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Challenging performance

PERFORMANCE-BASED remuneration is becoming a critical component of the executive compensation structure for many companies. Business leaders, along with shareholders, increasingly are calling for a review of schemes, which are in place for senior management remuneration, particularly in light of downward pressure on earnings.

This is perhaps one of the more complex areas of contemporary management technology and one which needs to be treated quite carefully, for two key reasons.

Firstly, single period earnings results will not adequately reflect the underlying capital and strategic position of the firm. Secondly, when a company decides to re-structure the way in which executives are rewarded, there can be significant implications in terms of behavioural change and decision making.

The design and implementation of any performance-based remuneration system, therefore, needs to address these two key issues.

The first issue – single period earnings results – can be addressed by using a measure that integrates both profit and loss and balance sheet performance, thus providing a much clearer signal as to value creation. Hence, economic profit – the return earned above the cost of capital – is the optimal measure to use.

The second issue – behavioural change and decision-making – can be addressed by ensuring that the organisation migrates to an upgraded remuneration system over a period of time, possibly two to three financial years. In this way the impact on behaviour and decision making can be assessed over a reasonable time frame.

If these two considerations can be accommodated there is a logical implementation cycle that should be followed.

p Review the current program and then develop a set of guiding principles. Ensure that you are not simply evolving the current system without a clear sense of the objectives for the program.

p Identify the key issues and considerations that will shape the program. Vesting and banking arrangements can play a big part, as can performance gates.

p Establish the economic profitability measures to use and be sure that the links to the existing system are clear.

p Finally, define the targets and model the impact of the proposed system.

Getting started with this type of program can be challenging but it also can be very rewarding. A performance-based remuneration program that aligns the executive team with the value-creation process will provide important assurance and clarity to the board, shareholders and other key stakeholders.

We receive regular queries on a wide range of corporate advisory topics. If there is a topic of particular interest or query that you would like covered within this column, please feel free to email the writer at anthony.wooles@trudo.com.au — or drop a line to the editor at Business News and we will attempt to respond at the earliest opportunity.

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