introduction
Executive compensation must first and foremost reflect the company's performance and create alignment with shareholders. Although market data, proxy advisor frameworks, and disclosure expectations are relevant inputs, they are secondary. The real value of incentive compensation lies in its ability to strengthen strategy, shape management behavior, and support long-term value creation.
Incentive plans that include intentionally crafted short-term and long-term components can be a strategic tool to focus leaders' attention and reinforce business priorities. When the plan's structure and mechanisms reflect a company's unique strategy, organizational context, and leadership approach, incentive compensation becomes a meaningful tool for translating business goals into results.
This is the third installment in our Executive Compensation Essentials series. In our first article, we considered how a clearly defined compensation philosophy serves as the basis for all executive compensation decisions. In the second article, we focused on building a relevant and defensible compensation peer group to provide the appropriate market context. With these foundations in place, remuneration committees are now in a position to evaluate the design and integration of annual and long-term incentives, the mechanisms that deliver strategy through pay.
Total direct compensation
Executive compensation is typically provided through three main components: base salary, short-term incentives (STI), and long-term incentives (LTI). Together, these elements form what is called direct total compensation.
Base salary provides income stability and is the basis for calculating incentive opportunities. Short-term incentives reward annual performance, while long-term incentives are designed to align leadership with multi-year strategic and shareholder goals. The design and alignment of these components must reflect both external competitive forces and internal strategic priorities.
A well-structured total compensation framework balances performance incentives, market relevance, and retention considerations. Based on this foundation, incentive components (STIs and LTIs) can be shaped to drive specific behaviors and reinforce business objectives.
Basic salary: Anchor points
Base pay is a fixed component of executive compensation, provides financial stability, and serves as the basis for determining incentive targets. Although base pay typically represents a small portion of a senior executive's total salary, it plays an important role in anchoring the compensation structure. Setting pay levels requires a balance between market competitiveness, internal equity, and strategic positioning. Some organizations intentionally keep base pay low to emphasize a performance-oriented culture through greater use of incentives. Annual adjustments should reflect individual performance, changes in role scope, internal pay relationships, and market movements to ensure fairness and consistency.
Short-term incentives: Drive annual execution
Short-term incentives (STI) are typically structured as annual bonus plans and are designed to focus management's attention on achieving the company's short-term financial and operational priorities. These plans typically reward performance over a one-year period and serve as an important link between business plans and executive pay results.
Most STI programs rely on a combination of quantitative financial metrics, such as revenue, EBITDA, and earnings per share, and strategic or operational goals that align with the company's efforts. More and more companies are incorporating non-financial performance metrics such as customer satisfaction, safety, and key transformation milestones to reflect a broader view of success.
Most plans use a framework of thresholds, targets, and maximum payouts, with carefully calibrated performance curves that provide upside risk for exceeding expectations and downside risk for underperformance. Ultimately, the STI plan must reflect the company's annual operating plan, measure true performance, and be clearly communicated to ensure alignment, transparency, and motivation.
Long-term incentives: enabling sustainable value creation
Long-term incentives (LTI) are a key mechanism for aligning management interests with sustainable shareholder value creation. For senior leaders, these programs typically represent the largest portion of total compensation and are structured to reward performance over multiple years, most commonly three years.
Some of the most popular LTI vehicles include:
- Performance Share Units (PSUs): Subject to achieving defined performance objectives, such as relative total shareholder return (rTSR), return on invested capital (ROIC), or multi-year revenue or profit growth. PSUs are the clearest expression of pay for performance.
- Restricted Stock or Restricted Stock Units (RSUs): Fixed-term bonuses typically used to support executive retention and reduce compensation volatility.
- Stock options: Although less common today, options remain important in growth-oriented companies where a direct link to stock price appreciation supports long-term value creation.
Effective LTI design requires careful calibration. Performance metrics must be clearly defined, achievable, yet rigorous, and aligned with the company's strategic goals. Vesting schedules must balance retention and performance motivation. Many companies also consider the mix and weighting of LTI vehicles to ensure the program reflects both business realities and talent goals.
Beyond financial alignment, LTI plays a strategic role in talent retention, succession planning, and strengthening shareholder alignment. When carefully structured, it provides meaningful differentiation to a management team's value proposition and supports its long-term stability.
Integrating incentive elements: a holistic approach
Base pay, short-term incentives, and long-term incentives each serve different purposes, but they should not be designed in isolation. A truly effective executive compensation program is aligned with business strategy, tailored to leadership philosophy, and serves as an integrated system within the organization's context.
Strategic alignment is the starting point. Companies pursuing stable, mature growth are likely to emphasize profitability and operational efficiency in their incentive metrics, while high-growth organizations are likely to place greater emphasis on revenue acceleration and market share gains. Incentive structures must clearly reinforce the strategic imperatives of the business.
Leadership philosophy is important. Some executives thrive on aggressive goals and high variable pay. Sometimes you need more stability to stay focused through cycles of instability. Incentive design should reflect the leadership team's appetite for risk and ability to manage long-term performance execution.
Finally, simplicity and transparency are key. Complex plan designs can be difficult for directors, executives, and shareholders to understand and evaluate. The goal is to create a clear link between performance, pay and long-term value creation.
After all, integration is more than just putting components together. That means designing a pay framework that informs strategy, drives execution, and supports long-term leadership effectiveness.
Governance considerations
The design of effective incentive plans must be supported by sound governance practices. Compensation committees must ensure that incentive programs are well-documented, consistently applied, and aligned with evolving shareholder and regulatory expectations.
Key governance tools include:
- Share ownership guidelines that strengthen long-term collaboration and encourage management to build meaningful equity ownership.
- A clawback policy that provides the ability to recover incentive compensation in the event of financial restatement or fraud.
- Clear disclosure of plan structure, performance targets, and dividend rationale. This is especially important for public companies that survive the scrutiny of proxy advisors.
Regularly reviewing incentive design and results against both internal goals and external standards helps maintain alignment, relevance, and credibility.
conclusion
Executive compensation plans do more than just provide a salary. They should serve as an intentional extension of the corporate strategy. A well-designed incentive program attracts the right leadership talent, motivates them with meaningful performance-based opportunities, and retains them through long-term value creation. When incentive plan structures, metrics, and goals align with business priorities and shareholder expectations, compensation becomes a tool that drives strategy execution, not just governance. The most effective programs are based on a clear philosophy, informed by market conditions, and tailored to a company's unique stage, strategy, and leadership model.
