Talking Points: Why - and How to - Implement Internal Pay Equity? (10/12/06)

What is Internal Pay Equity?

1. Target ratio of CEO compensation to compensation of senior line executives (group or division presidents)
   • Cash compensation ratio to cash compensation
   • Total compensation ratio to total compensation (taking into account executive benefits)
2. Also called "Proportional Pay"
3. It also may compare ratios of CEO to COO to Group/Div. CEOs
4. It is not ratio of CEO pay to average or lowest-paid employee
5. Neither is it the same ratio for every company. The right ratio will depend on a company’s unique circumstances and may change as the company’s circumstances change

Why Use It?

1. Helps correct the long-term bias in pay surveys that have raised CEO and top staff executives' pay at a faster rate than line executives, and allows more focus on what the right relationship is for a given company’s circumstances
   • Trend to market pricing all positions, and slavishly following surveys to determine the “value” of executive positions, has gone too far,
   • Use and abuse of surveys has led to escalating CEO pay ratios without any other justification
2. Provides, in combination with external surveys, a more balanced approach to determining pay guidelines for top executive positions
   • Mitigates biases in the marketplace that may favor certain positions but do not reflect their relative importance internally
   • Consistent with the 2nd Key Principle in NACD's Blue Ribbon Report: “Fairness” -internally, as well as externally
3. Places more emphasis on CEO pay as part of the overall “cost of management”
4. Allows companies to reflect company specific characteristics such as:
   • The internal value of the CEO's leadership style relative to other executives (e.g., "value creator" vs. team leader)
   • Organizational structure (e.g., flat vs. multiple levels; presence or absence of COO; relative number of general managers)
   • Strength of line management team
5. Provides additional, thoughtful logic and support to pay positioning for disclosure purposes
6. Leads to better employee relations and a stronger, more cohesive, company

How To Use It?

1. Track the company's internal pay ratios between CEO and direct line reports historically
2. If CEO pay ratio has risen disproportionately relative to other line executives, assess whether this is justified by internal factors or has occurred merely by slavish adherence to surveys
3. Set a ratio appropriate for your company here and now – for target annual compensation and total compensation
4. Set appropriate and competitive total compensation structure for senior line executives
5. Then, layer CEO and COO above that level, based on historical relationships or common sense, e.g., CEO/COO/EVP of 100/75/60-50
6. Mix of pay elements may vary between levels, but need not

Avoiding Unintended Consequences

1. Develop clear criteria for determining right multiple to avoid “multiple envy”
2. Establish clear protocol for how senior line executives’ pay levels will be determined to avoid total compensation “creep” for all
3. Determine how far Board is willing to let CEO pay levels fall out of synch with “market” before re-evaluating relative pay levels
4. Be open to adjusting ratio as management structure and individual incumbents change
5. Continuously evaluate "cost of management" and executive/shareholder value sharing