Inside Out: What Internal and External Factors Dictate Compensation Policy?

As seen in Chief Executive Officer Magazine 2025 – Solving the Remuneration Riddle Feature

When it comes to putting in place an executive compensation package that is fair, justifiable and in line with market practice, while also rewarding and incentivizing key personnel, there is never a simple solution. When remuneration is visible to employees, investors and other stakeholders, all will bring their unique lens to the program to determine whether they support its structure and objectives. Just as a program will be judged by many parties within or outside an organization, so will the factors that shape it come from the employees within the business, the shareholders who have an interest in both retaining the executives but also controlling costs, customers and many other groups. It will always be hard to make what seem like the right decisions under intense scrutiny, but the job of the compensation committee has never been easy.

So, what key factors should those committees bear in mind when they are designing compensation plans and programs for the executive team?

“There are many influences that go into the decision-making process around compensation,” says Jeff Keckley, a partner at Meridian Compensation Partners. “The internal factors include the company strategy, the business lifecycle stage of the company, the needs of the plan participants and the company’s culture.”

“Externally, committees will have to consider the needs of large institutional investors, proxy advisory firms, regulators and governing bodies, customers and many more,” he adds. “The factors are not always the same across industries, and there is often a different emphasis depending on the sector in which a company operates, so that must also be taken into consideration.”

Within and Without

The point that Keckley makes about industry sectors is an important one. Some industries are more influenced by consumers, while others might operate under tighter regulatory oversight. One could look to the retail sector as one in which customer influence is felt more keenly. Any executive perceived to be excessively rewarded might attract some degree of discontent among customers paying prices that ultimately fund that remuneration package. Executive compensation and company reputation may be inextricably linked. In the banking or utilities sectors, however, the views of regulators will have a more significant impact.

At the same time, these external factors cannot alone determine the nature and structure of the compensation programs that a company delivers to its key executives. After all, these factors do not directly reflect the company’s strategy, its recruitment and retention needs, the business cycle, or how its plans and programs compare with its direct competitors.

There is a need to ensure that a company acts in a manner that keeps key personnel in-house and ties their compensation to company performance in its efforts to achieve its strategic goals, both short-term and long-term. At the same time, remuneration for top executives must not be out of sync with how others in the organization – particularly those who might be in line to succeed key officers in the future – are rewarded for their contribution to the business. “There are numerous factors to consider,” says Michael Brittian, partner and member of the executive committee of Meridian Compensation Partners. “In our view, you must start with the internal perspective and the needs of the business. Then you can think about how to support your conclusions and adjust your program in line with external factors. You have to consider your business strategy, the company’s lifecycle and its internal culture. What kind of business is it, what are its values and how does the compensation program reflect that?”

The importance of the internal optics around compensation cannot be underestimated. How a program is perceived by other employees in the company can have a major impact on their decisions about their future within the organization, and their ability to work with senior executives. Ultimately, the link between pay and performance must be clear and appropriate.

“Another internal consideration is the makeup of the management team and the board,” says Brittian. “Is it a new group? A tenured group? A mix of both? An internal compensation philosophy is important, and it must reflect the perspectives and experiences of board members.”

A new group of board members will be looking closely to compare how every member of the management team is rewarded for their efforts, and how that compensation lines up with their contributions. Their criteria may be different to members of a long-standing group, who understand the path that others have taken through the organization and how they have contributed to defining and delivering strategic goals over time.

“Then, of course, there is the issue of cost,” says Brittian. “And you have to consider continuity. Internally and externally, people will be looking at previous compensation programs, and a committee will have to justify any divergence from previous policy. The more divergence there is, the more care and consideration will be required to explain the board’s rationale.”

“The more a program diverges from historical practices, the more need there will be for robust disclosure and a clear rationale for those decisions,” he adds. “All decisions will also be viewed in light of market practices outside the organization. That is always part of the calculus, and how things play in the media is important for the external optics.”

Companies must consider how decisions will be viewed not only by shareholders, but also by other external commentators. The list of factors – and their importance – will certainly be different for companies in the same industry and at different stages of the business cycle, and will also differ between industries, all of which makes the decision-making process more complex. But the most effective boards will be discussing all of these considerations all the time.

The Shareholder Conundrum

Shareholders are among the most influential forces shaping compensation policy. They want sustained returns on investment, and they want executive payment programs to align with that goal. Indeed, they have pushed the ‘pay for performance’ concept that so frequently arises in discussions around executive compensation.

“A company’s shareholders will focus heavily on pay for performance, and they expect performance indicators and metrics that have a clear link with compensation,” says Brittian. “They are market informed and will want to see a reasonable quantum of realizable pay from performance and earnout, including features typical in the market and aligned with credible peer groups.”

Since the Covid pandemic, shareholders have also looked for more resilient compensation programs that can resist unexpected impacts on the business. “This is a newer concept,” Brittian explains. “It is about dealing with the impact of external market shocks. One lesson that has been learned is that pay programs are now more balanced and able to withstand shocks because they have a mix of instruments – a balance between cash, equity, short- and long-term incentives, and they are in line with both short- and long-term metrics.”

“The intent is to not to have to pivot and make a lot of changes, but instead to have consistency,” he continues. “And robust governance and a year-round process of evaluation have become important, as has the inclusion of features and practices such as risk mitigation features, restrictions on share sales by executives, and more. Additionally, shareholders want the compensation committee to engage with them more.”

Engagement is important because it can head off many potential problems before they arise. It allows committees to address any differences in perspectives and approach, and it helps investors to understand the rationale behind the program. “Most of the large institutional investors publish their expectations or guiding principles, but they are not prescriptive in their views of how programs have to be designed,” says Keckley. “They highlight what is most important to them and they want to ensure companies are working within market practices and being transparent with their disclosures, but they understand that there is nuance.”

Compensation can be a hot button issue, and it can be viewed negatively, as there is an expectation that all companies should handle it the same way, even if they are at different stages and have different needs. Balance is the holy grail here, so how do companies achieve it?

“Ultimately, boards should design pay programs around the best interests of the company, building plans that align with strategy,” believes Keckley. “The right processes must be in place to help boards do this, and there must be a compensation philosophy to ensure consistency in decisions. Committees must understand any retention concerns for the executives in the program and must incentivize the appropriate behaviors.”

“Discussion takes time and deliberation,” adds Brittian. “You need to start with the framework and an understanding among the board and management of the goals. There may be a need to make a decision in the short term that might seem counter to shareholder interests but will benefit shareholders in the long term. The key is to make this clear.”