Co. It was found by Sears that its automotive service

advisers, acting under a commission sales plan, were selling parts and services that

customers did not need. That behavior harmed both the customer and company

in the long run. Sears eliminated incentive compensation and instituted a non-

commission program based on customer satisfaction (Bradley and Draeger 1994).

If a sales employee is motivated to act honestly, work hard and focus on

building long-term customer relationships and loyalty, the value of the business

will increase. This situation is represented by Quadrant II in Figure 7. Ethics is

a very important factor in the selection of a salesforce structure. Independent

reps’ commissioned-based compensation might motivate the salesperson to act

unethically to maximize sales. Pharmaceutical companies almost always use a

direct salesforce because of the ethical and accountability issues unique to selling

drugs (Making the Case 2002).


OVERHAUL OF THE EXISTING SALESFORCE STRUCTURE:

SOME CONSIDERATIONS

As an organization’s sales increase, the decision of salesforce structure should be

based on many factors beyond cost. When switching from independent reps to

a direct salesforce, an organization will lose long-term continuity with customers,

which may result in some customers going to competitors. A direct salesforce also

provides less territory coverage. Interestingly, a study by Dartnell concluded that

the average stay of a direct salesforce within a given territory is only 22 months,

while for independent reps the time is more likely to be around 22 years (Kaufman

1999). This can be an indication of a stable and reliable service that independent

reps provide for the customers in a given territory.

A decision to shift from independent reps to a direct salesforce made purely on

economics can backfire. The qualitative factors such as special relationships of the

salesforce with customers, the trade-off between control and flexibility of the sales-

force, and the short-term sales loss resulting from the switch should be considered.

Unless there are other compelling reasons for a sales organization to change

from independent reps to salesforce and vice versa, it is better to maintain the

salesforce structure. If after a thorough review of all economic and non-economic

Figure 7 | Relationship Between Pay Mix and Ethical Behavior of a Sales Employee

Sa

les

Ob

jec

tive

Sales Employee’s Behavior

Pay Mix

Firm

Va

lue

High

Low

Long Term

Short Term

EthicalUnethical

Variable Pay Fixed Pay

Quadrant - II

• Honest Behavior

• High Customer Loyalty

• High Firm Value

Quadrant - I

• Dishonest Behavior

• Low Customer Loyalty

• Low Firm Value



factors an organization decides to switch from independent reps to a direct sales-

force, the transition should be done as quickly as possible because it is risky and

time-consuming. On the other hand, converting to a direct salesforce from inde-

pendent reps is a slow, expensive process that incurs high initial costs, requires a

considerable commitment of overhead and takes time to generate returns (Zoltners,

Sinha, and Lorimer 2004). Therefore, organizations that demand quick returns on

investment may hesitate to convert to a direct salesforce from independent reps.

DISCUSSION AND RESEARCH IMPLICATIONS

To succeed in the long term, organizations must re-evaluate their salesforce structure

across the business life cycle. Salesforce structure decisions are likely to affect an

organization for many years. Salesforce structure is related to compensation manage-

ment, distribution channels and territory management. No matter how well a sales

organization hires and trains its salesforce, inefficient structure during the life cycle

of the business will prevent the salesforce from reaching its full productivity.

It is difficult for organizations to isolate the effect of the salesforce from all the

marketplace factors that affect sales. Those factors include pricing, advertising,

sales promotions, changes in distribution, market needs and competitive behavior.

However, the salesforce is a strategic lever for improving sales growth, market

share and profitability. The salesforce represents expensive and important HR

assets for an organization because it requires full productivity to be competitive

in the marketplace. Management of a salesforce structure is a key factor and, if

implemented correctly, can act as a catalyst in synergizing the efforts of a sales-

force leading to many positive outcomes such as increased revenue, reduced

compensation cost and enhanced profitability.

About 50% of North American businesses involved in sales use some form of

independent representative. Industries such as electronic components, hardware

and chemicals use independent reps for a substantial part of their business.

In times of recession and cost-cutting, the use of independent reps typically

increases. After the economic downturn of 2001, companies such as Intel, Texas

Instruments, Cirrus Logic and Hunt Wesson switched from a direct salesforce to

independent reps for some or all of their major product lines. Also many companies

chose to use independent reps after spinning off a division (e.g. the semiconductor

operation for Motorola and the Airpax for Phillips). (Making the Case 2002).

In the electrical as well as food service industries, 80% of businesses rely partially

or entirely on contract sales personnel (Weinrauch, Anitsal, and Anitsal 2007).

Waukegon, Ill.-based Cherry Electrical Products has had a very fruitful experience

working with an outsourced salesforce. Company officials estimated that building

direct sales organization from the ground up would cost about $5.7 million compared

to the $2.6 million it paid in independent reps’ commissions (Foster 2004).

An organization’s decision to serve a sales territory with independent reps or a

direct salesforces is evolutionary because as the business and its market change, the


appropriate configuration of the salesforce structure should change. There are many

strategic issues in selection of salesforce structure: fixed versus variable cost-to-sales

ratio; type of sales territories (dominant versus marginal); availability of a trained

and experienced salesforce; product characteristics and order size, short-term versus

long-term selling approach; and the stability of relationships (Madhani 2012).

CONCLUSION

Salesforce structure refers to the differing roles that an internal salesforce (direct

salesforce) and external selling partners (independent reps) should play. Salesforce

structure is critical for an organization because it determines how quickly a sales-

force responds to market opportunities, influences salespeople’s performances

and affects an organization’s revenue, compensation costs and profitability. An

organization that does not link evolving salesforce structure as it passes through

different stages of a business life cycle is placing itself at considerable risk in

implementing an effective salesforce management and compensation policy. While

organizations devote considerable time and money to manage their salesforces,

few focus much thought on how the salesforce structure needs to change over

the life cycle of a business. This research focuses on many economic and non-

economic factors for optimal choice of direct salesforce and independent reps

across the business life cycle. z

ABOUT THE AUTHOR

Pankaj M. Madhani, Ph.D. ([email protected]) earned his master’s degree in business administration from Northern Illinois University, a master’s degree in computer science from Illinois Institute of Technology in Chicago and a Ph,D. in strategic management from CEPT University. He has more than 27 years of corporate and academic experience in India and the United States. During his tenure with corporate, he received the Outstanding Young Manager Award. He is working as an associate professor at ICFAI Business School (IBS) where he has received the Best Teacher Award. He is also recipient of the Best Mentor Award. He has published various management books and more than 200 book chapters and research articles in several academic and practitioner journals such as Compensation & Benefits Review and The European Business Review. His main research interests include salesforce compensation, business strategy and corporate governance.

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This article presents an analysis of long-term incen-

tive plans (LTIPs) in place at Top 200 companies.

(Those top 200 companies have $10 billion in

market value and $10 billion in annual revenue. The

authors’ firm has been tracking these companies for at

least five years.) Performance shares have been around

for many years and now comprise the majority of the

long-term incentive (LTI) award (on a grant date value

basis) for the CEO of a large U.S. company. As demon-

strated by studies of executive pay and as reported by

publications like the Wall Street Journal, New York Times

and Associated Press, executive pay continues to rise

at a rapid pace, led primarily by long-term incentives,

and in particular, performance-based long-term incen-

tives such as performance shares and performance stock

units (Sweet 2014). These performance-based grants are

usually tied to financial performance measures or stock

price-based measures. However, does the use of perfor-

mance measures, particularly total shareholder return

(TSR) measures in LTI grants result in positive results in

company performance as measured by TSR? The authors

think there is reason to doubt there is a link between

performance-based grants and company performance in

certain circumstances as will be presented in this article.

David M. SchmidtArthur J. Gallagher & Co.

James F. Reda Arthur J. Gallagher & Co.

The X-Factor: What LTI Measures Drive Corporate Performance?


Third Quarter 2014


As noted, there are no signs of reductions or a leveling in CEO and top execu-

tive pay. Pay awarded to top executives continues to increase at a rate well above

inflation (Wall Street Journal 2013). Much of the executive pay increases are in

the form of long-term incentives based on achieving performance targets and

not just the stock price. When reviewing CEO pay in 2013 moving into 2014, the

authors see this shift to long-term incentive, performance-based pay continuing.

The authors have also reviewed the relationship between performance-based long-

term incentives and company performance.

The influence of proxy advisory firms and shareholder activists has become

stronger. Investors cannot review each company as there are too many to analyze,

so they rely on Institutional Shareholder Services (ISS) and Glass, Lewis & Co. for

voting guidance. ISS is becoming more accountable and more responsive to corpo-

rate concerns. For example, in March 2012, ISS established a Feedback Review

Board (FRB) designed to serve as a conduit for investors, issuers and various

market constituents to communicate with ISS. This is in addition to its annual pre-

season policy survey and open comment period and online verification tool for

governance data. ISS has also been offering draft analyses to S&P 500 companies

prior to issuing its final vote recommendations. Under pressure from corporations,

the Securities and Exchange Commission (SEC) has compelled ISS to reach out

to corporations for feedback on voting policy, which resulted in changes to peer

group selection and definition of pay (e.g., realizable pay).

ISS also has an explicit guideline that a CEO’s long-term incentive pay should

be at least 50% performance-based. This has helped drive the prevalence of

performance-based grants for top executives of the Top 200 U.S. companies from

75% in 2009 to 88% in 2012. Moreover, 60% of the Top 200 companies using

performance-based grants, such as performance shares or performance stock units,

had weights of 50% or higher in their LTI mix. In 2009, only 48% of the Top 200

companies had weights 50% or higher.

Performance metrics and LTI mix continue to be a primary topic of interest,

with continued emphasis on the pay-for-performance linkage and increase of

percentage of total pay tied to performance. But is it possible that performance-

based grants have no significant relationship to company performance? And if this

is the case, is this all about optics and tax deductibility or about real performance?

PAY FOR PERFORMANCE AND ISS

Performance usually is measured in terms of annual stock price performance

(increases) or, if a dividend-paying company, TSR.

Performance is also often described as, or related to, financial performance. Any

positive factors that support a pay-for-performance result are usually presented in

the Compensation, Analysis & Discussion (CD&A) portion of the annual proxy in

an effort to induce a convincingly positive say-on-pay vote. Along with the increase

in performance-based grants, the use of TSR as a measure has increased, especially


relative TSR – a company’s TSR as compared with peer group or industry group

TSR. Fifty-one percent of the Top 200 companies making performance-based

grants used a TSR measure, up from 43% in 2008. Indeed, since ISS measures

company performance using TSR, it would seem logical to include TSR as an LTI

measure. In addition, with relative TSR, there is no need to set goals three years

into the future, often a difficult, uncertain exercise.

The increased use of performance-based LTIs is partially in response to the

ISS methodology for determining its say-on-pay recommendations. If the initial

screening pay-for-performance test fails, the qualitative test needs to be acceptable

to ISS in order to avoid an “against” recommendation from ISS.

As a result of these ISS evaluation factors, which are reviewed by most major

investors, executive pay has undergone significant changes in the past five

years, including:

z A distinct shift from time-vested stock options, not considered performance-based

by ISS, to performance-vested stock grants linked to financial performance, TSR

or both. (See Figure 2.)

Figure 1 | ISS Say-on-Pay Methodology

ISS Initial Screening “Pay for Performance” Test:

i. RDA, CEO pay and company TSR for three years compared to ISS’ peer group below (limit=negative 30 percentile rank difference performance minus pay)

ii. MOM. CEO pay vs. ISS peer median (limit=2.33)

iii. PTA. Rate of change in CEO pay vs. company’s TSR performance over past five years (limit=negative 30% difference in performance increase minus pay increase)

Peer Group Selection:

i. Start with 8-digit GICS

ii. Consider subject company peer group

iii. Review size between 0.4x and 2.5x

iv. Broad market cap limits

• Micro cap: 0-$800 million

• Small cap: $50 million to $4 billion

• Mid cap: $250 million to $40 billion

• Large cap: 2.5 billion and over

v. If necessary go to 6-digit and then 4-digit

Qualitative Analysis:

i. Ratio of performance to time-based equity awards

ii. Ratio of performance-based compensation

iii. “Rigor” of goals and completeness of disclosure

iv. Operational/financial results

v. Realized pay comparison for S&P 1500

vi. Benchmarking practices

vii. Others as appropriate

“FOR” Say on Pay

Recommendation

“FOR” Say on Pay

Recommendation

“AGAINST” Say

on Pay

Recommendation

FAILPASSFAIL

PASS

Source: “2014 U.S. Proxy Voting Summary Guidelines,” December 19, 2013 and “Evaluation Pay for Performance-ISS” Quantitative and/Qualitative Approach,” published December 2012, revised January 2013.


z Pay increases that come primarily from increased equity grants (i.e., long-term

incentives).

z Increased use of TSR as a long-term incentive measure.

LONG-TERM INCENTIVES — PERFORMANCE PLANS

As further evidence of the shift toward meaningful performance plans, the authors’

firm’s analysis of the Top 200 public companies in the United States shows a

steady increase in the number of companies using either performance shares (PS)

or performance share units (PSU) with threshold, target and maximum payout

opportunities (James F. Reda 2013).

The authors think that proxy advisers have influenced this shift toward

performance-vested grants through their policies assessing the structure of CEO

compensation. The introduction of say-on-pay votes in 2011 has also had an effect.

And since the proxy adviser recommendations regarding say on pay are based in

Figure 2 | LTI Value Change from 1999 to 2012 (with estimate for 2015)

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

14%

38%

41%41%

43%

46%

50%

55%

8%

21%

19% 22%23%

22%21%

20%

78%

41%

40%

37%

34%

32%

29%25%

1999 2007 2008 2009 2010 2011 2012 2015 (Est).

Source: Study of 2012 of Short-Term and Long-Term Design Criterion Among Top 200 S&P 500 Companies, James F. Reda and Associates, December 13, 2013.

Appreciation Rights Restricted Stock/Units Performance-Based Stock/Cash


part on these considerations, the say-on-pay mechanism has helped to shape

these pay changes through the unplanned empowerment of the proxy advisers.

In general, there is little evidence of reductions in CEO and top executive pay.

What has changed are the form of pay and the increasing use of performance-

based vesting of LTIs. In addition, compensation committees and other company

representatives are reaching out to their major shareholders to present their pay

programs and solicit opinions on executive pay. ISS has clearly encouraged these

actions and, indeed, is checking for descriptions of these communication efforts

in the proxy, especially in cases where the say-on-pay “for” vote is less than 70%.

Unfortunately, these communications are not likely to address the important ques-

tion: “What are the key drivers of company performance and how do you know?”

It would seem most of the conversation is significantly shaped by ISS guidelines

and how the company is doing to conform to those guidelines.

BROAD ANALYSIS OF INCENTIVES AND PERFORMANCE

The authors’ firm has been studying STIs and LTIs for the past six years with

a focus on the Top 200 companies (James F. Reda 2013). Having published the

2012 study in December 2013, the authors began to review more closely the

relationship between select LTI performance measures and TSR performance.

Specifically, the authors reviewed the LTI performance measures used over the

past five years ending 2012 in relation to each company’s five-year TSR.

For this analysis, 195 of the current top 200 list had five full years of data for

TSR and LTI information. Two companies went from private to public ownership

within the past five years, 2008 through 2012, and three companies went from

public to private ownership. In those cases, there are not full five-year TSR values.

Over the past five years, those 195 companies used an average of 1.8 measures

for those years performance-based LTIs were granted. Sixty-four percent granted

performance-vested LTIs all five years. Eight percent did not grant performance-

vested LTIs in any of the five years.

Total Shareholder Return (TSR)

Fifty-three percent, or 103, of the companies used a TSR measure at least once in

the 2008-2012 period with an average five-year TSR of -0.18%. This is lower than

the overall average of 1.15%. Companies with LTIPs not using TSR had an average

return of 2.67%. Companies that did not grant performance-vested LTIs for any

of the five years had average returns of 2.54% (negative 0.47% excluding Apple

and Amazon). Companies using TSR for one to four years performed poorly.

Earnings per Share (EPS)

Thirty-seven percent, or 73, of the companies used an EPS measure at least once

in the 2008-2012 period with an average five-year TSR of 1.37%. This is slightly

higher than the overall average of 1.15%. Companies not using EPS had a slightly


lower average return of 0.81%. Companies not granting performance-vested LTIs

had average returns of 2.54% (negative 0.47% excluding Apple and Amazon). Of the

companies using an EPS measure, those using EPS for two or more years produced

average returns were much higher than the overall average (3.53% vs. 1.15%).

This category includes return ratios such as return on invested capital, return on

equity and return on assets. Economic value-added (economic profit) measures

were also included. Forty-four percent, or 86, of the companies used a capital

efficiency measure at least once from 2008-2012 and had average five-year TSR

of 0.68%. This is lower than the overall average of 1.15%. Companies not using

capital efficiency measure had a return of 1.36%, slightly higher than the average

return. Companies that did not grant performance-vested LTIs had average returns

of 2.54% (negative 0.47% excluding Apple and Amazon). Of the companies using

a capital efficiency measure, only those companies using a capital efficiency

measure for three or more years beat the average (2.79% vs. 1.13%).

This analysis of three popular types of LTI measures suggests that using EPS

is more closely related to strong TSR performance than use of relative TSR or

capital efficiency measures. However, this broad overview does not account for a

number of important factors such as industry mix and prevailing industry practices,

the rigor of the measures being employed, and the combination of measures

Figure 3 | TSR Measure vs. TSR Performance (2008-2012)

5-Y

ea

r T

SR

(%

)

Nu

mb

er o

f Co

mp

an

ies

Number of Years Using TSR

6

4

2

0

-6

-4

-2

-8

90

80

70

60

50

40

30

20

10

0

# Companies Average of 5 yr TSR 2012 (1%)

26

2.67

(1.17)

13

43

2.54

3.97

1015

(4.01) (3.70)

(6.61)

11

Average

None0 1 2 3 4 5

77


being used. However, the better-than-average TSR performance for companies

not using performance-vested grants brings into question the effectiveness of

performance-vested LTI grants for driving company performance. (See Figure

6.)

In Figure 6, values were weighted for each of the number of years these

measures were used to get the net effect. The TSR values were weighted by

the number of companies in each cell and the number of years used. Figure

6 clearly shows that using a consistently good measure for five or more years

produces positive results.

PERFORMANCE OF COMPANIES WITHOUT LTIPS

As discussed earlier, companies without LTIPs in place for the CEO either grant

nothing (Amazon and Google) or grant stock options (or stock appreciation

rights), restricted stock (or stock units) or both. Of the 195 companies with

five full years of data, only 15 did not grant performance-based LTIs to their

CEO. Again, the average TSR performance for this small group was noticeably

higher than the average for all 195 companies (2.54% vs. 1.15%). However,

these findings are far from conclusive and are also affected by the 22% TSR

performances coming from Amazon and Apple. Without the contributions

5-Y

ea

r T

SR

(%

)N

um

be

r of C

om

pa

nie

s

Number of Years Using EPS

6

4

2

(4)

(2)

-

(6)

120


107 2.108

10

30

2.54

4.09

1415

(6.33)

3

Average

None0 1 2 3 4 5

0

Figure 4 | EPS Measure vs TSR Performance (2008-2012)

100

80

60

40

20

(8)

5.04

2.62

0.81

16


of these two companies, the average TSR return drops to a negative 0.47%.

Nevertheless, even after this adjustment, the use of non-performance-based LTI

grants is only slightly worse than TSR-based LTI grants. Moreover, if Citigroup

is excluded (-32% TSR), companies with TSR-based grants had average TSR

well below companies not granting performance-based LTIs.

INDUSTRY ANALYSIS OF INCENTIVES AND PERFORMANCE

To get a better sense of the effectiveness of LTI measures for driving performance,

the authors examined results at the 4-digit GICS (Global Industry Classification

Standard) code level. For a number of industries in the Top 200 sample, there

are not nearly enough companies to draw any industry-specific conclusions.

Industries with better representation, such as Capital Goods, Energy, Retailing

and Utilities, provide a better opportunity to draw tentative conclusions.

5-Y

ea

r T

SR

(%

)N

um

be

r of C

om

pa

nie

s

Number of Years Using Capital Efficiency Measures


94

10

34

1315

2.54

3.03

(5.14)

1.93

2.84

(1.88)

Average

Figure 5 | Capital Efficiency Measures* vs. TSR Performance (2008-2012)

4 100

3 90

2 80

(1) 50

- 60

1 70

(2) 40

(3) 30

(4) 20

(5) 10

(6) 0

15

0 1 2 3 4 5 None

14


Total Shareholder Return (TSR)

While overall TSR does not stand out as an effective measure in promoting

above-average TSR results, there are industries where the use of TSR coin-

cided with better-than-average TSR results.

For example, the Energy industry in this sample group had average TSR of

negative 3.3% for 2008-2012. However, companies using TSR had a slightly

better TSR of negative 2.2% as compared with negative 6.9% for companies

not using TSR. Eight companies using TSR for at least four years averaged

nearly 1% TSR growth, much better than the overall average.

On the other hand, TSR measures did not relate well to performance for the

Capital Goods sample. From 2008-2012, the average TSR for Capital Goods

was 0.5%. For the 23 companies comprising this group, 11 companies used a

TSR measure and returned negative 2.2% and 12 companies using measures

other than TSR returned 3.0%. All 23 companies had LTIPs as part of their

LTI mix.

Another interesting case is Food Beverage & Tobacco with 12 companies.

The average TSR was 4%. Five companies using TSR averaged 3.6%. Four

companies using measures other than TSR averaged 4.4%. However, three

of these companies did not have an LTIP in place the past four years (2009-

2012) and yet had an average TSR of 10.1% (as compared to -0.3% for TSR

users and 2.9% for companies using other measures). So based on this small

sample, companies using a TSR measure had in the aggregate the lowest TSR

performance in this industry while the three companies with no LTIP for the

past four years had the highest TSR performance.

# Years Using Measure

TSR Measure

EPS Measure

Cap Efficiency Measure

TSR Measure

EPS Measure

Cap Efficiency Measure

TSR Weighted by Years and #

Companies0 * 2.67 0.81 1.36 77 107 94 1.511 (1.17) (6.33) (1.88) 26 16 15 (2.81)2 (4.01) 2.68 (5.14) 13 10 14 (5.25)3 (3.70) 5.04 1.93 11 3 10 (0.78)4 (6.61) 2.62 2.84 10 14 13 0.815 or more 3.97 4.09 3.03 43 30 34 18.52Avg Using Measure (0.42) 1.37 0.68 21 15 17 6.25Other Equity 2.54 2.54 2.54 15 15 15

* refers to use of measures other than column header measureNote: TSR performance is heavily influenced by industry performance

Average of 5-Year TSR 2008-2012 (%) # of Companies

Figure 6 | LTI Grants and Company Performance


Four industries with at least nine companies have been highlighted in Figure 7,

indicating that companies using TSR produced better results than companies

that did not use TSR.

Earnings per Share (EPS)

While overall companies using EPS had a higher average TSR than companies

using TSR measures, the results were not compelling at an industry level.

Only five industries with companies using EPS out-performed companies not

using EPS. These were Diversified Financials (only one company used EPS),

Food & Staples Retailing, Materials, Technology Hardware & Equipment, and

Utilities (highlighted below industries with at least eight companies).

Sectors with at least eight companies where EPS clearly didn’t relate to

TSR performance included Energy, Insurance, Media, and Retailing. (See

Figure 8.)

Figure 7 | TSR Measures and Industry Results

Industry TSR (%)*#

CompaniesUsing TSR

Not Using TSR

No LTIP

# Using TSR

# Not Using TSR

# No LTIP

Automobiles & Components 4.9 5 3.6 6.7 NA 3 2 0Banks (1.7) 3 (5.2) 5.2 NA 2 1 0Capital Goods 0.5 23 (2.2) 3.0 NA 11 12 0Commercial Services & Supplies (7.6) 2 4.6 (19.7) NA 1 1 0Consumer Durables & Apparel 9.6 2 NA 9.6 NA 0 2 0Consumer Services 7.2 4 14.0 5.3 4.1 1 2 1Diversified Financials (9.6) 9 (4.4) (13.0) (15.0) 4 3 2Energy (3.3) 18 (2.2) (6.9) (2.3) 12 4 2Food & Staples Retailing (2.3) 8 (10.2) 5.6 NA 4 4 0Food Beverage & Tobacco 4.0 12 3.6 4.4 NA 7 5 0Health Care Equipment & Services 2.3 11 4.4 1.9 (1.4) 3 7 1Household & Personal Products 6.2 3 8.7 4.9 NA 1 2 0Insurance (4.0) 10 (12.1) 2.5 (3.5) 4 5 1Materials (3.4) 9 0.7 (8.5) NA 5 4 0Media 11.2 9 8.1 15.2 NA 5 4 0Pharmaceuticals, Biotechnology & Life Sciences 6.5 8 6.0 8.0 NA 6 2 0Retailing 2.8 14 (5.9) 3.8 21.3 1 5 7 2Semiconductors & Semiconductor Equipment (0.7) 2 (1.8) NA 0.4 1 0 1Software & Services 2.0 6 (0.0) 3.0 2.0 1 2 3Technology Hardware & Equipment 1.7 11 (3.7) 10.3 12.3 2 7 2 2Telecommunication Services 5.0 3 5.0 NA NA 3 0 0Transportation 5.5 6 7.0 5.2 NA 1 5 0Utilities 1.9 17 1.8 4.1 NA 16 1 0Average 1.2 195 (0.2) 2.7 2.5 103 77 151 Includes Amazon (22% TSR) and Autonation (20% TSR)2 Includes Apple (22% TSR)* Average of 5 year 2012 TSR (%)

TSR Performance (%)


Capital Efficiency Measures

Companies using capital efficiency measures, such as the return on capital,

return on assets, return on equity and economic value added, had a lower

average TSR than companies not using capital efficiency measures. However,

eight industries with companies using capital efficiency measures outperformed

companies not using capital efficiency measures. These included Capital Goods,

Energy, Food Beverage & Tobacco, Health Care Equipment & Services, Insur-

ance, Retailing, Technology Hardware & Equipment, and Utilities (highlighted

in Figure 9).

Industries with at least eight companies where capital efficiency measures might

not relate to TSR performance included Diversified Financials, Food & Staples

Retailing, Materials and Media. For these companies, the authors noticed that the

use of capital efficiency measures was either significant or insignificant with little

middle ground, so drawing any type of conclusion is difficult. (See Figure 9.)

Figure 8 | EPS Measures and Industry Results

Industry TSR (%)*#

CompaniesUsing

EPSNot Using

EPSNo

LTIP# Using

EPS# Not Using

EPS# No LTIP

Automobiles & Components 4.9 5 NA 4.9 NA 0 5 0Banks (1.7) 3 NA (1.7) NA 0 3 0Capital Goods 0.5 23 0.7 0.4 NA 11 12 0Commercial Services & Supplies (7.6) 2 (7.6) NA NA 2 0 0Consumer Durables & Apparel 9.6 2 11.7 7.6 NA 1 1 0Consumer Services 7.2 4 8.2 NA 4.1 3 0 1Diversified Financials (9.6) 9 4.0 (10.1) (15.0) 1 6 2Energy (3.3) 18 (14.7) (2.6) (2.3) 1 15 2Food & Staples Retailing (2.3) 8 (0.3) (3.4) NA 3 5 0Food Beverage & Tobacco 4.0 12 6.1 3.4 NA 7 5 0Health Care Equipment & Services 2.3 11 2.7 2.5 (1.4) 8 2 1Household & Personal Products 6.2 3 5.1 8.3 NA 2 1 0Insurance (4.0) 10 (27.9) 2.8 (3.5) 2 7 1Materials (3.4) 9 8.0 (6.6) NA 2 7 0Media 11.2 9 9.4 13.5 NA 5 4 0Pharmaceuticals, Biotechnology & Life Sciences 6.5 8 5.8 7.8 NA 5 3 0Retailing 2.8 14 (11.0) 5.1 21.2 1 4 8 2Semiconductors & Semiconductor Equipment (0.7) 2 NA (1.8) 0.4 0 1 1Software & Services 2.0 6 (1.5) 9.0 2.0 2 1 3Technology Hardware & Equipment 1.7 11 1.1 (4.1) 12.3 2 6 3 2Telecommunication Services 5.0 3 NA 5.0 NA 0 3 0Transportation 5.5 6 2.6 7.0 NA 2 4 0Utilities 1.9 17 3.3 1.1 NA 6 11 0Average 1.2 195 1.4 0.8 2.5 73 107 151 Includes Amazon (22% TSR) and Autonation (20% TSR)2 Includes Apple (22% TSR)* Average of 5 year 2012 TSR (%)

TSR Performance (%)


OTHER HIGHLIGHTS

Number of Years With Same Measure

Looking across the sample of companies, Figure 10 indicates that companies

using at least one measure consistently for five or more years show higher TSR

performance results. Having consistency in LTI design and in the use of measures

provides a consistent focus for management and, perhaps, results in better perfor-

mance, especially considering that most performance periods are three years

long. Therefore, changing LTI measures from year to year can result in significant

confusion and loss of focus.

Number of Years Measures Changed

Similar results can be seen by looking at the number of measure changes made

over a five-year period (2008-2012). If there were no measure changes over the

Figure 9 | Capital Efficiency Measures and Industry Results

Industry TSR (%)*#

CompaniesUsing

Cap Not Using Cap Eff

No LTIP

# Using Cap Eff

# Not Using Cap Eff

# No LTIP

Automobiles & Components 4.9 5 (1.1) 6.3 NA 1 4 0Banks (1.7) 3 (1.7) NA NA 3 0 0Capital Goods 0.5 23 1.5 (2.3) NA 17 6 0Commercial Services & Supplies (7.6) 2 4.6 (19.7) NA 1 1 0Consumer Durables & Apparel 9.6 2 NA 9.6 NA 0 2 0Consumer Services 7.2 4 11.9 6.4 4.1 1 2 1Diversified Financials (9.6) 9 (7.5) NA (15.0) 7 0 2Energy (3.3) 18 (0.9) (4.9) (2.3) 6 10 2Food & Staples Retailing (2.3) 8 (3.0) 0.0 NA 6 2 0Food Beverage & Tobacco 4.0 12 8.5 2.5 NA 3 9 0Health Care Equipment & Services 2.3 11 3.6 0.5 (1.4) 7 3 1Household & Personal Products 6.2 3 8.3 5.1 NA 1 2 0Insurance (4.0) 10 (2.4) (6.0) (3.5) 5 4 1Materials (3.4) 9 (4.4) 4.8 NA 8 1 0Media 11.2 9 3.1 12.2 NA 1 8 0Pharmaceuticals, Biotechnology & Life Sciences 6.5 8 6.5 6.5 NA 1 7 0Retailing 2.8 14 8.1 (4.4) 21.2 1 4 8 2Semiconductors & Semiconductor Equipment (0.7) 2 NA (1.8) 0.4 0 1 1Software & Services 2.0 6 2.0 NA 2.0 3 0 3Technology Hardware & Equipment 1.7 11 3.0 (1.6) 12.3 2 2 7 2Telecommunication Services 5.0 3 1.5 6.7 NA 1 2 0Transportation 5.5 6 5.9 4.8 NA 4 2 0Utilities 1.9 17 3.0 1.6 NA 4 13 0Average 1.2 195 0.7 1.4 2.5 86 94 151 Includes Amazon (22% TSR) and Autonation (20% TSR)2 Includes Apple (22% TSR)* Average of 5 year 2012 TSR (%)

TSR Performance (%)


five-year period, the average TSR was much higher than the overall average

(5.07% vs. 1.13%). Also, as the number of annual measure changes increased, TSR

performance generally decreased.

SUMMARY

Only 15 companies in the 195-company sample did not make performance-based

grants between 2008 and 2012. Also, 19 did not make performance-based grants

from 2009-2012. Interestingly, in both cases, these companies averaged a higher

five-year TSR performance than the average for companies using performance

shares. The results bring into question whether performance-based grants are

more effective than time-vested grants in positively affecting performance.

For the majority of companies granting performance-based grants, relative TSR

is a commonly used performance measure. However, it isn’t clear the use of TSR

as a measure has a positive influence on company performance. Nevertheless,

performance-vested grants will continue to increase in importance. Whether LTI

measures affect performance, it is appropriate that under-performing companies

receive less value than high-performing companies through lower vesting amounts.

Since there is no overwhelming evidence that using performance-based grants

will result in improved results, companies need to understand as clearly as possible

which measures are most likely to motivate executives and positively affect company

performance as measured by long-term TSR. The analysis strongly suggests that

companies need to figure that out and then stick with it over the long haul.

The study reviewed three types of measures, TSR, EPS and capital efficiency,

Figure 10 | Using the Same Measure Each Year

#Years the Same

Measure TSR (%)* # Companies

1 (8.72) 15

2 (3.72) 19

3 1.40 23

4 (0.15) 30

5 3.8 93

No LTIP 2.54 15

____________________________________________________________________

Average 1.15 195

*Average of 5-year TSR 2012 (%)


and found that companies that had consistently used these measures for five or

more years experienced higher TSR results than the industry average. This strongly

suggests that stability of design — maintaining a consistent set of performance

measures over time — has value.

And of these three types of measures, using an EPS measure was most closely

related to strong TSR performance. (See Figure 6.) Most companies provide EPS guid-

ance to the investment community and it is typically an area of focus for management.

Companies are able to implement programs and initiatives that affect EPS, which

cannot be said for TSR measures. This suggests that line of sight has value.

The study provides some indications in Figures 7, 8 and 9 as to what might

work best for various industries and what doesn’t seem to work. For example, it

appears that Diversified Financials, Energy, Materials, and Health-Care Equipment

& Services industries used TSR measures with positive TSR results. EPS measures

were most successful in Diversifies Financials, Food & Staples Retailing, Materials,

Technology Hardware & Equipment, and Utilities. Capital Efficiency measures were

effective in Energy, Food & Staples Retailing, Health-Care Equipment & Services,

Insurance, Retailing, Technology Hardware & Equipment, and Utilities.

This is not a substitute for a more comprehensive industry analysis and for

correlation analysis that every company should be performing in designing an LTI

plan that works for both executives and shareholders.

Finally, the findings are not statistically significant but rather are directional

or at least indicate the effectiveness, or lack thereof, of commonly used perfor-

mance measures in long-term incentive plans. Nevertheless, this study shows

Figure 11 | Measure Changes

#Years the Same

Measure Changed TSR (%)* # Companies

1 5.09 56

2 0.87 49

3 (o.47) 40

4 (6.61) 6

5 (5.92) 4

No LTIP 2.54 15

____________________________________________________________________

Average 1.15 194

*Average of 5-year TSR 2012 (%)


convincing evidence of three important long-term incentive design elements for

producing relatively good TSR results. First, making performance-based grants

instead of time-based grants does not always translate into superior TSR perfor-

mance. Second, for companies using performance-based grants, TSR performance

is generally improved if one or more measures are used consistently over time.

And finally, TSR performance is better for companies who rarely change measures

from year-to-year. z

AUTHORS

James F. Reda ( [email protected]) is managing director, executive compensation of Arthur J. Gallagher & Co.’s Human Resources & Compensation Consulting Practice in New York.

David M. Schmidt ([email protected]) is senior consultant, executive compensation of Arthur J. Gallagher & Co.’s Human Resources & Compensation Consulting Practice in New York City.

REFERENCES

James F. Reda and Associates. 2013. Study of 2012 Short- and Long-Term Design Criterion Among Top 200 S&P 500 Companies. New York. Viewed: May 28, 2014. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2379518.

Sweet, Ken. “Median CEO Pay Crosses $10 Million in 2013.” Associated Press. May 27, 2014. Viewed: May 28, 2014. http://bigstory.ap.org/article/median-ceo-pay-crosses-10-million-2013http://bigstory.ap.org/article/median-ceo-pay-crosses-10-million-2013.

Wall Street Journal/Hay Group. 2013. CEO Compensation Survey 2012: Directors Work to Establish “Clear Line of Sight” Between Pay and Performance. New York. Viewed: May 28, 2014. http://www.haygroup.com/us/downloads/details.aspx?id=36975.

mailto:[email protected]


http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2379518

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2379518

http://bigstory.ap.org/article/median-ceo-pay-crosses-10-million-2013http://bigstory.ap.org/article/median-ceo-pay-crosses-10-million-2013

http://bigstory.ap.org/article/median-ceo-pay-crosses-10-million-2013http://bigstory.ap.org/article/median-ceo-pay-crosses-10-million-2013

A total rewards professional’s goal is to make

pay for performance work for all employees.

However, many rewards professionals may be

struggling to answer a number of critical questions

related to incentive design and delivery to improve

performance-based pay (in all its forms) in the current

environment, including:

z What are companies doing effectively on the executive

pay front in terms of how they are measuring and

paying for performance? Is the definition of perfor-

mance effectively aligned throughout the organization?

z What lessons can be learned from executive pay manage-

ment about what’s working, and how can these lessons

be applied to broad-based employee compensation?

z How should organizations think about different skill

sets needed to perform jobs in order to maximize

return on reward investments?

By exploring these issues, organizations can begin

to reassess their definition of performance and perfor-

mance metrics for all employees as well as the total

rewards vehicles available to managers throughout the

organization. The resulting insights will enable these

organizations to develop a more effective approach to

pay for performance for the entire workforce.

Lori WisperTowers Watson

Emory ToddTowers Watson

Don DelvesTowers Watson

Pay for Performance: Getting it Right Throughout the Organization


Third Quarter 2014


IMPROVED ALIGNMENT ON THE EXECUTIVE FRONT

Contrary to popular opinion, executive pay today aligns fairly closely with perfor-

mance. However, this alignment is a recent development. CEO pay skyrocketed

in the mid-to-late 1980s with the introduction of golden parachutes and “mega-

grants” of stock options. This trend continued in the 1990s. From 1993 to 2000,

CEO pay rose 375% owing largely to the use of stock options (Kaplan 2014). The

upward trajectory of CEO pay came to an abrupt halt in 2001 as the dot-com

bubble burst. At that point, CEO pay decreased slightly and since then has

remained in a fairly steady, albeit high, range.

Today, Fortune 500 CEOs earn, at the median, between $9 million and $12

million in annual pay. This pay is weighted much more heavily on stock perfor-

mance than in the past. For example, in 1990 the CEO pay mix consisted of 40%

salary, 40% stock options and 20% annual incentive. In contrast, today’s pay mix

is comprised of 20% salary, 20% annual incentives and 60% long-term incentives

(LTIs) consisting of options, restricted stock and performance shares. (See Figure

1.) The value of the stock compensation moves up and down with the company’s

stock performance. And the annual incentive and some of the stock compensation

will fluctuate depending on the financial performance of the company. Therefore,

most of the CEO pay package is linked to company performance.

Moreover, the last decade has seen significant improvements in corporate gover-

nance, which can be attributed largely to the passage of the Sarbanes-Oxley Act

of 2002 on the heels of the Enron and WorldCom scandals. Today’s boards are far

more independent than in the past, when many board members were handpicked

by CEOs. Owing to Sarbanes-Oxley and growing shareholder scrutiny, independent

Figure 1 | Approximate Mix of CEO PayWeighted much more heavily on stock performance.


non-executive directors now make up key committees in their entirety in almost

all publicly traded corporations.

When done right, executive pay adheres to four core principles that consist of:

1 | Focusing on purpose and the company’s mission

2 | Creating alignment with shareholders

3 | Holding executives accountable

4 | Creating management engagement.

Due to clear performance expectations and a wide range of well-defined reward

vehicles — meaningful salary adjustments, annual incentives tied to financial and

individual performance and multiple long-term incentive vehicles — along with

improved governance, today’s executive compensation programs adhere to these

principles reasonably well.

TENUOUS ALIGNMENT ON THE EMPLOYEE FRONT

While executive compensation programs have evolved over the past 10 years and

now align more closely with performance, the same is not true of compensation

programs designed for the broad-based employee population. In fact, companies

have struggled for decades to align employee pay with performance. During the

past five years, this struggle has only intensified as salary budgets have shrunk

and challenging economics continue to depress funding for incentives. More-

over, the use of employee stock options and profit sharing has also decreased

dramatically in most companies. Consequently, while companies strive to make

employee compensation programs adhere to the same core principles as executive

compensation programs, they often fall short due to a more limited employee

compensation toolset, which can become a barrier for organizations seeking to

improve the link between pay and performance.

To better understand this issue, below the two sides (performance inputs and

pay outcomes) of the employee pay-for-performance equation are examined:

z Organizations define performance inputs too broadly. Many companies expect

managers to consider an overly wide range of criteria when making the pay-for-

performance decisions and do not distinguish between the different elements

of performance for the purposes of linking them more effectively with rewards.

For example: Did the employee meet the job expectations? Did the employee

accomplish the goals set for him/her at the start of the performance period?

Is the employee ready for the next set of job expectations (i.e., often labeled

“high potential”)? Has the employee had sustained performance over time? Is the

employee in a hot skill or mission critical job? In addition, it can be challenging to

link each performance input to organizational performance metrics. For example,

an employee working in a mailroom may have as a goal to become proficient

in using new tracking software. It can be difficult if not impossible to establish

a link between this performance goal and corporate profits. While the challenge

of creating “line of sight” between an employee’s actions and the results being


measured is a given in the effective use of performance-based rewards, one can

learn from the lessons of executive pay for performance. Defining performance

more narrowly and clearly communicating those expectations goes a long way

to being able to effectively align rewards to performance.

z Organizations define pay outcomes too narrowly. At the same time that orga-

nizations are relying on an overly broad definition of performance, they are

providing managers with a narrow set of rewards options primarily in the form

of salary increases (merit increases), which may be accompanied by a small

annual bonus, depending on the level of eligibility for short-term incentive plans

at a company. If one examines how executive pay for performance is designed

and delivered, the pay outcomes are broader and more closely matched to the

performance inputs. Total rewards professionals may have to get more creative

on the broad-based employee side of pay for performance to achieve this than

in the executive pay arena, but it can be accomplished.

Performance is complicated. Yet, we managers don’t have sufficient guidance on

how to define and demystify it. On the contrary, managers are directed to fill the

“pay-for-performance funnel” with a broad range of performance inputs and then

are frustrated even further by being limited in the pay vehicles they can use to

reward a big picture version of performance. (See Figure 2.) How can employee

pay for performance be made more effective?

REDEFINING PERFORMANCE

To improve the pay-for-performance process, organizations need to redefine the

two sides of the equation (i.e., performance inputs and pay outcomes) by more

narrowly defining performance and expanding or broadening the definition of pay.

Following this approach, organizations should dissect every aspect of performance.

Figure 2 | Why Doesn’t it Work?Broad Performance “Inputs” and Narrow Pay “Outcomes.”


In doing so, they will develop a deeper understanding of each element of perfor-

mance, which in turn will enable them to focus on how to best reward for each

element. Following are some examples:

z Performance that meets job expectations. In the hiring process, organizations

understand that they are trying to match an employee’s unique skills, knowl-

edge and experience to a distinct set of job expectations. If what the employee

brings to the table falls below the job requirements (i.e., the job is somewhat of

a stretch for the candidate), a company may decide to start that employee at a

salary somewhat below the market value of the job with the expectation that as

the employee works his/her way up the learning curve, he/she will earn salary

increases that will put the employee in a salary range closer to the competitive

rate for the job.

According to prevailing compensation practice, the salary market rate reflects

the “fully competent” level of skill for a given job. Companies should be willing

to keep the base salary competitive of any employee who achieves this level by

giving him/her a salary increase that is reflective of how the market moves each

year for that job. For example, if the market moved at 3% in a given year, as it

did in 2013, and an employee’s salary is close to the competitive rate for the job,

the company should be willing to provide this employee with a 3% increase in

order to retain his/her skills for that year. In this instance, the organization is

REWARDING BUSINESS IMPACT IN BIOPHARMACEUTICALS

A bio-pharmaceutical services organization was facing the classic challenge of growing the top

line in new customer segments while continuing to squeeze margins out of an increasingly price

sensitive core-commercial business. However, the organization’s culture was largely paternalistic

and egalitarian with total rewards programs that were not performance-oriented or differentiated

across business units and levels. To meet this challenge, the organization realized it needed a

better grasp of the impact of various employee groups and roles on its business. It also needed

to develop customized rewards for these segments as a means to both optimize its rewards spend

and to better invest in the roles and behaviors that would result in long-term growth.

To address this situation, the company embarked on a process to segment its workforce based

on strategic and financial impact, and to develop differentiated rewards programs based on the

segmentation results. It first segmented job families into pivotal, proficient and efficient (or core)

role categories. Next, it customized rewards choices or outcomes by role category – varying

programs to emphasize or de-emphasize key rewards guiding principles including performance

orientation, competitiveness and career development. For example, employees in pivotal roles

received higher annual upside potential, access to long-term equity and leadership effective-

ness training for above and beyond performance. Employees in proficient roles were targeted

at the median of the market with an emphasis on shorter-term performance and greater access

to development programs.

The new rewards program tailored to different employee segments allowed the organization to

re-allocate or divert investments to pivotal roles, improving engagement and retention among

employees in these roles. It also allowed for greater strategic alignment of the workforce by better

aligning performance inputs and reward outcomes


not using the salary increase as a reward to pay for overall performance (the

broad definition of performance). Instead it is rewarding a very specific element

of performance — meeting job expectations.

z Performance that is time-based and goal-driven (and typically tied to a

12-month period, such as Jan. 1 to Dec. 31). Even today, in many performance

management systems, managers are expected to rate employees on both their

competency level, which is very similar to the “performance that meets job

expectations” designation defined above, and their “results for the year” typically

defined as a set of goals — the tasks/projects/assignments they have to accom-

plish before the end of the performance period.

In dissecting performance, one can consider this performance element separately,

such that it is best rewarded not through the use of a salary increase, which would

add to fixed costs and tie these costs to a performance element that is variable by

its nature, but through either a bonus award or some other element of pay/rewards

that is a one-off type vehicle. In rewarding time-based, goal-driven performance,

companies may also want to consider using innovative, non-traditional vehicles

that employees value such as supplemental PTO days, training/learning/mentoring

opportunities, flexible work arrangements, etc. In this way, not only are the inputs

that define performance narrowed, but the pay outcomes are also broadened.

z Performance that goes beyond meeting the job expectations. As described

above, if an employee is meeting expectations outlined in a job description, total

USING DIFFERENTIATED REWARDS TO IMPROVE RETENTION

A popular restaurant chain offering both fast-casual and full-service dining was looking to better

manage its rewards spending while continuing to pay employees well and averting the high

turnover typical in the industry. This chain did not want to be perceived as a company that limits

employee hours to avoid making a significant investment in benefits. It also recognized that it

would not be financially feasible to have all employees work a 40-hour week and receive full

benefits. At the same time, this company realized that not all employees wanted to work full time.

Some were happy to work part time. Nor did all employees expect or need to receive benefits

including health insurance. For instance, some younger employees were still on their parents’

health plans while others were covered by a spouse’s plan.

To better understand the needs and preferences of different employee groups, this restaurant chain

undertook an employee segmentation initiative. It segmented its workforce first by demographics

and then by job. The segmentation enabled this company to divide its workforce into several

groups ranging from those who wanted to work full time in key areas such as internal operations

or customer experience management and work their way up the corporate ladder to others who

were happy to work part-time hours as servers without benefits or the possibility of promotion.

Using the segmentation data, this company was able to develop a rewards program tailored

to different employee groups, which rewards different performance inputs/elements. It also

continued to pay employees above the industry average. The higher salary budget more than

paid for itself in efficiency reflected in improvements such as fewer missed orders and less

overflow in the bar area. Overall, this approach helped this company retain employees whose

skills it valued while optimizing its reward spend.


rewards professionals should be willing to give that worker a salary increase

to keep his/her pay competitive in order to retain their skills. However, if an

employee is exhibiting skills/competencies required for the next job up the ladder,

this element of performance should be dissected in order to figure out the best

way to reward it.

The traditional approach to paying for this element of performance is via a

promotion in which the employee is given a rather substantial increase in base

salary (getting the worker closer or to the market rate for that higher level job)

and perhaps even a higher bonus target commensurate with the new higher level.

However, many organizations’ talent pipelines are clogged because of fewer

employees leaving or retiring due to the still somewhat gloomy labor-market

conditions. In cases where promotions are not possible, this element of perfor-

mance should still be recognized and rewarded through other pay vehicles such

as long-term incentive awards, which are often used effectively in rewarding

high potentials, or via non-financial rewards that employees in this category

may value such as training/learning/mentoring opportunities. For example, if

an employee has demonstrated leadership potential, another reward outcome

may be to send him/her to a leadership training program (one in which he/she

may not normally have access to at his/her level).

It is important for companies to formalize the processes in this approach, and to

use today’s technology to automate these processes as appropriate. For example,

once performance is more narrowly defined, companies can easily provide

managers with a web-based menu of pay element options that would best suit

each element of performance. Overall, this approach will enable organizations to

develop a performance-based pay strategy that aligns performance inputs with

the right pay outcomes. (See Figure 3.) And it relies on practices similar to those

found in executive compensation programs where each performance element is

clearly defined, as are the diverse reward vehicles.

USING SEGMENTATION TO OPTIMIZE PERFORMANCE-BASED REWARDS

Companies can take this approach to performance-based pay to the next level by

using employee segmentation. Not only is segmentation a core building block in

the design and delivery of a performance-based pay strategy, but it is critical to

improving ROI on rewards investments. Recent research has found that organizations

that customize their total rewards strategy by critical workforce segments see five

times higher levels of engagement and two times better financial results (Towers

Watson 2012-2013). Employee segmentation involves first categorizing employees

into groups based on key dimensions, for example, the value of their roles to the

organization or personal and social characteristics (e.g. age, tenure and/or lifestyle),

and then gaining an understanding of the rewards preferences of these segments.

Organizations that realize the greatest return on their segmentation efforts use

it as a strategic differentiator by following a three-step approach:


z Pivotal Role Analysis. First, companies identify the business units, functions,

levels or roles that have the greatest impact on strategic goals. This is accom-

plished typically through a pivotal role analysis that classifies the workforce into

three broad categories: pivotal, proficient and core.

- Pivotal Roles: These are roles that either (a) deliver immediate and significant

value to the business — where having even one person with the wrong skills

(or having an open position) materially impacts business performance in a

given year — or (b) are essential to delivering the longer-term strategy, where

having even one person with the wrong skills (or having an open position)

today puts the entire strategic plan at risk. For example, in the pharmaceu-

tical industry, a clinical operations project manager would be considered a

pivotal role as the person would have a direct impact on the approval or

failure of clinical trials, which are critical to a healthy product pipeline and

shareholder value.

- Proficient Roles: Roles that require employees to have significant technical

skills to execute work on a regular basis and to operate within a defined range

of performance. For instance, a vice president of quality assurance could be

regarded as a proficient role due to the specialized skills needed to ensure

quality protocols are followed within a set of principles.

- Efficient Roles: Consist of roles that are core to how work gets done in the

organization but are readily available in the marketplace and can be quickly

trained. There is tolerance for open positions in these roles. For example,

many distribution or even sales roles could be considered efficient given avail-

able talent pools and the ability to translate competencies.

Figure 3 | Performance-Based Pay Strategy: Aligning Performance: Inputs with the Right Pay Outcomes.

Base salary and merit increases

Benefits and continued vesting

Job-related training

Meeting Job Expectations Performance

Annual incentive

Recognition

Non-traditional: Flexible work arrangements, PTO

Time Based/Goal Driven Performance

Promotional base salary increase

“Cool” training or developmental opportunity

Equity

Above and Beyond Meeting Job Expecations Performance

Illustrative Performance Based Pay Strategy

Perf

orm

ance

Inpu

ts

Pay Outcom

es

May Look Different for Different Employee Segments

Performance Based Pay Strategy: Aligning performance “inputs” with the right pay “outcomes”


z Total Rewards Optimization. Next, companies conduct conjoint or trade-off

research to determine employee preferences for different reward combinations.

For example, would an employee prefer a smaller bonus in favor of more PTO?

Or would an employee like greater access to career development programs versus

stock options? They also assess the relative costs and potential savings associ-

ated with various rewards combinations to determine the optimal portfolio of

rewards programs for each segment. This process, which the authors refer to as

total rewards optimization, enables companies to offer rewards programs that

have the highest perceived value at the lowest cost.

z Customization of Rewards Programs. Because segmentation enables compa-

nies to recognize which jobs are most critical to their business, especially those

that help create competitive advantage, and understand the rewards prefer-

ences of their employees, they can customize how they reward the different

elements of performance (performance inputs) that much more effectively.

This process can also be used to identify and customize rewards programs

for different employee segments based on elements other than jobs, such as

demographics, performance levels, engagement levels and others. In this way,

the efficiency and effectiveness of these programs is not only increased, but

attraction, retention and engagement of talent, as well as productivity and

overall business performance are all improved.

Consider, for example, the hypothetical case of a global technology company

that segmented its workforce and determined that software engineering is a pivotal

IS BETTER ALIGNMENT BETWEEN EXECUTIVE AND EMPLOYEE PAY FOR PERFORMANCE NEEDED?

The article started with how executive pay programs have improved in their linkage to perfor-

mance. The authors have attempted to make the case that there are lessons to be learned from

the executive pay experience as total rewards professionals look to improve pay for performance

for the broader employee population. Having examined each separately, is there also value in

looking at whether they should be more closely linked? Because so much of performance for

executives is tied into stock price and shareholder value, one way to do this may be through the

broader deployment of stock options.

Stock options were once widely used as a way to share stock price appreciation broadly with

most or all employees. Most companies stopped granting options widely when an expense for

options was introduced in 2005. With this accounting change, options were deemed too expensive

relative to the perceived value by employees.

What if an option could be designed that had a very low expense and a relatively high perceived

value? Employees could be rewarded for stock price growth, with a limited accounting expense

and zero cash outlay by the company.

How would one do this? Design and grant options that have a five-year term (rather than the

traditional 10) and cap the upside at two times today’s stock price. This will deliver plenty of

upside opportunity at an expense that is about half of that for a typical stock option. And, in this

way, organizations gain the alignment between executive pay for performance and broad-based

employee pay for performance that could mean significantly greater results than without it.


role that is difficult to source and also has a significant impact on innovation, growth

and long-term profitability. The organization conducted a conjoint survey to identify

the different types of rewards that software engineers value. It then analyzed the

results by key demographic criteria and discovered that engineers with less than five

years of tenure placed significant value on PTO and developmental opportunities

over all other rewards (except base salary, which was No. 1 across all segments).

Using the definitions of performance outlined above, the company determined that

for “performance that is time-based and goal-driven,” it could use supplemental PTO

days to reward high performance in this area. This takes the pressure off of the

incentive budget and provides managers with a more diverse toolset to reward high

performance. This approach resulted in higher retention among software engineers

with less than five years of tenure while improving engagement and overall financial

performance.

PAY FOR PERFORMANCE THAT WORKS

To remedy this situation, companies need to carefully examine both sides of the

performance equation — examining performance elements/inputs in a narrower and

more surgical manner — and then assessing all the different pay outcomes a company

might use to reward a very specific aspect of performance. Taking this a step further,

a company might also offer a broader array of pay outcomes by employee segment

for each level of performance input.

Three levers help to ensure greater alignment with the practices used in executive

pay management: 1) be clear about what aspects of performance you are measuring

and how employees will be rewarded for this performance; 2) use the full breadth

of rewards vehicles; and 3) provide a well-defined governance structure for your

pay-for-performance program.

This approach goes a long way toward enabling organizations to focus the entire

employee population from the top to the bottom on the achievement of desired

results in a way that they have not been able to do using the pay for performance

processes of the past. z

ABOUT THE AUTHORS

Don Delves, CPA, ([email protected]) is a senior consultant at Towers Watson. Prior to that, he was president and founder of The Delves Group. He works with boards, compensation committees, senior executives and salesforces to improve their effectiveness and reassess the way they are organized, directed and rewarded. He is the author of McGraw Hill’s Stock Options & the New Rules of Corporate Accountability. Delves holds a master’s degree in business administration, specializing in finance, from the University of Chicago. He serves on the board of the Chicago Compensation Association and has been a speaker at the WorldatWork Total Rewards Conference & Exhibition.

Emory Todd ([email protected]) is the managing consultant for Towers Watson’s Southeast market. He is a leader of Towers Watson’s Total Rewards Initiative, focusing on employee value proposition (EVP) and reward program linkages to financial, customer and people outcomes. Todd specializes in total rewards, EVP, incen-tive design, value driver analysis and measurement. Since joining Towers Watson in 1996, Todd has worked with a variety of global organizations designing and implementing innovative solutions to address key compensation, HR and business challenges. Todd has written articles, spoken widely and facilitated group meetings on incentives, rewards optimization, goal setting and performance management.




Lori Wisper ([email protected]) leads the rewards practice in Towers Watson’s Rewards, Talent and Communication line of business in Chicago. She has more than 25 years of experience both in consulting and corporate human resources, primarily focused on compensation. She has consulted with clients on broad-based compensation and talent management issues including global compensation strategy and design, global job leveling and career frameworks, total compensation strategy, incentive plan and base salary design, sales effectiveness and sales compensation, performance management and compensation processes and admin-istration. In addition to consulting experience with two other national compensation consulting firms, Wisper spent several years working as the head of global compensation within the corporate HR function of several companies.

REFERENCES

Kaplan, Steven N. 2014. “Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges.” University of Chicago Booth School of Business and National Bureau of Economic Research.

Towers Watson. 2012-2013. “Global Talent Management and Rewards Study.”


Asako TsumagariMevident Inc.

Celina Pagani-TousignantNormisur International

Designing an Effective Corporate Health and Wellness Strategy

W ith all the regulatory changes, this is a big

moment for employers to take drastic action

in their health and wellness strategies. Many

employers saw a big jump in medical plan premiums for

2014 renewals. As health benefits are discussed daily in

the media, they also have become a frequent topic of

discussion among corporate executives.

This is the moment that HR or compensation and

benefits managers will have to come up with a strategic

framework for their health and wellness initiatives and

guide other executives, such as the CEO and CFO, to

the right decisions. (For the sake of brevity, this article

will refer to anyone who manages a benefits program

as an “HR manager.”) However, HR managers are often

put on the defensive for the existing benefits programs

that include a long list of items from medical, dental

and vision plans to behavior and alternative-medicine

packages, life and long-term care insurance, Employee

Assistance Programs (EAPs), work-life initiatives,

concierge services, onsite gyms, weight-loss programs

and the list goes on.

Under the cost pressure of rising medical-plan

premiums, some executives may demand HR managers


Third Quarter 2014


cut programs such as wellness initiatives, while other executives interested in

talent attraction may ask HR managers to add new programs. In addition, HR

managers receive countless calls from benefits brokers, all with ideas how to

solve the cost problem by dropping employees to a public exchange, changing

the coverage design or moving to self-funding. HR managers also receive calls

from vendors who are developing tools in such areas as wellness, engagement

and benefits management.

In this environment, it is a daunting task for HR managers to develop a health

and wellness strategy that can articulate all the programs in the portfolio and obtain

buy-in from other executives. Particularly if HR managers are entrenched in the

operational aspects of these programs, they will have a hard time communicating

with other executives who have no domain expertise in health and wellness benefits.

The key is to first develop a health and wellness strategy that supports, and can

be explained from, the overall business strategy of the company in the language

of the CEO and CFO. Whatever health and wellness programs HR managers

put in place, they have to make sense and be easily understood by CEOs and

CFOs who are looking at issues

from the perspectives of running

the company.

In publicly traded companies,

CEOs and CFOs are ultimately in

charge of delivering and reporting a

profit to their shareholders. Driving

innovations, achieving efficiencies,

and reducing costs are goals that

generate more revenue and reduce

expenses, and ultimately deliver

more profit.

But indeed, in all annual strategy

sessions, budget sessions, investor presentations and business manager perfor-

mance reviews, CEOs and CFOs are ultimately looking for ways to improve the

profitability of the company.

The first step to making the connection between the HR operation and the world

of the CEOs and CFOs is to understand the company’s business focus designed

to improve its profitability. Is the business focusing on innovation and growth? Is

it focusing on operational efficiency? Then, as the second step, it is important to

examine the implications of the business focus to the HR operation and health

and wellness strategy.

Next, the article will look at two contrasting companies, Safeway and Google.

These two companies are often used as examples in corporate health and wellness

case studies for their active investment in wellness programs.

As Table 2 shows from a financial viewpoint, the nature of the business is very

Table 1 | The World of CEOs and CFOs

Revenue

COGS

SG&A

Interest

Tax

Gross Profit

Operating Profit

Profit Before Tax

Net Profit


different between

the two companies.

Safeway is a low-

margin business,

with low profitability

and low revenue

growth rate.

For Safeway, the

cost of health benefits

and workers’ compen-

sation is more than

3% of revenue while

operating profit is

only 2.5% of revenue.

For Google, the cost

of health benefits and

workers’ compensa-

tion is negligible in the total financial picture.

For a company such as Safeway, it is critical to achieve operational efficiency to

maintain profitability, and hence, managing health-care cost is a critical issue. For

Google, the focus is on innovation and talent acquisition in order to support high-

revenue growth. Consequently, what these two companies do in the health and

wellness area is driven by completely different motivations.

Table 3 shows Cisco, another high-tech company, which is in Silicon Valley and is

highly profitable, and PG&E, a large utility company that is modestly profitable and

has a lower growth rate.

The data show Cisco is

not growing so much

anymore.

PG&E cannot be put

in the same category

as Cisco. Again, it is

important to further read

through PG&E’s annual

report to understand

the company’s business

focus, which is very

much on risk manage-

ment. The example of the

gas pipeline explosion

in San Bruno, Calif., on

Sept. 9, 2010 highlights

Table 2 | Comparing Google and Safeway

Source: Annual Reports, Yahoo! Finance

Revenue (2012) $50 Billion $44 Billion

Number of Employees 46,000 171,000

Revenue Per Employee $1.1 Million $260 K

Revenue Growth Rate 32% 1%

Gross Profit Margin 59% 26.5%

Operation Profit Margin 25% 2.5%

% of Health-Care and Workers Comp Cost in Revenue

= 0.5% = 3.2%

Google Safeway

Table 3 | Comparing Cisco and PG&E

Revenue (2012)* $49 Billion $15 Billion

Number of Employees 75,000 20,600

Revenue Per Employee $650 K $730 K

Revenue Growth Rate 5.5% 0.6%

Gross Profit Margin 61% 26%

Operation Profit Margin 23% 11%

% of Health-Care and Workers Comp Cost in

Revenue= 1.5% = 1.5%

Cisco PG&E

Source: Annual Reports, Yahoo! Finance*The figure from Cisco is from FY ending July 2013


the importance of risk management

for PG&E. The company reported

it incurred cumulative charges of

about $1.83 billion related to the

San Bruno explosion.

VALUE CREATION

FRAMEWORK: CEO/CFO

LANGUAGE

There is a framework that helps

to articulate the contribution of

the health and wellness strategy to the business by using the language of the CEO

and CFO. The framework shown in Table 4, developed by McKinsey & Company

and the Boston College Center for Corporate Citizenship (2009), explains how

corporate social responsibility or sustainability strategies contribute to the busi-

ness in the four dimensions of value that the financial market usually assesses:

market creation, efficiency in operations, risk management and the quality of

the leadership.

The framework can be useful to explain a company’s business focus. “Market

Creation” characterizes a company like Google; “Efficiency in Operations” char-

acterizes a company like Safeway; “Risk Management” characterizes a company

like PG&E; and lastly “Leadership Quality” characterizes a company like Cisco.

How can the framework be leveraged to explain the contribution of the

health and wellness strategy to the business? Depending on the company’s

financial focus, the benefits should be developed accordingly and can be

explained as follows:

z A company like Google that focuses on market creation wants healthy and

engaged employees who are able to launch new products. Health and well-

ness initiatives will concentrate on team activities, concierge services, fitness

and stress-related programs.

z For a company like Safeway that wants efficiency in operations, the incen-

tive to keep employees healthy is to keep costs down. Coverage redesign,

prevention and disease-management strategies will be key components of

the health and wellness portfolio.

z Utility companies similar to PG&E are concerned about risk management,

so employee safety is very important. Such companies will focus their health

and wellness initiatives on activities that keep employees safe, such as EAPs,

safety programs and ergonomics.

z Finally, companies like Cisco that rely on the leadership quality of employees

don’t want high turnover. They will develop health and wellness benefits

focusing on attractive coverage, work-life, career development and other

programs, so that they attract and retain the best talent.

Marketing Creation(new clients, products

and markets)

Efficiency in Operations(cost control)

Risk Management(License to operate,

supply chain and

reputation)

Leadership Quality(development of

leaders/long-term

decision making)

Table 4 | Value Creation Framework


DEVELOPING A HEALTH AND WELLNESS STRATEGY

There are four steps involved in developing an effective health and wellness

strategy.

Step 1: Understand the company’s business focus

As demonstrated earlier, the first step in developing a health and wellness strategy

is to understand the company’s business focus. If a company is publicly traded,

corporate documents such as annual reports, Securities and Exchange Commission

filings, investor presentations and press release are accessible. An HR manager may

feel he/she understands the company being there day in and day out. Nonetheless,

the HR manager will still want to read those documents because they explain

the company at the high level in a language that is familiar to the CEO and CFO.

But most important of all is to listen carefully to the CEO and CFO. The HR

manager may reach out to the CFO for his/her perspectives on the direction of

the business.

Table 5 shows examples of metrics to examine regarding a company’s business

focus.

Step 2: Understand your population and develop your health and wellness

strategy

The next step in designing a successful health and wellness strategy is to under-

stand how the business focus intersects with the company’s workforce.

This is an area that HR managers traditionally manage, and they have great

expertise — the question to ask now is, “Who are the employees?”

If the company’s business focus is on market creation, it’s likely it will want

Table 5 | Metrics to Measure a Company’s Business Focus

Market Creation

• Percent of revenue from new launches

• Year-to-year revenue growth > 10%

• Number of new innovations, products and services a year

• Workforce percent is high in innovative jobs

• Revenue/employee > $500K

Efficiency in Operations

• Very few new launches a year

• Percent of operating profit margins < 10%

• Year-to-year revenue growth < 5%

• Workforce percent is high in blue color/repetitive jobs

• Revenue/employee < $500K

Risk Management

• Potential magnitude of any one safety inci-dence caused by any one employee is very high

• Number of safety incidences a year is high

• Regulatory safety compliance is critical in operations

Leadership Quality

• Workforce percent is high in knowledge work which is highly technical and where experiences matter

• Headhunting of talents among competitors happens often


to hire creative workers. But if the workers the company is trying to attract are

mostly Generation Y male engineers or Generation X female marketers, this

could make a big difference to the health and wellness strategy. Programs that

are appreciated by different populations are different. Work-life options may be

more appealing to Gen X female workers who may also be caregivers, whereas

an onsite gym would appeal to Gen Y male engineers.

The impact of population difference can be highlighted by the different ways

Google and Cisco approach their health and wellness strategies. According to a

workplace survey, the average age of Google employees is around 31 years while

that of Cisco employees is 40. Cisco is known for its investment in one of the most

cutting-edge onsite medical centers in the United States that includes a radiology

center, pharmacy and diagnostic laboratory, while Google is known for its onsite

meditation rooms, massages, various sports activities and organic cafeterias in

addition to its onsite medical staff. The difference between the two health and

wellness strategy approaches makes sense considering that Cisco has an older

population of employees who are at the stage of developing chronic illnesses.

Table 7 illustrates some directions an HR manager may want to take into

account based on population profiles. The more insights gained in order to find

best ways to engage employees, the more successful the programs become.

Step 3: Build a return on investment (ROI) case for a health and wellness

strategy

In order to gain buy-in from the CEO and CFO, the next step is to build an

ROI case that connects the health and wellness strategy with the profit of

the company.

Table 6 | Employee Population and Health and Wellness Strategy

Business Focus

Market Creation

Efficiency in Operations

Risk Management

Leadership Quality

Population Nature

Examples

Fitness,

wellness and

emotional

support

to keep

employees

productive and

engaged

Examples

Benefit restruc-

turing, health

intervention to

reduce medical

leaves and

absenteeism

Examples

Safety,

ergonomics,

and EAP

Examples

Good benefits,

work-life

programs,

convenience

services to

attract and

retain talents

Type A

Type B

Type C


In order to do so, the HR manager should go back to the corporate accounting

concepts of revenue and expense. Step 1 identified the business focus of the

company and the business metrics the company is using to measure that focus.

Now, HR metrics need to be connected to those business metrics.

For example, a company’s business focus is on market creation and the identified

business metric is the number of new product launches during a year. How will

the HR manager connect this business metric with the health and wellness strategy?

HR managers need to identify HR key metrics that could contribute to the business

key metric that has been identified. Key HR metrics could include high employee

engagement, low sick days, low presenteeism, low team conflicts and high team

cohesiveness.

Health and wellness programs will deliver against these HR metrics that deliver

against the business metric under the business focus. Now, the HR manager can

quantify the benefits of the health and wellness programs. For example, how much

more revenue will be added when the health and wellness programs improve

employee engagement and help the company add one more product launch a year?

By connecting these metrics to the ultimate business focus and corporate profit-

ability and quantifying them as much as possible, HR managers can effectively and

confidently present their health and wellness strategy and explain why it makes

sense to the company.

Table 7 | Factoring Employee Population Into Health and Wellness Strategies

Older (>40) vs.younger (>40)

Older employees may be more motivated about their health issues

while younger employees engage better with positive messages of

fitness and wellness.

Blue collar vs. white collar

Blue-collar workers may not have access to technology-based solu-

tions while at work compared to white-collar workers who are always

connected.

Male vs. femaleFor female workers, specific attention needs to be paid to pregnancy

care, lactation support and women’s health as well as family care

giving to some extent (as more women play this role than men).

Remote workers vs.office workers

Remote workers won’t be able to participate in onsite programs,

hence specific attention needs to be paid to leverage technologies

and local resources.

Native Englishspeakers vs.non-native

Programs in their native languages will likely engage non-native

English speakers better. Also programs need to be adjusted to

culture, particularly around lifestyle (e.g., diet/cuisine, types of

fitness activities).


ROI CHALLENGES OF HEALTH-CLAIMS DATA

Among various focuses of health and wellness strategy, health-care cost reduc-

tion is considerably more challenging than any other area. Even tracking and

monitoring team engagement and engineering productivity can be easier.

Health-claims data analysis can be obtained from the carriers and/or benefits

consultants. Such data can help identify the target conditions or risk factors that

affect sizable population. Ideally, premiums would go down if the HR manager

can successfully intervene to reduce those claims.

In reality, many companies are not able to get the full analysis of health-claims

data, or even if they do and could implement a program, they may not see their

premiums go down.

RAND (2013) highlighted these challenges. The study reported most employers

couldn’t formally evaluate health-care cost reduction because of lack of access

to data, limited capabilities to prove causal relationships and methodological

questions. In addition, RAND projected that the programs would likely be cost-

neutral (no positive ROI) after five years.

There are a number of factors associated with this challenge:

z It’s often challenging to attribute any change in health-care cost to programs.

- It requires complex data tracking to see claims reductions among program

participants compared to those who did not participate.

- Claims could go up in one area and go down in another area but the link

is challenging to prove (e.g., more diabetes claims due to participations in

screening but reduced claims in acute cardiac incidents).

z Health-care cost can go up even if there’s an improvement.

- Even if the number of diabetic employees is reduced, if the treatment cost

per diabetic employee goes up, the health-care costs go up.

- Even if the total cost of diabetes claims is reduced, a few new incidents of

cancer may wipe out those savings.

From these perspectives, it is critical for HR managers to understand all other

possible goals that could contribute to company’s business strategies beyond

health-care cost reduction. For example, if the efficiency in operations is impor-

tant and health-care costs are a critical issue, the company is likely facing issues

with workers’ compensation costs, costs associated with medical leaves and

absenteeism, and lost productivity from presenteeism.

Can ROI be gained from those factors and not just health-care costs? Can other

metrics be traced? Can programs be justified in this broader picture while taking

steps to tackle benefits designs with brokers and consultants?

Step 4: Track and monitor the outcome of the new strategy

The last step is to start collecting data on all the identified metrics and track them

over the years so the HR manager can actually ensure the health and wellness

strategy is delivering the expected results or is able to adjust them accordingly.


In tracking data, the HR manager would like to examine not only HR metrics but

also the target business metrics that connect the health and wellness strategy with

the company’s business focus.

Some data, such as the level of employee engagement, may not be easily quan-

tifiable. Even then, HR managers should still develop a way to make an objective

and measurable assessment. The health and wellness strategy is critical enough

to establish a data dashboard to facilitate the review process in years to come.

CASE STUDIES

Case studies from the authors’ experiences illustrate how this works.

Case Study 1: Levi Strauss

In the past 25 years, Levi Strauss has been at the forefront of the retail industry

because of its innovative and progressive approach to health and wellness. The

company has taken a strategic view of health and wellness issues with the purpose

of improving employee health and shareholder value. When Levi still had factories

in the United States, the health and wellness strategy varied according to the

different divisions that had diverse goals and populations.

At the corporate office, the business focus was on developing fashionable

products that brought good revenue. Health and wellness practices that fostered

innovation and creativity were key to keep the workforce, composed of designers

and administrative staff, engaged. The health and wellness needs of the profes-

sional population were very different according to jobs. Designers who traveled,

often without advance notice, were looking for a safety net for emergency travel,

while administrative staffers wanted to have control over their hours. The company

established a dependent-care travel policy that was welcomed by designers and

summer hours to the delight of employees at headquarters.

At the manufacturing facilities, the company was highly focused on operational

efficiency, augmenting productivity and reducing the cost of making a pair of pants.

Team conflicts due to the inability to negotiate work-life conflicts affected produc-

tivity. At the Levi plants, workers had received training to work in self-directed teams,

but training was not offered, nor were guidelines established, to negotiate work-life

conflicts within the team. Within an average team of 40-50 people and a workforce

with many single mothers, absenteeism was likely to occur due to a sick child or

lack of child care. It was difficult to provide coverage for an absent employee, so

productivity suffered due to team conflicts. The portfolio of health and wellness

solutions for this population included work-life training at the team level, child-care

resource and referral services, a child-care voucher to help pay for the services and

financial support for child-care community agencies near the plants.

This is an example that shows how a company’s business focus and diverse

needs of its population can drive the health and wellness strategy. The success of

this case was in understanding that within Levi there were two distinct businesses


with different goals and populations, and in the HR manager’s active participation

in high-level discussions with the division leaders.

Case Study 2: A premier hotel

The hotel industry is ahead of other industries in launching wellness programs,

with leading examples like Marriott and Westin. Their goals are often:

z Reducing workers’ compensation claims (efficiency in operations)

z Stabilizing worker turnover (leadership quality).

In the hotel industry, each site’s revenue growth is limited by the number of

rooms and pricing levels of competitors in the same area. Once marketing pres-

ence is established to fill rooms, the business is very focused on efficiency and

workforce management to ensure positive customer experiences.

This particular hotel is a premier hotel that was experiencing almost $4,000 per

employee per year of workers’ compensation costs, including all associated costs

(e.g., accidents and remediation, building engineering). In addition, the frequent

work-related injuries were causing disability claims, medical leaves and high

turnover, which could affect the quality of customer service. Despite efforts to

improve the work environment (e.g., equipment) for workers, work-related injuries

continued to be filed.

Led by the general manager, hotel leaders implemented a comprehensive ergo-

nomic behavior program, focusing on the task behaviors and fitness of workers.

Ergonomic experts made full analysis of tasks and risks associated with those

tasks for each of various job functions and provided behavior and fitness training

programs to all employees based on their job functions. The final report and recom-

mendations of how to continue internal training were provided to the management.

As a result, workers’ compensation costs, including all associated costs, have been

reduced by 50%. The ROI was more than 20 times the project cost. Based on other

cases the authors have observed, the hotel industry realizes an average of 20% to

30% reduction in workers’ compensation costs with wellness programs. So, this

program surpassed the expectations.

SUMMARY

The next few years are critical for employers to take drastic action in their health

and wellness strategy. However, a company’s business focus, not regulatory

changes, should drive health and wellness strategy. HR managers should engage

in a discussion with their CEO and CFO and understand the company’s business

focus and business metrics they are ultimately expected to support. By under-

standing and connecting the company’s business focus with key HR metrics, the

HR manager will ascertain what is required of the health and wellness strategy.

HR managers can develop their health and wellness strategy, evaluate programs,

determine new programs and guide senior executives effectively, without being

entrenched in tactical and operational matters. z


AUTHORS

Celina Pagani-Tousignant ([email protected]) is the president and founder of Normisur International, an international management consulting firm that specializes in corporate social responsibility, community involve-ment, work-life, diversity and executive coaching. Pagani-Tousignant, who has a master’s degree in clinical psychology, has been coaching individuals and teams for the past 27 years. She has worked with numerous corporate and private clients in the U.S. and abroad, as well as clients from non-profits and academia. Her clientele includes customers in the United States, Canada, Latin America, Europe and Asia.

Asako Tsumagari ([email protected]) is founder and CEO of Mevident Inc., a network of service providers that develops solutions and technologies to integrate wellness services in corporate health and wellness benefits. Mevident currently services a number of large corporations in the San Francisco area and manages a network of more than 200 wellness providers. It specializes in creating onsite wellness programs. Tsumagari has a master’s degree in business administration.

REFERENCES

McKinsey & Company and Boston College Center for Corporate Citizenship. 2009. How Virtue Creates Value for Business and Society: Investigating the Value of Environmental, Social and Governance Activities. Boston. Viewed: June 3, 2014. http://commdev.org/files/2426_file_Boston_College_McKinsey_31909.pdf

RAND Corporation. 2013. Workplace Wellness Programs Study. Santa Monica, Calif. Viewed: June 4, 2014. http://www.rand.org/pubs/research_reports/RR254.htmlhttp://www.rand.org/pubs/research_reports/RR254.html



http://commdev.org/files/2426_file_Boston_College_McKinsey_31909.pdf

Kyle EastmanCompensation Advisory Partners

Michael KeebaughCompensation Advisory Partners

Eric HoskenCompensation Advisory Partners

Executive Pay Disclosure: Realized and Realizable Pay

The required shareholder “say-on-pay” vote has

led to a heightened focus on the relationship

between executive pay and performance, but

current required disclosure, as seen in the summary

compensation table (SCT) and the grants of plan-based

awards table (GPBA), does not provide the whole story

when assessing this relationship. With greater pressure

on companies to “get it right,” there has been an effort

led by executive compensation professionals to find a

more useful pay definition for the purpose of comparing

pay and performance.

In response to the limitations of required SCT and

GPBA disclosure, companies, investors, shareholder

advisory firms and compensation professionals have

begun to consider realized and realizable pay as alter-

native definitions of compensation:

z Realized pay refers to the compensation that an execu-

tive actually takes home (similar to W-2 compensation)

z Realizable pay refers to the potential value of compen-

sation awarded over a defined period, valued at a

specific point in time.

Figure 1 provides an overview of how realized pay

and realizable pay are typically calculated.


Third Quarter 2014


Under most approaches, SCT, realized, and realizable pay are very similar in the

treatment of annual incentives or short-term cash compensation (base salary and

bonus). However, when it comes to long-term incentives (LTI), the three measures

of pay are fundamentally different. Although it is a simplification, it may be helpful

to think of SCT- and GPBA-disclosed compensation as “what was granted,” real-

ized pay as “what was received” and realizable pay as “what could potentially be

received at a given point in time.”

THE CASE FOR REALIZED PAY DISCLOSURE

If a company plans to assess “what was granted” versus “what was ultimately

received,” comparing grant-date pay and realized pay is likely the most appropriate

method. Realized pay helps communicate to shareholders what an executive takes

Pay Definition Treatment of Pay Elements

Realized Pay Actual Cash Compensation:• Salary received

• Annual incentive and bonus received

• Long-term cash incentive paid

Equity Awards:• Performance-based equity awards – value paid out

• Restricted stock – value at vesting date

• Stock options – value gained at exercise or vested and exercisable

Mixed Practice: Other Compensation• Special awards (e.g., sign-on bonus)

• Other compensation (SCT number, pension value, perks, etc.)

Realizable Pay Actual Cash Compensation:• Salary received

• Annual incentive and bonus received

• Long-term cash incentive granted and paid or targeted payout of awards granted but not yet paid

Equity Awards (valued using stock price at end of period): • Performance-based equity awards

• Actual awards granted, vested and paid out during the period analyzed

• Target value of awards granted but not vested (ISS methodology)

• Restricted stock (vested or unvested)

• Value of shares awarded during period under review at end of period

• Stock options (vested or unvested)

• Options awarded during the performance period, analyzed using “in the money” value (spread between exercise price and stock price at end of period)

Mixed Practice: Other Compensation• Special awards (e.g., sign-on bonus)

• Other compensation (SCT number, pension value, perks, etc.)

Figure 1 | Typical Components of Realized and Realizable Pay


home over a specific period of time (e.g., three years, five years, etc.). This is a

useful communication tool for companies to illustrate the impact of performance

outcomes on compensation, specifically in situations where grant-date pay greatly

outweighs realized pay. Companies with a stagnant or declining stock price may

find that the grant-date value of long-term incentives as disclosed in the SCT and

GPBA are substantially larger than the value that the executive actually realized

over the same period.

Therefore, supplemental disclosure of realized pay can aid companies by demon-

strating to shareholders that the SCT and GPBA may be overstating the value that is

ultimately delivered to executives for specific periods of time, which then enables

companies to argue that the SCT and GPBA do not accurately reflect what the

executive actually receives. However, although this statement is true on its own

and realized pay is indeed a valuable piece of information for companies and

shareholders alike, it is not the most effective means of expressing how compensa-

tion programs align with recent performance.

THE PROBLEMS WITH REALIZED PAY DISCLOSURE

The most fundamental problem with companies’ realized pay disclosure is timing.

To date, these companies have generally compared realized pay to SCT and

GPBA pay over a common time period (e.g., most recent three-year grant-date

pay vs. most recent three-year realized pay). This is not a problem for annual

cash compensation, but can lead to a misinterpretation of LTI because it is not

an “apples-to-apples” comparison. Ideally, the comparison should be between the

grant-date value of compensation for a particular year and the value ultimately

realized in the future from those grants. However, this becomes complex because

each LTI vehicle pays out over different periods of time and different vesting

schedules. For example, restricted shares often vest over three to five years

and may vest all at once (i.e., cliff vest) or have some type of staggered vesting

schedule (i.e., ratable vest). Performance shares and cash performance plans most

commonly pay out over a three-year performance period. Stock options generally

vest over three to five years, but can often be exercised for up to 10 years after the

date of grant. As a result, accurate comparisons become highly complicated and

may require looking back as far as 10 years to find the grant-year compensation

that is associated with realized values.

Since the value an executive “realized” in a given year could be the result of

grants that were made 3 to 10 years prior, a disconnect can arise between what

was recently granted and what was recently realized. In the context of pay versus

performance, the values that are potentially associated with realized pay may

have little to do with the current compensation program and could result in a

misleading comparison with recent grant-date pay. For example, awards granted

anywhere from 3 to 10 years earlier could reflect pay for the executive while

serving in a different role or be the result of a different compensation program


altogether. Another disconnect could arise in situations where there is major stock

price volatility around the time of the grant (3 to 10 years prior) followed by more

recent (less than three years) stock price stability. Consequently, companies risk

misleading shareholders, and shareholders have the potential to misunderstand

the true pay versus performance relationship.

It is also challenging to conduct relative comparisons of pay and performance

using realized pay. Which performance period should be used as the basis for this

comparison as different portions of the compensation realized are earned over

different time periods (e.g., annual bonus vs. 3-year performance share payout vs.

10-year stock option exercise)? For example, should companies compare realized

pay to 1-, 3- or even 10-year relative total shareholder return (TSR)? How does

one account for different pay programs among other companies? The answer, if

there is one, is not obvious and, as a result of this complexity, few companies try

to assess realized pay on a relative basis against peers.

THE CASE FOR REALIZABLE PAY DISCLOSURE

If a company plans to assess “what was granted” versus “what could potentially be

received,” comparing grant-date pay and realizable pay is likely the most appro-

priate method. Realizable pay helps companies communicate the value of grants

that were made over some period (e.g., three or five years) at a specific point

in time — most commonly the end of the fiscal year. This is a valuable tool for

companies because it shows how grant-date pay has been impacted by company

performance since the grant date. Unlike realized pay, realizable pay includes only

awards that were granted within the period being measured and, as a result, a

better apples-to-apples comparison of grant value to realizable value is possible.

From a pay versus performance perspective, this allows companies to show that

their pay programs fluctuate appropriately in conjunction with company perfor-

mance on an absolute and relative basis without the potential distortions caused

from grants made outside of the period being measured. For example, given pay

and performance alignment, as stock price goes up and performance goals are met

or exceeded, the realizable value will rise above grant-date values. Alternatively,

if share prices fall and performance goals are not met, the realizable value will

fall below grant-date values.

THE PROBLEMS WITH REALIZABLE PAY

Although realizable pay is an attractive method for describing the relationship

between pay and performance, it has some challenges in application, particularly

with how companies define the realizable value of stock options and outstanding

performance-based vehicles. Generally speaking, the definition used for realized

pay is universally agreed upon (with a few differences of opinion when it comes

to the inclusion of benefits and perquisites), but this has not been the case for

realizable pay.


Treatment of Stock Options

The treatment of stock options is perhaps the most controversial aspect of realiz-

able pay, and the two most commonly used methods of valuing stock options

are the intrinsic valuation and the Black-Scholes valuation. The intrinsic value

of stock options is intuitive and easy to understand as it reflects the extent to

which the option grants are in-the-money (to solve for the intrinsic value of an

outstanding option award, one simply multiplies the number of options granted

by the spread between the current stock price and the exercise price). This

definition is appealing because it is the value that the executive would receive

upon exercising an option at the time being measured. When options are valued

this way, the result “makes sense on paper” and is easily understood by readers.

The fundamental problem with intrinsic value is that it ignores the “time value”

of an option (i.e., the value of potential future price appreciation). This would not

be a major issue if realizable pay analyses tracked the value of the options over

a long period of time. Unfortunately, most realizable pay analyses are conducted

over a three-year period, so options are being valued approximately one, two and

three years following their grant date. For any options with a current stock price

below the exercise price, the award is considered to be worthless even though

the option may have seven to nine years of life remaining.

For example, if an option valued at the end of some measurement period is even

one cent less than or equal to the grant-date value of an award, then it is consid-

ered worthless, even if there is a significant portion of the option life remaining.

Therefore, regardless of whether an option is 1% or 99% underwater, the intrinsic

value is the same (zero). This issue becomes magnified when conducting relative

comparisons to peer companies because of the differences in LTI vehicle mix.

Holding all things equal, companies that grant a larger mix of options tend to have

lower realizable pay values than companies using full-value shares, because when

share prices drop below the grant-date price, full-value shares still have value.

The Black-Scholes valuation alleviates this issue because its definition includes

the time value of options as they are intended to be a long-term vehicle, gener-

ally having a life of seven to 10 years. Since the Black-Scholes model recognizes

that there is always the potential for stock price growth, outstanding options with

remaining life will never have a zero value. This is an important point because

recent company performance — particularly stock price movement — is directly

correlated with the associated value of an award. For example, the further an

option goes underwater, the lower its Black-Scholes value will be, (which is

in contrast with using the intrinsic valuation where all underwater awards will

have a zero value). Therefore, Black-Scholes valuation solves the relative pay-mix

complications associated with intrinsic valuation.

From a disclosure perspective, particularly in cases where options are under-

water, the Black-Scholes methodology is less attractive to companies because it

increases the total value of realizable pay and complicates communication as it


is a less intuitive approach. While an executive can recognize the intrinsic value

of the option through an exercise, there is no way for the executive to sell the

option to a third party and realize the Black-Scholes value (unlike an option on

the open market).

Another challenge to using the Black-Scholes model is a question of the most

appropriate inputs. When granted, stock options are typically valued using an

expected life that is less than the total life (e.g., five-year expected life for an option

with a 10-year term). If an option with a 10-year term was originally valued with

an expected life of five years, what is the best expected life to use three years

later? Will this depend on how the stock price has moved between the date of

grant and the revaluation? Once again, the answer is not obvious. As a result, there

are many opposing schools of thought on the most appropriate option valuation

inputs for use in realizable pay.

As a technical aside, there is another caution for companies that use Black-Scholes

for realizable pay modeling: when the options are significantly “in-the-money” and

the company pays a dividend, it is critical to instead use a binomial model to

value the options. If the Black-Scholes model is used, then the valuation will be

inaccurate, as Black-Scholes does not allow for the early exercise of stock options

when it is optimal. In extreme cases, use of the Black-Scholes model will result

in the absurd finding that the intrinsic value of options is greater than the Black-

Scholes value (i.e., the option has negative “time value”).

Long-term Performance Plan Treatment

The treatment of long-term performance plans is yet another challenge associ-

ated with realizable pay. Ideally performance awards granted within a realizable

pay measurement period would be incorporated based on actual performance

against the predetermined criteria for each award cycle, regardless of whether

it has vested. However, most companies do not disclose actual results until the

end of the performance cycle. As a result, compensation practitioners have used

either performance award payouts during the measurement period or the payouts

of awards granted within the realizable pay measurement period plus the target

value of awards still within their performance cycle.

If compensation practitioners simply use performance award payouts, they risk

misaligning the pay and performance periods because such payouts could come

from awards granted outside of the realizable pay measurement period. For example,

for performance plans with a three-year performance period, the payout in year

one of a realizable pay measurement period is the result of an award granted

two years prior. If compensation practitioners choose to use performance award

payouts plus the target value of awards still within their performance cycle, then

the methodology works well when awards are both granted and paid within some

realizable measurement period. However, for outstanding awards with incomplete

performance cycles, the methodology is of limited value in measuring the impact


of interim performance on award value. With performance shares, the target value

is used and although shares are revalued at the end of the performance period,

they are essentially treated like time-vested shares because the leverage element

and possibility of forfeiture of such performance awards is completely disregarded.

This becomes even more of an issue with long-term cash performance awards

because the cash target value is used for both grant-date pay and realizable pay.

Yet again, the best methodology is not obvious and involves tradeoffs between

imperfect methodologies.

MARKET PRACTICE TO DATE: A STUDY OF THE FORTUNE 250

One of the major developments of the 2013 and 2014 proxy seasons was a rise in

the voluntary disclosure of realized and realizable pay. As mentioned previously,

many companies have become concerned that the values reported in the SCT and

the GPBA have the potential to misguide readers on the levels of compensation

that executives actually receive, potentially leading to a perceived disconnect

between pay and performance. To alleviate the limitations of SCT and GPBA data,

companies have begun to disclose realized and realizable pay. In order to monitor

this growing trend, the authors’ company, Compensation Advisory Partners (CAP),

reviewed the 2013 and 2014 proxy statements (as of May 31, 2014) of Fortune 250

companies and tallied the disclosure of realized pay and realizable pay.

For companies that presented a discussion on this topic, CAP included the

following in their analysis: the use of graphics (e.g., tables and charts); methods

that companies used to compare different definitions of pay (e.g., versus SCT/

GPBA/target pay, relative to a peer group, etc.); and companies that supplemented

their discussion with the use of performance metrics.

Results

Among Fortune 250 companies, 16% in 2013 and 17% in 2014 supplemented the

SCT and GPBA with realized and/or realizable pay disclosure. Of the companies

that disclosed this information, results show that about half did so in the form of

realized pay while the other half did so in the form of realizable pay (see Figure 2).

Realized Pay Disclosure

For companies that disclosed realized pay, the most common calculation used

was the sum of base salary actually paid, bonus actually paid, the value of shares

that vested during the period, and the value realized upon exercise of options

during the period. The majority of companies presented realized pay on an

absolute basis (i.e., without comparing to peers or some other index) and this

should be expected because, as mentioned above, obtaining realized pay data for

peers is time consuming, and realized pay is not particularly valuable for relative

comparisons. Of the companies that disclosed or discussed the concept of realized

pay, most (85%) used some type of chart or table, 70% compared realized pay to


some other definition of pay, and approximately 40% compared realized pay to

a performance metric (most commonly TSR.) (See Figure 3.)

In 2012, a majority of companies that disclosed realized pay had lower TSR

than the median of the Fortune 250, as shown in Figure 4. This provides some

evidence that companies with lower TSR are more likely to disclose realized pay

to bolster the pay for performance relationship. However, once companies disclose

realized pay after a year of low performance, they may feel obligated to disclose

in subsequent years, even when performance is strong. This is evidenced by the

fact that the median TSR for companies disclosing realized pay was similar to the

Fortune 250 median in 2013, and the prevalence of disclosure did not decrease

from 2012 to 2013.

Realizable Pay Disclosure

As stated above, among companies that disclosed realized and/or realizable pay,

approximately half disclosed some form of realizable pay. Realizable pay is typically

calculated as the sum of base salary, actual bonus paid, vested long-term incentives

valued at the vesting date, and outstanding long-term incentives valued at the end

of the period. The values of long-term incentives are calculated as follows:

Pe

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s

Percentage of Companies that

Disclosed Realized Pay

Percentage of Companies that

Disclosed Realizable Pay

Percentage of Companies

that Disclosed Both

20142013 2013 2014 2013 2014

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

Figure 2 | Percentage of Fortune 250 Companies Disclosing Realized and Realizable Pay

8.61%

9.57%

7.66%

0.48%

10.05%

2.39%


z The value of shares subject to time-based vesting is calculated by multiplying the

number of shares granted by the stock price at the end of the period.

z The value of stock options is most often calculated by multiplying the number of

options granted by the intrinsic (in-the-money) value based on the stock price

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an

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Dis

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d

Pay

Companies that Used Graphic

in Realized Pay Disclosure

100%

80%

60%

40%

20%

0%

Figure 3 | Characteristics of Realized Pay Disclosure

85.00%

90.00%

Companies that Disclosed

Individual Components of

Realized Pay

Companies that Disclosed Realized Pay

vs. Peers

Companies that Disclosed Realized Pay

vs. Other Form(s) of Pay


Realized Pay vs.

Performance Metric(s)

40.00%

15.00%

70.00%

Figure 4 | Annual TSR of Companies Disclosing Realized Pay

Cos. that Disclosed Percentile Fortune 250(1) Realized Pay (1)

(n=189) (n=20)

75th Percentile 53% 54%

Median 37% 38%


2012 TSR

(1) Sample includes public Fortune 250 companies that had filed an annual proxy statement as of 5/31/2014.


(n=189) (n=20)


Median 16% 5%

25th Percentile 5% -7%

2013 TSR


at the end of the period (though in some cases an updated Black-Scholes valu-

ation is used).

z The value of performance shares included in the calculation of realized pay typi-

cally only includes shares granted within the specified period. Shares that were

granted and subsequently vested during the period are valued using the closing

stock price on the vesting date, while any granted shares that were outstanding

as of the end of the period are valued using the end-of-period stock price.

Most of the companies that disclosed realizable pay used an accompanying

graphic (81%), and the most commonly used graphics included tables or charts

that showed, side-by-side, the difference between grant-date/target pay and realiz-

able pay; realizable pay and TSR; or some combination of the two (see Figure 5).

Since realizable pay was primarily used as a tool to show the difference between

an executive’s grant-date/target pay and potential pay, there was usually a “back-

story” associated with this additional disclosure, often tied to poor performance

or say-on-pay issues in the past. A strong majority of companies that disclosed

realizable pay reported SCT and GPBA pay that was greater than realizable pay.

This should not be surprising as companies in this type of situation are attempting

to convince readers that their pay programs provide a better alignment of pay and

performance than an analysis of the grant-date/target pay would indicate alone,

particularly in cases where the company performed poorly or had a low level of

support for say-on-pay in prior years. On the other hand, companies that have

had strong performance typically have realizable pay values that are larger than

Pe

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ay

Companies that Used Graphic in Realizable Pay

Disclosure

100%

80%

60%

40%

20%

0%

Figure 5 | Characteristics of Realizable Pay Disclosure

80.95%

85.71%


Individual Components of Realizable Pay

Companies that Disclosed Realizable Pay

vs. Peers


Realizable Pay vs. Others Form(s) of Pay


Realizable Pay vs.

Performance Metric(s)

57.14%

28.57%

95.24%


values disclosed in the SCT and GPBA, and therefore, generally do not disclose

supplemental pay definitions because there is little need to do so.

Like realized pay companies, most of the Fortune 250 companies that disclosed

realizable pay had a 2012 TSR that trailed the median of the full Fortune 250 group.

(See Figure 6.) This indicates that lower performing companies are more likely to

disclose realizable pay to help make their pay for performance case. For 2013, the

median TSR of realizable pay companies was more similar to the full Fortune 250.

Because the prevalence of realizable pay disclosure was similar in 2012 and 2013,

it can be assumed that companies disclosing realized and/or realizable pay in a

year following poor performance may be hesitant to discontinue this disclosure

in subsequent years, even if performance improves.

CONCLUSION

Executive compensation professionals will continue to monitor the trends within

compensation design and as incentive compensation plans evolve, the definitions

that are used to evaluate them will evolve as well. The 2013 proxy season was the

first time a meaningful number of companies disclosed realized and/or realizable

pay, and an increase in this type of supplementary pay disclosure followed in 2014.

Although realized and realizable pay have flaws, when correctly implemented

they clearly provide benefits over traditional definitions of pay. For example, the

mismatch in timing that typically occurs when comparing grant-date/target pay to

realized or realizable pay can be alleviated through the use of longer timeframes

(e.g., five to seven years or over the course of an executive’s tenure). A deeper

understanding of compensation will lead to a more accurate evaluation of the

Figure 6 | Annual TSR of Companies Disclosing Realizable Pay

(1) Sample includes public Fortune 250 companies that had filed an annual proxy statement as of 5/31/2014.


(n=189) (n=20)


Median 16% 10%

25th Percentile 4% -2%


(n=189) (n=20)


Median 37% 34%


2012 TSR

2013 TSR


link between pay and performance. The continued discussion and refinement of

supplemental pay definitions, such as realized and realizable pay, will improve

this understanding. z

AUTHORS

Eric Hosken ([email protected]) is a partner at Compensation Advisory Partners, where he works with senior management and compensation committees on all aspects of executive compensation. He has co-authored multiple articles in workspan and recently co-authored a white paper for WorldatWork on obtaining equity plan shareholder approval. He has also written articles on executive compensation for CNBC.com, The Corporate Executive Board, the Executive Counsel and multiple Compensation Advisory Partners’ publication CAPflash.

Michael Keebaugh ([email protected]) is an associate at Compensation Advisory Partners, where he works with senior management and compensation committees on all aspects of executive compensa-tion. He has recently co-authored an article published in workspan and also multiple Compensation Advisory Partners’ proprietary publication CAPflash.

Kyle Eastman ([email protected]) is an analyst at Compensation Advisory Partners, where he assists in the development of materials presented to senior management and to compensation committees.

Published Research in Total RewardsA review of total rewards, compensation, benefits and HR-management research reports.

(Compiled by the editors from the WorldatWork Newsline column at www.worldatwork.org.)

Investing in Employees’ Well-Being Drives Engagement, Company Culture

Employees are seeing the benefits of workplace wellness programs, reporting improved company

culture and health, and increased energy and productivity in the workplace.

Eighty-seven percent of employees say wellness programs positively impact company culture

and 96% are participating to improve their own health, according to Virgin Pulse’s “The Business

of Healthy Employees 2014: A Survey of Workplace Health Priorities.” In addition to benefiting

the workforce, 88% of respondents indicated the programs provide a benefit to companies in

the recruitment process.

However, many employers are struggling to commit to and measure proven strategies that drive

employee engagement, productivity and happiness. Following are some of the major findings

from the study:

• Employers are leaving money on the table: Nearly half of the employers surveyed, 43%,

aren’t planning to take advantage of incentives offered as part of health-care reform.

• Wellness programs attract talent: 88% of respondents state that having health and wellness

programs designates an organization as an “employer of choice.”

• Employees want to be healthy: 96% of employees participate to improve their own health,

making improved health a bigger motivator than financial incentives.

• Mental health is a priority too: 52% of employers offered services for mental health and

depression management in 2014, a 14% increase from last year.

• Measurement remains a significant challenge: 30% of employers are dissatisfied with

measurement strategies, and many organizations are not tracking key areas. Forty-eight

percent are not tracking enhanced engagement, and more than half of the organizations

(53%) don’t track improved productivity.

• Employees want more: Employers are not meeting employee demand for access to physical

activity programs, healthy food choices and on-site gym facilities or fitness classes.

Reduced Options, Cost Shifting Among Changes for American Workers

How did employers evaluate costs and make health-care benefits decisions as the launch of

health-care reform approached? The fourth annual Aflac WorkForces Report (AWR) showed the

kind of benefits restructuring employers made in 2013, which included reducing major medical

plan options and shifting costs to employees.

Employers’ desire to control the bottom line was a likely driver of benefits changes in 2013. The

results show that almost half (49%) of employers agreed that controlling costs is the top business

issue facing companies today, up from 28% who agreed that controlling costs including health

and/or medical costs was their top business concern in 2011. According to the study, businesses:

• Eliminated or delayed raises (32%)

• Eliminated or cut back on benefits (22%)

• Changed some full-time workers to part-time workers (21%)

• Reduced the number of major medical plan options (14%).

In addition to changes in employer-sponsored benefits plans, a number of businesses took

advantage of new insurance options introduced by the Patient Protection and Affordable Care Act

(PPACA). Seven percent offered employees health insurance through the new federal and state


Third Quarter 2014




government exchanges for small businesses (SHOP) or moved employees’ health insurance to a

private exchange. And about 6% decided to give employees a stipend to use to purchase their

health insurance plan through the public exchanges instead of offering insurance.

Executive Pay Increases Show Impact of Shareholder Activism

CEO pay at top public companies increased in 2013 by the largest percentage since 2010, as

shareholders experienced record-breaking performance, according to results from “The Wall

Street Journal/Hay Group 2013 CEO Compensation Study.”

Following two years of only modest increases to total compensation, CEOs experienced a material

uptick in pay in 2013. Base salaries grew 1.7% to $1.2 million, while annual incentive payments

increased for the first time since 2010, jumping 4% to $2.3 million, yielding an overall increase

of 3.7% in median cash compensation to $3.6 million. For the fourth year in a row, long-term

incentives (LTI) also increased, growing 3.8% to $7.9 million. In sum, total direct compensation

increased 5.5% to just more than $11.4 million.

While the median rise in pay was greater in 2013 than in the two years prior, it lagged significantly

behind the growth in company net income and total shareholder return (TSR). In 2013, the median

company showed a net income growth of 8% and a TSR of 33.8%. That’s compared to a modest

2.1% median net income growth and a still-strong 16.3% TSR in 2012.

For the third year in a row, long-term performance plans (equity and cash) were the most heavily

weighted piece of the entire pay puzzle, making up 32.3% of the average CEO’s total direct

compensation, up from 30.3% in 2012. Bonuses were the second-heaviest weighted component of

pay, making up 22% of the average CEO’s total direct compensation, compared to 23.2% in 2012.

Other key findings from the study include:

• Performance plans became the rule, not the exception: Performance awards made up more

than half (51%) of the value of LTI in 2013, up from 49% in 2012. Companies also continued

to add performance awards to their LTI plans, with a record 83% of companies offering

these awards, up from 72% in 2012.

• Realized long-term incentive pay remained strong: For the third year in a row, CEOs expe-

rienced significant compensation in the form of take-home equity-based pay. Following two

years where realized pay saw a marked increase (13% in 2011 and 28.3% in 2012), take-home

realized LTI values remained nearly flat in 2013 at $7.9 million.

• Companies maintained a portfolio-approach to LTI: 79% of companies that granted LTI

in 2013 used more than one vehicle, with the most prevalent combination (used by 31% of

companies) including all three (i.e., stock options, restricted stock and performance awards).

The next most popular combination consisted of stock options and performance awards

(25%), followed by the combination of performance awards and restricted stock (18%). The

least-used LTI plan design in 2013 was the once-popular use of 100% stock options (now

used by less than 4% of companies).

• Utilities CEOs saw the highest pay increase, while oil and gas CEOs saw the lowest: For

the second year in a row, CEOs in the Utilities sector saw the largest pay increases in 2013

(15.9%) despite a median 0.2% drop in net income and a relatively modest 10.3% TSR. Pay

for oil and gas company CEOs, on the other hand, remained nearly flat at negative 0.1%, in

conjunction with a survey-low negative 6.8% median net income growth.




• Financial services pay rebounded: For the first time since the financial crisis, pay levels

rose substantially for financial services CEOs in 2013, increasing 12.9% over 2012. Financial

services was the highest-performing sector in the study, realizing a median net income

growth of 15.4% and a survey-high TSR of 43.5% in 2013.

• Perks faced additional cuts: After a year of significant cuts to perquisites in 2012, 2013

brought slower but continued perquisite elimination, as nearly every perquisite declined in

prevalence. Elimination of spousal travel benefits was the fastest-declining perk in 2013,

falling to 20% prevalence, while personal use of the corporate aircraft remained the only

perquisite in the study to be provided by more than half (64.7%) of companies.

Going Broke in Retirement Is Top Fear for Affluent Americans

Running out of money in retirement trumps other stress-inducing situations and pressures such

as public speaking, gaining weight and going to the dentist for affluent Americans, according

to Bank of America’s “Merrill Edge Report.” Despite the prospect of not having enough money

to live on later in life, many are unwilling to cut spending on indulgences now in order to invest

for retirement.

The bi-annual survey conducted among 1,000 mass affluent Americans — individuals with $50,000

to $250,000 in investable assets — found that even though many are likely to forego saving for

retirement in order to maintain their customary spending habits, the majority of parents surveyed

say they would cut spending on themselves in order to help their children. Thirty-five percent

have even withdrawn from their own savings/investment accounts to cover children’s expenses.

When surveyed about long-term financial management topics including their attitudes about

making trade-offs, how they prioritize savings and the role finances play in relationships, mass

affluent respondents revealed:

• Respondents say having enough money to live “in the here and now” is a more popular

priority (63%) than saving more for the future (48%).

• More than a third of women report unexpected costs have gotten in the way of their retire-

ment savings, compared to 28% of men.

• While more than half (55%) of respondents surveyed say they’re frightened of not having

enough money throughout retirement, many won’t consider cutting back on indulgences such

as entertainment (33%), eating out (30%) and vacations (28%). Even if they were to receive

a hypothetical $1 million windfall, only 1 in 5 say they would make it a priority to set aside

the “found money” for their retirement years.

• More women than men (59% vs. 51%) are frightened about the possibility of not having

enough money when they retire. The fear of an uncertain retirement is also most common

among 61% of Gen Xers (ages 35 to 50) and 61% of Boomers (ages 51 to 64); only 41% of

Millennials (ages 18 to 34) feel this way.




79% of SaaS Sales Representatives Miss Quota

A large percentage of quota-carrying software as a service (SaaS) sales representatives are

not hitting their goals. A study from Xactly found that 79% of sales representatives miss quota

and 14% never achieve even 10% of quota. Across the entire SaaS data set, the average quota

attainment is 58%. The data remained consistent regardless of tenure.

These patterns were consistent across all companies analyzed, regardless of size or market.

The report indicated that SaaS companies are prioritizing growth rather than traditional sales

performance. The report also found that SaaS companies with under $100 million in sales are

paying more in variable compensation relative to companies with more than $1 billion in sales,

on average 46% more. Smaller companies are paying $1,000 in variable compensation for every

$22,000 in sales, compared to larger companies that pay $1,000 in variable compensation for

every $36,000 in sales.

The study also found that tenure was not a factor in making quotas. Fifteen percent of sales

representatives who were in their roles for at least a year made quota, and 5% didn’t achieve

even 10% of quota. For sales representative in their roles for less than a year, 16% made quota

and 19% didn’t achieve even 10% of quota.

Majority of Companies Seek to Demonstrate Strong Link Between Executive Pay and Performance

A majority of companies are going to greater lengths to enhance shareholder engagement as they

seek to demonstrate a strong relationship between executive pay and performance, according

to Meridian’s “2014 Trends and Developments in Executive Compensation Survey.”

The survey also found that just over half of companies (56%) reported 2014 annual incentive

payouts (for 2013 performance) were above target; of the companies that paid out below target,

a majority were only slightly below target (i.e., 75%-94% of target). Companies continue to set

more challenging performance goals as the broader economy continues its slow recovery.

For senior executives, LTIs continue to be the largest component of their total compensation.

Within the LTI segment, performance plans now make 53% of total 2014 grant values, with stock

options down to only 18%. A slight majority of companies using long-term performance awards

use relative TSR measured over a three-year period.

Additionally, companies continue to expect, and receive, strong shareholder support on say on

pay. The great majority of companies (96%) expect to receive shareholder support well above

the critical level (70%) in 2014.

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