Lecture 03

LESSON 3 Role of Compensation and Rewards in the Organization Chapter 1: Introduction to framework of Compensation Policy Learning Objective •

Introduction to the concept of Framework

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Understanding the Framework of a Compensation Policy

Introduction to the concept of Framework A compensation framework that supports a long term strategic vision for compensation and implements new initiatives, will provide the needed direction, changes will involve moving towards solving special salary problems using innovative concepts. The way we do compensation is undergoing major change towards a more flexible and timely corporate compensation systems. The new system will have increased delegation to managers and will be driven by the business needs of Government and ministries. It will be faster, more efficient and eliminate duplication, focus on a long term approach to compensation management. Move from being highly centralized to a decentralized approach whereby deputy ministers and senior mangers will have increased authority to make decisions. Integrate compensation with the other areas of human resource management. And Emphasize transparency, monitoring, reporting and accountability. The vision for compensation will assist the pubic service in attracting and retaining key employees. Managers will have more accountability for the compensation of their employees, and will be profiled with the required tools, systems and support. Senior mangers will approve, within the framework, exceptional compensation changes, based on sound business decisions. Senior managers will also have authority to approve the classification levels of pre-identified jobs within their organization. Framework of a Compensation Policy Employee motivation and performance management depend on good systems that offer both financial and non-financial rewards (non-monetary rewards). This performance management article applies to all organisations. Constant change and high expectations are taking their toll in some organisations, as well as in industry and government generally. Sometimes this is shown in employee turnover.

Sometimes it is hidden because of job insecurity. Many employees make a New Year's resolution to seek other employment. Many are also seeking more balance in their life. Rewards and remuneration must be scrutinised. Employee motivation and performance are critical. Non-monetary rewards can be as important as monetary rewards. In some organisations, a multitude of different salary and pay arrangements exist. It is time to bring these different systems into a new framework. Employees at all levels need to have confidence in the salary administration system. Employees want the rewards to be shared fairly and equitably. If they are not, dissatisfaction can cause severe morale and performance problems. If they haven't done so already, leading organisations will need to establish an improved salary administration structure. It is possible to develop a simple structure that overcomes the difficulties of the past, yet is simple enough for everyone in the organisation to understand. This structure can be tied to a completely new performance management approach, including better performance appraisal mechanisms. Some industry's remuneration systems have been dominated by the industrial relations system. Enterprise bargaining and local area work agreements, individual performance based contracts, and the effect of competition on organisational structures, have had a big impact. A good rewards and remuneration system ensures that each person receives appropriate financial and nonfinancial recognition to account for the personal contribution they are making and the overall value of their position to the organisation. This includes: Creating and maintaining an organisational structure and culture that facilitates both employee and organisational performance. Recognising and rewarding individual and team performance, financially and otherwise, in relation to the overall contribution made. Implementing compensation systems that fairly treat and recognise all employees, regardless of their level within the organisation. This is the equity issue. It involves matching remuneration with the contribution made, particularly where job requirements can change rapidly. The best performance appraisal system in the world will not work if it is linked to a rewards and remuneration system that employees do not trust or support.

A motivated employee will achieve a great deal. A demotivated employee will be slow, prone to error and not likely to achieve. Motivation influences performance. It also suggests that the 'lack of', 'promise of', or receipt of either financial or non-financial rewards may also influence motivation. A feedback loop between motivation and performance exists, with each potentially impacting the other. Remuneration is a component of both financial and non-financial reward; financially, in terms of cash and benefits received; non-financially in terms of recognition, status and esteem, e.g. the status of full private use of a motor vehicle. Job evaluation is a process to determine the contribution of a position to an organisation. It needs to be seen by both the employee and organisation as fair and equitable. Good salary administration requires that employees should receive financial recognition for the contribution that they make, and that positions of equal value should be entitled to equal compensation. If organisations handle this incorrectly, or manipulate it in some way, the impact on the employee is significant. Past pay systems often paid little attention to incentives. It is only in recent years that some systems have provided for differentiation based on performance. The concept of fair incentives should be on the agenda. An integrated system is required such as the following diagram represents.

Perception is the reality. If the current system is not working as intended, then the organisation has a real problem. Some key questions: Does the documentation give a full, comprehensive description of each position?

Is the evaluation system used soundly based and rigorously applied? Is consideration given to market competitiveness in setting the remuneration range? Is the performance appraisal system well designed and accepted by all employees? Is the review process conducted fairly and within agreed time limits? As well as checking goal achievement, does the review reconsider the job and changes that may have occurred? Are non-financial rewards considered along with financial rewards? The system should not be bureaucratic, but it has to be perceived as fair. It also has to be actually administered fairly. Where do you rate your system on a scale of 1 to 10? 1 Employees are showing their total disenchantment by leaving as quickly as they can. Morale and motivation are non-existent. 2 Employees are unhappy and grumble frequently about the non-existence of a remuneration system. They openly talk about the problems instead of getting on with their work. 3 Employees are unhappy and comment frequently about the remuneration system that is supposed to be in place but doesn't work. However, a work ethic exists and they do some work. 4 Employees believe that 'management' controls and manipulates the system. They continue on regardless, but they do not like it. 5 Employees are aware of a remuneration system but do not see it working for them. It causes some dissatisfaction. 6 Employees believe the remuneration system only works for 'management'. 7 Some employees believe the remuneration system is working, others believe it could be better targeted to their particular situation. 8 A comprehensive system is in place. Position value and remuneration is fairly evaluated and most are well compensated. Areas for improvement are recognising individual and team contributions fairly. The system is reviewed regularly. 9 A comprehensive system is in place. Position value and remuneration is fairly evaluated and nearly all are well compensated. Individual and team contributions are recognised. Higher achievement will come from better implementation.

10 Everyone from the CEO down believes that the remuneration system is working well and being equitably administered. Individual and team contributions are recognised and rewarded accordingly. Although some would like more pay, no one is unhappy with the system. They are motivated and productive. Tutorial Activity 1.1 Let us study the case below the framework of compensation policy at University at Minnesota.

Approved by the : Faculty Senate on February 18, 1993 Accepted and Implemented by the: Administration on April 26, 1993 Action by the:

Board of Regents - no approval required

Faculty Compensation Policy Background on Compensation at the University Of Minnesota Faculty are compensated for their contributions to teaching and advising, research and scholarship, and service to the institution and the state/region/nation/other nations, as well as their professions. Total compensation includes annual base salary plus fringe benefits, including retirement, health and dental coverage, and life and disability insurance. In some instances, annual base salary is augmented through internal sources, such as overload teaching, or from external sources in the case of approved external consulting. Initial annual base salary is negotiated at the time of hire, with floors establish for the instructor and assistant professor ranks only. Increases to annual base salary for faculty occur in the following ways: through annually determined merit increases; through acceptance of a retention offer that includes an increase; in conjunction with a promotion in rank and/or the awarding of indefinite tenure; through an augmentation attached to an administrative title or a set of administrative duties. For many faculty, annual base salary is supplemented with summer school or other internal summer employment, such as grant research. Annual base salary may also be supplemented internally during one's contract period through means such as extension teaching. Normally, new salaries go into effect for A base faculty on July 1 and for B base faculty on September 16 of each year.

The salary determination process must provide an objective unbiased evaluation of each faculty member following a thorough review of his/her work. The process must encourage continued good or improved performance, which in turn, should be rewarded by the compensation system. Criteria for Annual Salary Increases and Promotion Any salary determination process at the University of Minnesota must be nondiscriminatory. Initial salary offers, periodic increases, and retention offers may not be based on considerations related to the race, color, creed, religion, national origin, sex, sexual preference, marital status, public assistance status, veteran status, or age of the person being considered. The criteria for determining salary increases must be similar to those used for promotion and tenure. The tenure and promotion regulations of the University, adopted in 1985, provide the following instructions which form the framework within which salary decisions must be made: 7.11 General Criteria The basis for awarding indefinite tenure is the determination that the achievements of an individual have demonstrated the individual's potential to continue to contribute significantly to the mission of the University and to its programs of teaching, research, and service over the course of the faculty member's academic career. The primary criteria for demonstrating this potential are effectiveness in teaching and professional distinction in research; outstanding discipline-related service contributions will also be taken into account where they are an integral part of the mission of the academic unit. The relative importance of the criteria may vary in different academic units, but each of the criteria must be considered in every decision. Faculty Involvement Faculty input into the discussions surrounding criteria and procedures for salary increase determination is essential to maintaining an equitable and collegial environment. With the administrator of each unit, the faculty must have the opportunity to develop the criteria for, and the format of, the process through which annual salary increases are determined. The documents that describe these criteria, formats, and processes shall be shared with the college dean, the appropriate vice president, and finally the Senior Vice President for Academic Affairs. This process must include the provision that the department chair (unit leader) meet with each faculty member individually, at least once per year, to review his or her performance. The sessions shall review the past year's performance and offer suggestions for enhancing productivity, where appropriate. Units may choose to conduct more in

depth evaluations on a periodic basis (e.g. 4 or 5 years) that would include outside evaluations. Allocation Format Each year the annual salary increase pool for meritorious performance received by the unit will be distributed based on the criteria specified in the University's Regulations Concerning Faculty Tenure and appropriate departmental faculty evaluation documents. Unsatisfactory performance, which shall be documented and communicated to the individual involved, shall serve as justification for withholding an individual's increase. Promotion Increases Beginning with the 1993-94 salary year, promotion from assistant professor to associate professor will be accompanied by an extraordinary $1,500 increase in base salary and promotion from associate professor to professor will be accompanied by an extraordinary $2,000 increase in base salary. It is intended that these promotional increments will be in addition to the annual salary increase award related to meritorious performance. The dean will set aside, from those funds provided to his/her unit for salary increase distribution, sufficient funds to cover these promotional increments. It is understood that the dean may also set aside funds from this overall pool to address special merit or retention purposes. It is intended that this promotion increment will receive inflationrelated increases in future years. Other Recommendations A standing administrative and faculty compensation committee (including representatives of the Senate Faculty Affairs Committee) will examine and make recommendations on policies such as salary levels in the University as a whole, salary disparity among units, minimum salary levels for associate and full professors, and salary compression. Tutorial Activity 1.4

CALIPERS” Let us analyse the Executive Compensation Framework policy with regard to the organization CALIPERS’. Company Background: The purpose of CalPERS' policies on executive compensation is to raise the level of accountability of Boards and Compensation Committees to shareowners. CalPERS feels it will benefit shareowners in the long-term if shareowners can provide an enhanced level of oversight in relation to Compensation Committee actions. This results in more shareowner friendly compensation programs.

Compensation programs are one of the most powerful tools available to companies to attract, retain and motivate key employees, as well as align their interests with those of shareowners. Poorly designed compensation packages may have disastrous impacts on the company and its shareowners by incentivising short-term oriented and self -interested behavior. Conversely, well-designed compensation packages may help align management with owners and drive long-term superior performance. Since equity owners have a strong interest in long-term performance and are the party whose interests are diluted by stock option plans, CalPERS believes shareowners should provide stronger oversight of executive compensation programs. In recognition of this, CalPERS' believes that companies should formulate executive compensation policies and seek shareowner approval for those policies on a periodic basis. Since SEC's Release #34-48108, adopted on June 30, 2003 as listing standards, for the NYSE and NASDAQ, companies must give shareowners the opportunity to vote on all equity compensation plans and material revisions (with limited exemptions). The ability to vote on these plans provides the checks and balances on the potential dilution resulting from earmarking shares for equity-based awards. With this in mind companies should design executive compensation policies to be comprehensive enough to provide shareowners with oversight of how the company will design and implement compensation programs, yet broad enough to permit the Compensation Committee flexibility in implementing the policy. CalPERS does not believe that it is optimal for shareowners to approve individual contracts at the company specific level. CalPERS developed a model policy guideline designed to assist companies in formulating executive compensation policies. This also provides a framework by which interested parties may gauge the quality of company specific executive compensation programs and practices. General Policy Guidelines. This also provides a framework by which interested parties may gauge the quality of company specific executive compensation programs and practices. General Policy Guidelines Executive compensation programs should be designed and implemented to ensure alignment of interest of management with the long-term interest of shareowners. Executive compensation should be comprised of a combination of cash and equity-based compensation. Direct ownership should be strongly encouraged. Executive compensation policies should be transparent to shareowners. The policies should contain, at a minimum, compensation philosophy, the targeted mix of base compensation and "at risk" compensation, key methodologies to ensure alignment of

interest, and parameters for guidance of employment contract provisions, including severance packages. Companies under new SEC guidelines must provide shareowners the opportunity to vote on any material revisions to these plans. Executive contracts should be fully disclosed, with adequate information to judge the "drivers" of incentive components of compensation packages. Executive Compensation Policies In particular, executive compensation policies should contain, at a minimum, the following components: 1. The company's desired mix of base, bonus and long-term incentive compensation This section should include adequate detail to shareowners regarding the company's philosophy of base pay components versus "pay at risk" components of the program. Details should include reasonable ranges based on total compensation within which the company will target base salary as well as other components of total compensation. Overall targets of total compensation should also be provided. This section should also provide an overview of how the company intends to structure the compensation program, such as how much of overall compensation is based on peer relative analysis and how much of it is based on other criteria. The policy should clearly articulate how the company ensures optimal alignment of interests with shareowners through the design and implementation of its executive compensation program. 2. The company's intended forms of incentive and bonus compensation, including what types of measures will be used to drive incentive compensation. In addition to the relative mix of base salary and any form of incentive compensation, the company should provide a breakdown of the types of incentive compensation and reasonable ranges based on total compensation targets for each type of incentive compensation within the program. The policy should include the company's philosophy related to the major components of incentive compensation, including the strengths and weaknesses of each and how the overall incentive component of the plan provides optimal alignment of interests with shareowners. CalPERS believes that in the case of option plans and restricted stock, a significant portion of the overall program should consist of performance-based plans. These include index-based options, premium-priced options and performance targets tied to companyspecific metrics.

Performance-based plans should be constructed to reward true out-performance, and should include provisions by which options will not vest if hurdles are not obtained. Time-accelerated vesting is not considered a meaningful performance-based hurdle. The policy should include the specific drivers the company will use in constructing the performance-based components of the plan. CalPERS suggests using metrics such as Return on Invested Capital (ROIC), Return on Assets (ROA), and Return on Equity (ROE), and the relative mix of how performance metrics will be weighted. CalPERS believes that optimal plan design will utilize multiple performance metrics in a fashion that will tie small portions of vesting to individual metrics or larger portions of vesting to multiple metrics. CalPERS believes that if metrics are used in combination, the plan should require that each component be satisfied to achieve vesting as opposed to one of several that must be achieved. 3. The company's intended distribution of equity-based compensation The policy should include the company's philosophy related to how equity-based compensation will be distributed within various levels of the company. In the event that the company uses equity-based tools in its compensation program, the policy should articulate how the company will address the issue of dilution. For example, the company should provide a detailed plan with each option program addressing the intended life of the plan and the yearly run rate. If the company intends to repurchase equity in response to the issue of dilution, the plan should clearly articulate how the repurchase decision is made in relation to other capital allocation alternatives. CalPERS does not favorably view repurchase plans that are 4. The company's philosophy relating to the dilution of existing equity owners simply targeted to mitigate and obfuscate dilution caused by stock option plans. 5. The parameters by which the company will use severance packages, if at all. 6. The parameters by which the company will utilize "other" forms of compensation, if at all. The policy should provide broad guidelines by which the company will use alternative forms of compensation, and the relative weight in relation to overall compensation if "other" forms of compensation will be utilized. The term and length for "other" forms of compensation should be disclosed. Other forms of compensation include but are not limited to pension benefits, deferred pay, perquisites

and loans. In some cases, other forms of compensation can provide significant value to executives which are not readily comparable to more basic forms of compensation such as salary, bonus and incentive. Other forms of compensation are also more likely to be perceived by shareowners as not providing meaningful alignment of interests or incentive value. To the degree that the company will provide other forms of compensation, it should clearly articulate its philosophy for utilizing these tools with specific treatment of how shareowners should expect to realize value from including these forms of compensation Executive compensation programs should be designed and implemented to ensure alignment of interest of management with the long-term interest of shareowners. Executive compensation should be comprised of a combination of cash and equity-based compensation. Direct ownership should be strongly encouraged. Executive compensation policies should be transparent to shareowners. The policies should contain, at a minimum, compensation philosophy, the targeted mix of base compensation and "at risk" compensation, key methodologies to ensure alignment of interest, and parameters for guidance of employment contract provisions, including severance packages. Companies under new SEC guidelines must provide shareowners the opportunity to vote on any material revisions to these plans. Executive contracts should be fully disclosed, with adequate information to judge the "drivers" of incentive components of compensation packages. In addition to the relative mix of base salary and any form of incentive compensation, the company should provide a breakdown of the types of incentive compensation and reasonable ranges based on total compensation targets for each type of incentive compensation within the program. The policy should include the company's philosophy related to the major components of incentive compensation, including the strengths and weaknesses of each and how the overall incentive component of the plan provides optimal alignment of interests with shareowners. CalPERS believes that in the case of option plans and restricted stock, a significant portion of the overall program should consist of performance-based plans. These include index-based options, premium-priced options and performance targets tied to companyspecific metrics. Performance-based plans should be constructed to reward true out-performance, and should include provisions by which options will not vest if hurdles are not obtained. Time-accelerated vesting is not considered a meaningful performance-based hurdle. The policy should include the specific drivers the company will use in constructing the performance-based components of the plan. CalPERS suggests using metrics such as

Return on Invested Capital (ROIC), Return on Assets (ROA), and Return on Equity (ROE), and the relative mix of how performance metrics will be weighted. CalPERS believes that optimal plan design will utilize multiple performance metrics in a fashion that will tie small portions of vesting to individual metrics or larger portions of vesting to multiple metrics. CalPERS believes that if metrics are used in combination, the plan should require that each component be satisfied to achieve vesting as opposed to one of several that must be achieved. Answer the questions below based on the above case study: •

What is the purpose behind CalPERS' policies on executive compensation?

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Based on the above case study how can you say that compensation programs are one of the most powerful tools available to companies?

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Discuss the components of executive compensation.