Compensation Strategy for the Knowledge Workers

Col (retd) KK Sharma

Compensation is an important motivator when you reward achievements of a desired

organizational result. While the transactional reward (monetary) is well known, socio-
psychological compensation (challenging work environment, learning opportunities) is
less used but has an equally important role to play in keeping knowledge workers
motivated. Many research organisations like EVAluation (Stern & Steward & Co.
Research) focus attention on the compensation concepts for the knowledge work-forces
of modern work economies1.
Compensation Strategy is an essential
human resource management
intervention, as it influences costs of
an organization. Compensation
programs need to be designed and
managed to meet the needs of today's
competitive markets through
attracting, retaining, motivating, and
developing people. In some
organizations, the compensation
department is just in a supporting role
for the line management, while in
others the compensation and benefits
manager is a very powerful employee
of the organization. The role of
different components of the
compensation can differ and therefore assumes increasing importance. For example, the
role of bonuses can primarily be, either in performance reward or the retention of the
employees - a policy that an organization has to decide2.

Management often recognizes that incentive compensation is one of the most

powerful levers that can be used to drive corporate strategy. Yet most companies
struggle to take full advantage of this potential due to lack of proper tools, expertise and
visibility. Instead, they are bogged down in Excel spreadsheets and Word documents
trying to build effective plans3. One of the biggest questions that employers ask
themselves today is which compensation strategy will have the greatest impact on their
bottom line. Organisations are talking about performance based compensation programs
to face the market upsurges in BRIC countries, where retention of talent is a major issue.
Many writers have focused it on managing for value - the executives all over the world.
But still in many companies, performance measurement and reward schemes have not
kept with the changing economy from its income statement-centric profit measurement.
Old economies are not able to keep pace with the talents and their unique requirements
at all levels in this New Economy.

1
Justin petit and Ahmar Ahmed, Compensation strategy for New Economic Age, EVAluation
may 2000
2
2008 HRM Advice.
3
Incentive Compensation White Paper ; The Pitfalls of Using Spreadsheets for Incentive
Compensation; Makana Solutions.
 Measurement and motivation are age-old ably linked elements. Old saying of what
gets measured gets managed may be applicable in a traditional corporate or sector, but
may not be ideal for the new age economy. In today’s globalised economy, the
importance of opportunities for growth, advancement and work-life balance in the office
vary from one employee to other and the key of retention strategies is to identify what
motivates employees to deliver more than what job design requires them to do. “Buy
Earnings” as a strategy of traditional economy relates to re-investment and vertical
integration without caring about the value creation. Managers are often drawn to higher
margin businesses that, on the surface, may seem more attractive. Percentage returns
remain another bane of the old economy but this focus on ROI deprives stars the
required capital and helps companies in “dog” house of Porter’s competition strategy
matrix. Invariably a low-return business may be motivated to go after return of expanding
growth but eventually result in a loss of capital and value.

Some of the philosophies in compensation are, “competitive levels of compensation”,

“performance-related pay” and “significant levels of pay at risk”. Main focus appears to
be to find out an optimal level of
competitive pay, thus attempt to strike a
balance between the compensation, pay
or cost to company and perhaps the
revenue generation. Most often
competitiveness in pay structures is the
focus of attention, build as a retention and
cost-cutting strategy. In 2008 and 2009,
we witnessed huge compensation
packages to the corporate executives
even when the companies were filing
Chapter 11 appeal. As the writer has
stated, executive and incentive
compensation policy must align employee
interests with value creation, limit
retention risk – the risk of losing good
people during the inevitable periods of
poor or volatile performance, and to achieve this at a reasonable total economic cost.

In practice, variable pay is often more an ex post form of participation, than an ex

ante performance motivator4. Many theorists and behaviour scientists have opined that
incentives, in a behaviour modification and reinforcement role, are essential to good
corporate governance. A good compensation system must align the interests of
employees with owners. The authors have cited many examples of auto-makers from
the UK and USA, relating to the pitfalls of bonuses and cash incentives. Like the one in
Eastern Europe, instead of bonuses, job security was the prime concern, thus needed to
apply Maslow’s hierarchy of needs principles.

The level of pay analysis appearing in many write-ups including EVAluation, is a

cross-sectional view of four years of CEO Total direct compensation or TDC and TSR
data, with TSR explaining only 1% of the variation in levels of “Old Economy” company

4
ibid
CEO pay and 2% of the variation of CEO pay for the “New Economy” set 5. Despite the
discouraging results of our regression analysis we did find that most CEO pay seems to
be pay at risk – even more so for the New Economy CEOs. It was also found out that 70
to 80% of total pay is actually “pay at risk”. For the new economy, more percentage is of
equity or Employees Stock Options (ESOPs). Whatever be the components, real
compensation must look after the interests of both – the employees and the employers.
Another debate has been on ownership versus pure monetary incentives. Many
executives find that compensation is sometimes adversely influenced by the impact of
holdings. In recent times, there has been an increase in stock ownership holdings and
adopt formal ownership guidelines for executives. The sharp increase in the use of stock
and stock options is also partly driven by the failure of other forms of compensation.

Broad-based use of stock and stock options may not be the simple answer to
aligning interests and motivating value maximizing behaviours. Some of the limiting
factors in terms of the equity could be - stock volatility, which at times is mysterious,
frustrating and even de-motivating. Another dampener for many employees and
executives is their inability to understand and work into the global capital markets and
have only a vague understanding of valuation. Also the equity incentives are far less
prescriptive, or actionable, than cash incentives, where the linkage between actions and
results can be made clear and period measures, upon which operating decisions are
routinely made, are also used to drive pay. Last point given by the authors is that the line
of sight between a traded security and the sphere of influence of most employees is
poor, leaving little ownership over results and thus not affecting behaviour. This further
proves that Compensation systems are not only complex, but they also permeate the
organization's entire social fabric and can set the tone for the culture of the organization.
Add to that the prohibitive
costs associated with
compensation management
and payroll costs themselves
and one is left with a recipe--
either for success or disaster6.
Thus while working out
compensation, one needs to
look at basics including job
analysis, job evaluation,
surveys, job pricing, benefits,
incentive pay, performance
appraisal, and the
compensation of special
groups such as sales people,
top executives and
expatriates7.

Another measure is of creating guidelines for option grant price mechanics, which
actually can undermine compensation objectives. Grant guidelines create a connection
between pay and performance like cash incentives. On the other while hand ownership
5
Justin petit and Ahmar Ahmed, Compensation strategy for New Economic Age, EVAluation
may 2000
6
Edward E. Lawler Ill. San Francisco: Jossey-Bass, 2000. 327 pp.
7
Donald L. Caruth and Gail D. Handlogten, Managing Compensation (And
Understanding It Too), Greenwood Press, Inc. (Quorum Books).
guidelines and stock options are important elements at senior levels; they may be only a
part of the compensation solution. Option mechanics and their integration with cash
incentives must be considered as important degrees of freedom in the design process. It
is seen that at workers level, equity incentives are generally less effective and provide
only marginal benefits at substantial economic cost. It has been argued that grant
guidelines with a fixed share grant, rather than a fixed value grant, greatly enhance the
sensitivity of pay to performance. Alignment and motivation can be further strengthened
by linking the annual and long-term plans with the bonus multiple used as a grant
multiplier. Finally, out-of-the-money options are more shareholder-friendly and serve to
increase pay sensitivity. The paper has given examples and certain steps to prove these
observations. High powered stock options represent a practical alternative to front-
loaded options, or mega grants, because they achieve a similarly high degree of wealth
leverage, but limit retention risk issues through annual the annual grant feature and the
effective mechanics of step vesting.

Some of the problems are that there is a tendency everywhere to add more and new
layer of incentives to the existing old measures, leaving it to the incentive participants to
somehow resolve any conflicts and determine the real goal. The incentive effect is
perverse, but unfortunately not seen by all in the same light. Another is the use of goals
for planning, budgeting and incentive compensation, when we talk about base goals or
expectations and stretch goals, and the bonuses warranted for each. Goals mandated
from the top leadership create their own problems as they lack any ownership. Missing
stretch goals by a small margin may deprive one from a bonus but there are no
disincentives if one misses these by a wide margin. Too many measures, incentives tied
to the measured performance rather than improvement, negotiating goals linked to
targets, and caps on incentives thus virtually putting a cap on performance and single
year horizon makes such incentive schemes dysfunctional.

To tide over these shortcomings changes in the compensation structures are

required. The compensation solution cannot merely replace conflicting and incomplete
measures within the confines of a traditional incentive plan. The stated philosophy and
objectives of the vast majority of public companies can only be reached through a
combination of features that effectively create an owner-employee contract to share
value creation. The measures suggested are as follows8:

1. Economic value added simply and simultaneously captures profit, capital and the
cost of capital, converting net present value into a flow measure.
2. Value-based goals are essential to establish the correct performance standard
and align the interests of employees and owners.
3. Accountability for multi-year performance is created with annual payments as a
function of annual performance, but held as a draw against cumulative, multi-
year performance.
4. A straight line provides the simplest and the most sensible payment, with every
dollar of value creation valued equally, at any level of performance. An unlimited
upside/ downside not only guards against damaging short-term behaviour, but it
also ensures a continuously motivating payment structure that never “turns off”,
even in exceptional years.

8
Justin petit and Ahmar Ahmed, Compensation strategy for New Economic Age, EVAluation
may 2000.
 Patricia Ziengheim and Jay Schuster on the other hand show how to approach the
issue of changing compensation based on a diagnosis of organizational needs with six
underlying reward principles: gain employee understanding and support of change
initiatives through communication, education, and involvement; align rewards with goals;
extend people's line of sight so they can see the link between their efforts and bottom
line results; use the various reward approaches, cash and non-cash, in a way
customized to needs; reward individual competencies, performance over time, and labor
market value; and reward results with variable pay9.

The basic predicament discussed here is as to make the employees and executives
think like owners of a company. Traditional incentive schemes have many shortcomings,
which need to be overcome for the new age economy and for the knowledge worker. A
critical flaw in traditional competitive pay practice is the commitment to always
maintaining competitive levels of pay. Limitations to the dominant total compensation
strategy require that a new approach be developed. The stated philosophy and
objectives of the vast majority of public companies can only be reached through a
combination of features that effectively create an owner-employee contract to share
value creation.

9
Patricia K. Zingheim and Jay R. Schuster, ‘Pay People Right: Breakthrough
Reward Strategies to Create Great Companies’, Jossey-Bass Inc., Publishers.