Developing an Executive Compensation Philosophy

A well-defined compensation philosophy is a key input for effective pay design. Not only does it serve as a basis for almost all compensation decisions, it is also a valuable tool for communicating—both internally and externally—a company’s values and goals and how they translate into employee rewards. And despite their significance, compensation philosophies can be an overlooked component of compensation planning or they may only be quick, check-the-box exercises.

It is true that like mission statements, philosophy statements are somewhat abstract and developing (or updating) one forces companies to consider complex questions to which there may not be clear answers. This is never an easy task and it can be particularly challenging for companies operating under pressure and in fast-paced environments where there is real business risk and many other priorities to focus on. Nevertheless, a compensation philosophy is a key element for the organization’s overall talent management strategy.

Breaking Down the Compensation Philosophy

In its simplest form, a compensation philosophy is a summary of an organization’s guiding principles for its compensation program. If it is relevant and done well, it will be informed by a thorough and ongoing assessment of organizational culture, strategy, and human capital needs.

While structures of compensation philosophy vary across companies and industries, they generally address the following key goals:

1. Documents objectives for the compensation philosophy;
2. Defines appropriate competitive reference points;
3. Describes the roles of various elements of compensation;
4. Determines the relative emphasis of compensation elements;
5. Clarifies the relationship between people, pay programs, and company purpose/values; and
6. Outlines company-specific pay considerations.

Trends and best practices certainly create overlap in compensation philosophies across all industries, although it’s the subtle differences between companies within industries that can create competitive advantage. Taking time to carefully consider each of the items above is critical in the development process and, once defined, each item should translate and manifest itself in the overall compensation design.

Leveraging this Framework to Develop or Diagnose your Compensation Philosophy

Below, we present each component of a compensation philosophy and suggest key questions for companies to consider as they develop their policies. The resulting compensation philosophy outcomes illustrate how responses can translate into actionable items to drive compensation design.

Ongoing Assessment

Once the compensation philosophy has been developed and its principles are reflected in the pay program design, it’s important for companies to conduct ongoing annual reviews to ensure that it remains relevant and that it’s resulting in the desired outcomes. Below are a few examples of key compensation program objectives, and potential analyses that can be used to demonstrate whether the company is achieving its desired goals. There are also various tools that can assist in the monitoring process and diagnose potential issues.

Of course, not every aspect of the compensation philosophy requires a specific quantitative analysis to confirm its effectiveness. In some instances, where there are inconsistencies between company culture and strategy, the lack of alignment between compensation philosophy and pay program design may be very apparent. (For example, if your strategy is to pay consistently below median, but you have retention problems.) Most important, however, is that companies routinely revisit the philosophy and that this process allows decision makers among the board and in the executive ranks to optimize pay programs accordingly.

In Summary

While they can be difficult to define, compensation philosophies provide a consistent framework for companies to work within by ensuring that all pay decisions are drawn from the same set of values. It is up to compensation committees and executive leadership to ensure the compensation philosophy reflects company culture and evolves with it over time.