Compensation Strategy for the Knowledge Workers

Col (retd) KK Sharma

Compensation is an important motivator when you reward achievements of a desired organizational result. While the transactional reward (monetary) is well known, socio-psychological compensation (challenging work environment, learning opportunities) is less used but has an equally important role to play in keeping knowledge workers motivated. Many research organisations like EVAluation (Stern & Steward & Co. Research) focus attention on the compensation concepts for the knowledge work-forces of modern work economies1. Compensation Strategy is an essential human resource management intervention, as it influences costs of an organization. Compensation programs need to be designed and managed to meet the needs of today's competitive markets through attracting, retaining, motivating, and developing people. In some organizations, the compensation department is just in a supporting role for the line management, while in others the compensation and benefits manager is a very powerful employee of the organization. The role of different components of the compensation can differ and therefore assumes increasing importance. For example, the role of bonuses can primarily be, either in performance reward or the retention of the employees - a policy that an organization has to decide2.

Management often recognizes that incentive compensation is one of the most powerful levers that can be used to drive corporate strategy. Yet most companies struggle to take full advantage of this potential due to lack of proper tools, expertise and visibility.  Instead, they are bogged down in Excel spreadsheets and Word documents trying to build effective plans3. One of the biggest questions that employers ask themselves today is which compensation strategy will have the greatest impact on their bottom line. Organisations are talking about performance based compensation programs to face the market upsurges in BRIC countries, where retention of talent is a major issue. Many writers have focused it on managing for value - the executives all over the world. But still in many companies, performance measurement and reward schemes have not kept with the changing economy from its income statement-centric profit measurement. Old economies are not able to keep pace with the talents and their unique requirements at all levels in this New Economy.

1 Justin petit and Ahmar Ahmed, Compensation strategy for New Economic Age, EVAluation may 20002 2008 HRM Advice. 3 Incentive Compensation White Paper ; The Pitfalls of Using Spreadsheets for Incentive Compensation; Makana Solutions.

Measurement and motivation are age-old ably linked elements. Old saying of what gets measured gets managed may be applicable in a traditional corporate or sector, but may not be ideal for the new age economy. In today’s globalised economy, the importance of opportunities for growth, advancement and work-life balance in the office vary from one employee to other and the key of retention strategies is to identify what motivates employees to deliver more than what job design requires them to do. “Buy Earnings” as a strategy of traditional economy relates to re-investment and vertical integration without caring about the value creation. Managers are often drawn to higher margin businesses that, on the surface, may seem more attractive. Percentage returns remain another bane of the old economy but this focus on ROI deprives stars the required capital and helps companies in “dog” house of Porter’s competition strategy matrix. Invariably a low-return business may be motivated to go after return of expanding growth but eventually result in a loss of capital and value.

Some of the philosophies in compensation are, “competitive levels of compensation”, “performance-related pay” and “significant levels of pay at risk”. Main focus appears to be to find out an optimal level of competitive pay, thus attempt to strike a balance between the compensation, pay or cost to company and perhaps the revenue generation. Most often competitiveness in pay structures is the focus of attention, build as a retention and cost-cutting strategy. In 2008 and 2009, we witnessed huge compensation packages to the corporate executives even when the companies were filing Chapter 11 appeal. As the writer has stated, executive and incentive compensation policy must align employee interests with value creation, limit retention risk – the risk of losing good people during the inevitable periods of poor or volatile performance, and to achieve this at a reasonable total economic cost.

In practice, variable pay is often more an ex post form of participation, than an ex ante performance motivator4. Many theorists and behaviour scientists have opined that incentives, in a behaviour modification and reinforcement role, are essential to good corporate governance. A good compensation system must align the interests of employees with owners. The authors have cited many examples of auto-makers from the UK and USA, relating to the pitfalls of bonuses and cash incentives. Like the one in Eastern Europe, instead of bonuses, job security was the prime concern, thus needed to apply Maslow’s hierarchy of needs principles.

The level of pay analysis appearing in many write-ups including EVAluation, is a cross-sectional view of four years of CEO Total direct compensation or TDC and TSR data, with TSR explaining only 1% of the variation in levels of “Old Economy” company CEO pay and 2% of the variation of CEO pay for the “New Economy” set5. Despite the

4 ibid5 Justin petit and Ahmar Ahmed, Compensation strategy for New Economic Age, EVAluation may 2000

discouraging results of our regression analysis we did find that most CEO pay seems to be pay at risk – even more so for the New Economy CEOs. It was also found out that 70 to 80% of total pay is actually “pay at risk”. For the new economy, more percentage is of equity or Employees Stock Options (ESOPs). Whatever be the components, real compensation must look after the interests of both – the employees and the employers. Another debate has been on ownership versus pure monetary incentives. Many executives find that compensation is sometimes adversely influenced by the impact of holdings. In recent times, there has been an increase in stock ownership holdings and adopt formal ownership guidelines for executives. The sharp increase in the use of stock and stock options is also partly driven by the failure of other forms of compensation.

Broad-based use of stock and stock options may not be the simple answer to aligning interests and motivating value maximizing behaviours. Some of the limiting factors in terms of the equity could be - stock volatility, which at times is mysterious, frustrating and even de-motivating. Another dampener for many employees and executives is their inability to understand and work into the global capital markets and have only a vague understanding of valuation. Also the equity incentives are far less prescriptive, or actionable, than cash incentives, where the linkage between actions and results can be made clear and period measures, upon which operating decisions are routinely made, are also used to drive pay. Last point given by the authors is that the line of sight between a traded security and the sphere of influence of most employees is poor, leaving little ownership over results and thus not affecting behaviour. This further proves that Compensation systems are not only complex, but they also permeate the organization's entire social fabric and can set the tone for the culture of the organization. Add to that the prohibitive costs associated with compensation management and payroll costs themselves and one is left with a recipe--either for success or disaster6. Thus while working out compensation, one needs to look at basics including job analysis, job evaluation, surveys, job pricing, benefits, incentive pay, performance appraisal, and the compensation of special groups such as sales people, top executives and expatriates7.

Another measure is of creating guidelines for option grant price mechanics, which actually can undermine compensation objectives. Grant guidelines create a connection between pay and performance like cash incentives. On the other while hand ownership guidelines and stock options are important elements at senior levels; they may be only a part of the compensation solution. Option mechanics and their integration with cash

6 Edward E. Lawler Ill. San Francisco: Jossey-Bass, 2000. 327 pp.7 Donald L. Caruth and Gail D. Handlogten, Managing Compensation (And Understanding It Too), Greenwood Press, Inc. (Quorum Books).

incentives must be considered as important degrees of freedom in the design process. It is seen that at workers level, equity incentives are generally less effective and provide only marginal benefits at substantial economic cost. It has been argued that grant guidelines with a fixed share grant, rather than a fixed value grant, greatly enhance the sensitivity of pay to performance. Alignment and motivation can be further strengthened by linking the annual and long-term plans with the bonus multiple used as a grant multiplier. Finally, out-of-the-money options are more shareholder-friendly and serve to increase pay sensitivity. The paper has given examples and certain steps to prove these observations. High powered stock options represent a practical alternative to front-loaded options, or mega grants, because they achieve a similarly high degree of wealth leverage, but limit retention risk issues through annual the annual grant feature and the effective mechanics of step vesting.

Some of the problems are that there is a tendency everywhere to add more and new

layer of incentives to the existing old measures, leaving it to the incentive participants to somehow resolve any conflicts and determine the real goal. The incentive effect is perverse, but unfortunately not seen by all in the same light. Another is the use of goals for planning, budgeting and incentive compensation, when we talk about base goals or expectations and stretch goals, and the bonuses warranted for each. Goals mandated from the top leadership create their own problems as they lack any ownership. Missing stretch goals by a small margin may deprive one from a bonus but there are no disincentives if one misses these by a wide margin. Too many measures, incentives tied to the measured performance rather than improvement, negotiating goals linked to targets, and caps on incentives thus virtually putting a cap on performance and single year horizon makes such incentive schemes dysfunctional.

To tide over these shortcomings changes in the compensation structures are required. The compensation solution cannot merely replace conflicting and incomplete measures within the confines of a traditional incentive plan. The stated philosophy and objectives of the vast majority of public companies can only be reached through a combination of features that effectively create an owner-employee contract to share value creation. The measures suggested are as follows8:

1. Economic value added simply and simultaneously captures profit, capital and the cost of capital, converting net present value into a flow measure.

2. Value-based goals are essential to establish the correct performance standard and align the interests of employees and owners.

3. Accountability for multi-year performance is created with annual payments as a function of annual performance, but held as a draw against cumulative, multi-year performance.

4. A straight line provides the simplest and the most sensible payment, with every dollar of value creation valued equally, at any level of performance. An unlimited upside/ downside not only guards against damaging short-term behaviour, but it also ensures a continuously motivating payment structure that never “turns off”, even in exceptional years.

Patricia Ziengheim and Jay Schuster on the other hand show how to approach the issue of changing compensation based on a diagnosis of organizational needs with six underlying reward principles: gain employee understanding and support of change

8 Justin petit and Ahmar Ahmed, Compensation strategy for New Economic Age, EVAluation may 2000.

initiatives through communication, education, and involvement; align rewards with goals; extend people's line of sight so they can see the link between their efforts and bottom line results; use the various reward approaches, cash and non-cash, in a way customized to needs; reward individual competencies, performance over time, and labor market value; and reward results with variable pay9.

The basic predicament discussed here is as to make the employees and executives think like owners of a company. Traditional incentive schemes have many shortcomings, which need to be overcome for the new age economy and for the knowledge worker. A critical flaw in traditional competitive pay practice is the commitment to always maintaining competitive levels of pay. Limitations to the dominant total compensation strategy require that a new approach be developed. The stated philosophy and objectives of the vast majority of public companies can only be reached through a combination of features that effectively create an owner-employee contract to share value creation.

9 Patricia K. Zingheim and Jay R. Schuster, ‘Pay People Right: Breakthrough Reward Strategies to Create Great Companies’, Jossey-Bass Inc., Publishers.