2009 Rem Strategy Chapter Final

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Copy of chapter 3.2 (pages 96 to 104)

In The Corporate Guide to Expatriate EmploymentEdited by Jonathan Reuvid

Published by Kogan Page, London in 2009

Part 3 - Compensation, benefit and expatriate support

3.2 REMUNERATION STRATEGY FORMULATION ANDDESIGN

Natarajan Sundar, Orgdesign Limited

In an increasingly competitive world, each organisation has to formulate a

unique remuneration strategy aligned with its own business priorities andhuman resources agenda. The remuneration structure and the fixed vs.variable pay mix should address its specific challenges, and enable it toattract and retain required talent in the context of the relevant market andhelp drive performance. Short-term and long-term incentives shouldincorporate performance measures that reflect shareholder value creation forthe company. A case study of Unilever at the end of this chapter illustratesvarious aspects of remuneration strategy formulation and design.

Remuneration, or the financial returns that people receive from theiremployers, is among the most important reasons why they work for an organisation.

For the employers, remuneration is among the biggest costs. The way in whichremuneration is determined and paid has a significant bearing on the quality ofpeople it attracts and its performance. Even though it is a major cost, the challengelies less in controlling it and more in deriving the maximum benefit for the individualand the organisation. Therefore, within broad limits of the prevalent norms andpractices in the country and the industry, each company has to formulate its ownunique remuneration strategy, structure and design. This chapter focuses on thefinancial rewards, fully mindful that non financial rewards, such as career, jobsatisfaction, training and felt fairness, are at least as important.

REMUNERATION STRATEGY

A good remuneration strategy has three basic policy objectives.

Attract and retain the quality of people the organisation needs and in therequired numbers: To be able to do so, the organisation has to becompetitive in the market,

the ‘relevant’ market for this purpose beingdefined in the context of the company’s line of business and its strategy.

Deliver performance: While what matters ultimately is the performance of thecompany as a whole, it is the performance as individuals, teams, units anddivisions that add up to corporate performance. Therefore, how performanceis defined, measured at various levels and linked with rewards is the secondcrucial element of remuneration. The company’s business strategy and thehuman resources agenda become important as it is with these that the



remuneration has to be aligned. In turn, this would result in alignment withshareholder interests. The watchword is alignment.

Enable ‘ felt- fairness’ : The crucial thing about money is not just how muchone is paid but how much in comparison with others, especially those in thesame organisation. People increasingly accept that differentiation in rewardson the basis of performance is inevitable in the competitive global world, butthey want it done in a fair, transparent and objective way. Ensuring a generalfeeling of ‘felt-fairness’

requires robust systems, processes andcommunication, not just in remuneration but in all HR practices.

While external competitiveness, performance link and internal equity are thethree key elements of remuneration, all these need to be achieved at minimal cost.

FORMULATING REMUNERATION STRATEGY

Strategy is about being clear on where one wants to be and, broadly, how to get

there: formulating a unique winning approach that takes account of the opportunitiesand risks, core strengths and weaknesses. In today’s globally competitive world,organisations need a strategy that deals with their unique context and challenges inhuman resources including, importantly, remuneration as much as in business. TheRemuneration strategy itself should be a differentiating, competitive, advantage forthe organisation.

The industry in which one operates has a major impact on the remunerationstrategy. There is a wide range of scenarios:

At one extreme are industries, heavily skill and knowledge based withrelatively little capital, eg IT consultancies. Efficiency and effectiveness of

human capital are paramount for their success. One of the world’s largest ITconsultancy companies ensures that 85 per cent of employee time is billable.These companies have to be very closely market aligned and have strongperformance linkages with pay.

At the other extreme are highly capital intensive industries. While they mayneed very high skills, in technology and science, the numbers required aresmall and the manpower cost modest in comparison with revenue generation.Oil and Gas exploration, especially in the current high oil price context, areclassic examples. Holding on to top talent is so crucial for them that theywould not mind paying more than the competition.

Horses for Courses

The stage of growth of a company also makes a big difference toremuneration strategy, even between companies within the same industry. At thestart up stage, there is particular need for successful business innovation. The needis to attract talent of the highest calibre. A total remuneration position of 75th percentile of the relevant market may be needed. However, the revenue stream inthe innovation phase of the company is low. Cash remuneration, ie base salary andbonus needs to be modest. But stock options have to be well above the market. Asinnovations pay off and get reflected in the share value, the employees also get theirshare in the success of the company.



When a company is at a ‘mature stage’ the need is to control all costs toensure that they deliver current value. The tendency is to aim at market medianposition on base pay and higher than median on total pay including incentives,provided that performance is delivered. However, as spectacular share priceincreases are not expected, the emphasis is on annual bonuses and on share grantsrather than share options.

REMUNERATION STRUCTURE

‘Structure follows strategy’ – this is true of remuneration as much as of business.Clearly, it is not possible to achieve all the objectives of a good remuneration policythrough one element of pay. It is therefore common to have a mix of pay elements.Some elements of pay are fixed or guaranteed to be paid during the year, eg basesalary, pension and benefits such as healthcare or a car allowance. Other elementsare dependent on, and indeed aimed at incentivising performance, both short-termand long-term. The higher one goes up in the organisation, the greater is the

proportion of pay at risk.

Figure 3.2.1 shows the typical mix of pay at different levels in a large FTSEcompany in the UK. At the level of a junior manager, the bonus is modest and,barring exceptions, there is no long-term incentive. At the other extreme, ExecutiveDirectors qualify for a target annual bonus of 100 per cent of the base salary and amaximum of 125 per cent as the value of shares granted. The actual bonus can bebetween 0 and 150 per cent of the target bonus. Likewise, the actual performancelinked vesting of long term incentives can be 0 to 100 per cent of the grant. Morethan 2/3rds of their ‘target’ pay is therefore at risk.

Figure 3.2.1

REMUNERATION STRUCTURE ACROSS LEVELS

100 100100

100

40

325

Junior

manager

Long-term incentives

Short-term incentives

0

Senior

manager

10

125

20

Base salary

110

160

Executive

Director



REMUNERATION DESIGN

Once there is clarity on the remuneration strategy and structure, one has to

decide on appropriate competitive positioning and actual design of incentives totranslate them into remuneration plans.

Competitive Positioning

Competitive positioning is about deciding whether the remuneration paid by thecompany should be at, above, or below the market rate in relation to the ‘market’.First, one has to answer the question – what is the appropriate market? Thisdepends on what the relevant pool of talent is and who else is competing for them.For most jobs, it is the local or national market and for many jobs it is also the sameindustry. However, for some specialist and functional jobs, the competition is beyondthe industry. Also, at the most senior levels, regional and international levels of pay

become relevant.

Second, there is no such thing as a single ‘market rate’ for the job. Howeversophisticated a remuneration survey may be, it makes judgements (albeit informed)on job matches across companies with different organisation structures and jobprofiles and converts the market data into statistical measures such as median,average, 75th percentile, etc. The median is exactly what it says: it could be that noone else in the market is actually paid at that rate and half are actually paid higherand other half lower.

Third, even between two companies with the same total remunerationpackage, there may be significant differences in the mix. One company could be

paying relatively higher salary and modest bonuses, another a lower base salary buthigher long term incentives and a third one paying actually less total remunerationthan either but still attracting people because it provides superior non-financialrewards.

Companies therefore need to look at market data not as a precisemathematical figure but as a reference point and decide on their own remunerationstrategy and pay mix. This is particularly important for small companies. They do notnecessarily have to match the big companies in each element of pay, or in total‘financial’ remuneration, as they can often offer much better job challenges andworking conditions.

Design of Short-term Incentive Plan

Short-term incentives are designed to include an upside potential, and adownside risk, linked to performance. Three key design issues are:

What is the performance to be rewarded – the individual’s, the company’s, or,both?

What will be the measure of company performance?

How will individual performance be assessed?



Performance definition

Ultimately, the company’s overall performance is paramount. However,employee surveys show that paying every one the same bonus does not help: noone likes ‘free riders’. People want rewards to be commensurate with theirperformance. Equally, the danger in rewarding only individual performance is that itcan hurt group effort. There are two ways of handling this. The traditional option is tohave two separate elements of bonus, one for business results and the other forindividual performance, and then add the two together to arrive at the total bonus forthe individual. An alternative approach that is increasingly preferred is to link theoverall bonus amount to business performance and within the resulting ‘budget’ baseindividuals’ differentiation on their contribution.

Organisational Performance measures

Each organization will need to choose those performance measures that bestreflect its shareholder value creation. For annual bonus these will usually include a

profit measure and an efficiency measure, such as return on capital employed. Therecould be additional or alternative measures such as cash flow, volume, market share,business development, innovation, health, safety, security and environment.

Assessing individual performance

The standard practice is to agree explicit individual performance targets forthe year and make an assessment of performance against these targets. This shouldnot be simply an assessment at the end of the year. Instead, there should be regularperformance reviews during the course of the year, with improvement achievedthrough training and coaching.

Design of Long-term Incentive Plans

In the UK, the performance period for ‘vesting’ is typically three years,although in the case of stock options employees have a further period of 7 years toexercise their options. There are two common types of long-term incentives: stockoptions and stock grants. A stock option is a right given to an employee to buy theshares of the company at a future date at a predetermined price. A stock grant is likea post-dated cheque; the employee will receive a certain number of shares at afuture date. In both cases, there is a requirement that the employee should continuein the employment of the company until vesting and there are usually performanceconditions.

Share Options vs. Stock Grants

Although stock options dominated throughout the 1990s, in recent years theirpopularity has waned. First, share price growth is not dependent just on companyperformance but on the industry and overall equity market trends. Second, in a bearmarket when options go ‘under water’ there is little ‘incentive’ value left. Lastly,options have to be expensed and the cost reflected in the profit and loss account ofthe company: not surprisingly, companies want the best value for money. For allthese reasons, incentive plans based on whole shares rather than share optionshave become more prevalent recently, especially for the top executives. In the UK,they generally tend to be performance shares, ie a promise to grant shares at afuture date, subject to ‘satisfactory’ corporate performance. Performance sharesalways have some value, although the performance conditions have to be met. Stock



options and stock grants are both relevant depending on circumstances. Companiestherefore tend to use them in a flexible and complementary way, with multiple butrelevant performance conditions.

Performance Conditions

Performance conditions should be aligned with shareholder interests andsuch that the employees can influence their achievement. Finding measures thatsatisfy both these criteria has been the Holy Grail in the last few years. With stockoptions, especially as they are often granted across levels of employees in anorganisation, the tendency is to go for simple ‘internal’ measures such as growth in‘earnings per share’ or ‘r eturn on investment’ to which all employees can relate.

With stock grants, as they tend to be awarded mostly to the more seniormanagement, the search is for ‘external’ and more objective performance measures.Total shareholder return (TSR) is considered to be most aligned with shareholdervalue creation and therefore commonly used. It is the return on investment obtained

by holding a company’s shares over a period, mainly determined by the change inthe market value of shares and dividend flow. As the absolute TSR is heavilyinfluenced by general equity market trends, ‘relative’ TSR, one that assesses theTSR of the company against a ‘comparator group’, is commonly used.

Tough Choices

Formulating remuneration strategy, deciding on the remuneration structureand designing incentive plans all imply making tough choices. The processesfollowed are therefore as important as the substance. It is a challenge to come upwith a unique, cost efficient remuneration proposition for any organisation withinlimits discernible in the market. Understanding what the employees really want and

value, and engaging the line managers in the design will greatly help this greatly.More importantly, it will help in implementation.The case study below of how Unilever, a well known multinational company, hasgone about formulating its remuneration strategy illustrates the process.



CASE STUDY – FORMULATION OF UNILEVER’S REMUNERATION STRATEGY AND DESIGN

Unilever is one of the world’s largest consumer products companies, operating inover 100 countries with over 200,000 employees. Several of its brands are household namesin home care, foods and ice cream: Dove, Pond’s, Vaseline, Persil, Flora, Lipton, PG Tips,

Hellmann’s, Walls, Ben and Jerry. In recent years, its challenge has been growing in both top-line and bottom-line at the same time. Volume growth alone can be achieved by sacrificingprofits. Likewise, it is possible to grow profits in the short-run by compromising on marketingand other ‘investment’ spends. Sustained growth in profits and, in turn, shareholder value canonly be produced if there is also growth in volume.

During 2007 Unilever carried out a comprehensive review of its remunerationstrategy, as well as the design of its short-term and long-term incentive plans. The overridingobjective of its remuneration policy is to ensure that it recruits and retains the best performersand effectively incentivises them to achieve superior results. It is also the aim to manage thediffering elements of total remuneration in a fully integrated manner.

Five strategic principles serve as the platform for Unilever's approach to remuneration

for its Executive Directors and other leadership team members:

• alignment with shareholders' interests;• robust linkage to performance;• alignment with strategic priorities;• market competitiveness; and• ease of understanding and communication.

These five principles provide the foundation for the level and structure of Unilever’sremuneration. The different elements of pay are complementary to one another. Theremuneration structure shown in Figure 3.2.2 pertains to the Executive Directors and theleadership team across countries, but the principles are valid for managers worldwide.



Figure 3.2.1 - Unilever Remuneration Structure

Element ofPay

Payment Vehicle ValueDetermination

Plan Objectives

FIXED

Base Salary Cash Market Median Attract and retain highperformers

Pension Remain in the homefund or equivalentvalue

Attract and retain highperformers

VARIABLE As % of basesalary

Annual Bonus Cash (75%)Shares (25%)

For ExecutiveDirectors (EDs) upto a maximum of

150%

Economic Value Added

Top-line growth

Individual key deliverables

Global ShareIncentive LongTerm Plan

Shares Grant level for EDsup to 180%

Vesting 0 -200% ofgrant

Shareholder return at upperhalf of peer group

Top-line growth

Free cash flow

Share MatchingPlan

Shares For EDs 25% ofannual bonus paidas 3 year deferredshares with a 1-for-1 match

Alignment withshareholders’ intereststhrough executiveshareholding

Retention

Notes: The total remuneration package for Executive Directors is intended to be competitive

in a global market, with a strong emphasis on performance related pay.

A significant proportion of their total reward is linked to a number of key measures ofGroup performance to create alignment with strategy, business priorities, andshareholder value.

The Remuneration Committee of the company sets both short-term and long-termperformance targets. In so doing, it is guided by what would be required to delivertop third shareholder value.

Internal and external comparisons are made with the reward arrangements for othersenior executives within Unilever to support consistent application of Unilever’sexecutive reward policies.

Source: Unilever Report and Accounts for the year 2007



Author Notes

‘Sundar’ has been in the UK since 1995, as the lead global remuneration expert of two

of the largest global companies, Unilever and BG (British Gas) Group. He has led

major global projects in human resources, organization design, and remunerationintelligence, strategy and design. Between 2002 and 2004, he was the first coordinator

of a remuneration corporate governance group of some of the largest companies in

Europe including BP, Shell, Unilever, GSK, ING, Fortis, Daimler Chrysler, Nestle,

Total and Siemens.

As Director of Orgdesign Limited, Sundar is an independent consultant, based in both

the UK and India. He specializes in Remuneration, Organizational Design and

Performance Management. Recent major projects include Global Reward Strategy,

Framework for Managing People Cost in a Conglomerate, International Assignee and

Pay Policy, and Role Clarity and Performance Management for some of the largestcompanies in the UK and India.

Before relocating in the UK, Sundar has had a chequered career in India for nearly 30

years in science, finance, general management and human resources in Bhabha

Atomic Research Centre, Punjab National Bank (PNB) and Hindustan Unilever

Limited (HUL). After being the youngest Principal of Staff Training College of PNB,

he joined HUL in 1975 as their first banking and finance manager. In the late 1980’s

he was appointed HUL’s first national remuneration head and in the wake of India’s

economic liberalization, pioneered adaptation of global remuneration practices to

Indian context. He pilot tested the commercial application of a new approach to

organization design, ‘work level’, along with a professor from London School ofEconomics. Between 1992 and 1995 he was the Finance and HR Director of Pond’s

India Limited. In 1995 he was handpicked by Unilever to design and implement a

new global pay policy and later on to lead their biggest ever global HR project

‘Integrated Human Resources’ comprising work levels, new pay policy and systems,

skills and competencies framework and personal development plans.

Sundar is an alumnus of Madras, Delhi (FMS), Stanford and New York Universities.

Currently member, Advisory Board and visiting professor at the LM Business School,

London, he is a regular invitee contributor to Croner’s British Personnel Management

Newsletter. During 2008-2009 he was on the UK CIPD advisory panel on ‘Shaping

the Future’.

Contact Details

Orgdesign Limited, 8A, Malden Park, New Malden, KT3 6AS, UK

Email: [email protected] Phones: (0044) 20 8949 5755 / (0044) 7802782659

When in India:

D2, Ashok Amoga, 46, 1st Main Road, Gandhinagar, Chennai 600020

Phone: (0091) 9840097842

mailto:[email protected]




2009 Rem Strategy Chapter Final

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