Toad or Butterfly?: A Constructive Critique of Executive Compensation Practices

Toad or Butterfly?: A Constructive Critique of Executive Compensation PracticesAuthor(s): J. TaylorSource: Industrial and Labor Relations Review, Vol. 21, No. 4 (Jul., 1968), pp. 491-508Published by: Cornell University, School of Industrial & Labor RelationsStable URL: http://www.jstor.org/stable/2520753 .

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TOAD OR BUTTERFLY?: A CONSTRUCTIVE CRITIQUE OF EXECUTIVE

COMPENSATION PRACTICES

J. TAYLOR

"My dear friend, clear your mind of cant. You may talk as other pepole do; it is a mode of talking in Society; but don't think foolishly."-Dr. Samuel Johnson

ALMOST all personnel executives are L familiar with the debates which have raged for several years in professional journals, professional conferences, staff meetings, and indeed, wherever and whenever personnel executives have an opportunity to share experiences and ideas. These debates center on that yet unresolved question of whether compensation is a motivator or a dissatisfier, and they continue into related specula-

Present executive compensation practices, with their large "standard benefits package," are a major source of employee dissatisfaction and employer-employee conflict. This is not because compensation is inadequate but because so much of it is spent by a paternalistic employer in ways he thinks best for an employee who greatly values his own independence and free choice. The author suggests that a way out would be to allow employees freedom to choose their own mix of cash and benefits. He recognizes several difficulties in implementing this "revolutionary" solution but believes it imperative that the effort be made.

J. Taylor is senior economist, Pfizer Inter- national, Inc. He completed this manuscript while staff assistant to the vice-president for corporate development, Ritter Pfaudler Corpo- ration, Rochester, New York. The views ex- pressed herein are his own and do not represent or reflect the official opinions or practices of either his past or present employer.-EDITOR

tions about the degeneration of wage and salary administration into a sterile ritualism of area surveys, industry surveys, least-squares plots, and other eso- terica designed more for the support of the wage and salary administrator's diktat than for the illumination of his victims. It's all good clean fun, of course, and provides numerous excuses for group entertainment, but it seems to get us nowhere. This article may turn out to have the same destination, but its purpose is not so much to get us some- where in particular as to force us to take another look at the map with a suspicion that perhaps there may be a route through the mountains which im- pedes our advance, some route other than the dead-end path on which we seem to have found ourselves.

We start by examining briefly the function of compensation as seen by employers and employees, making no at- tempt to look at its broader societal functions.' We then explore the implications of the different frames of reference of employees and employers which

'This is a study in microeconomics because, as a practicing personnel executive, this is my field of operational discretion. The external environment, for which a macroeconomic approach would be appropriate, is taken as a datum.

491



492 INDUSTRIAL AND LABOR RELATIONS REVIEW

point up a crucial dilemma in the personnel function of the modem corporation. It is in this dilemma that we find the fundamental source of the dis- appointments and difficulties in the handling of compensation problems by the accepted techniques of wage and salary administration. We then tenta- tively explore a revolutionary approach to the problem for consideration by our fellow practitioners. Finally, we touch on some of the difficulties which we can see in implementing it.

The Function of Compensation

To the employer, the compensation program is an expensive device which enables him to (a) recruit and maintain a competent work force; (b) denote the pecking order of the various jobs; and (c) motivate employees, by means of a judicious mixture of rewards and pun- ishments, to give a superior performance and to develop their potentialities for higher things. The program is neither good nor bad in itself. It is an instrument-a technique-to be evaluated in terms of results, of purposes achieved, measured against costs incurred. That both the measurable results and the total costs, from the nature of the operation, are vague does not assist clear managerial thinking about the nature and efficiency of the instrument.

For the employee, compensation provides (a) an income for his present needs and future security, (b) an objective evaluation of his "worth" in comparison with his peers, and (c) prestige in terms of self-esteem.

By juxtaposing these two functions of compensation, we get a hint of where problems could easily arise. The employer's concept of compensation is objective and active-it is something by

means of which he manipulates other people for his own purposes. The employee's concept, however, is subjective and passive-it is something to which he is subjected for the purposes of other people. No matter that the amount is "satisfactory," the traditional compensation manager's approach to the matter derogates from the human dignity of the individual employee who feels that he is equated with a job description and a point on a least-squares line:

The toad beneath the harrow knows Exactly where each tooth-point goes; The butterfly upon the road Preaches contentment to that toad.

Rudyard Kipling, Pagett, M. P.

Compensation and its administration feel very differently, depending on whether we are toad or butterfly.

Two Frames of Reference At first sight, the employer's frame of

reference is the easier to understand. "Correct compensation" is an objective fact to be determined by the compensation manager based on the scientific principles of wage and salary administration. Job evaluation, area and industry surveys, least squares, maturity curves, and the other analytic techniques of "scientific" compensation managers enable them to price the job correctly and competitively. They can assume that their employee benefits package, though it may differ in detail from those of other firms, is broadly comparable and can be ignored in its specifics as a differentiating factor. How do they know that it is comparable? In the same way they know they have priced the job competitively-by taking quick glances over their shoulders and seeing what the man on the left is doing and what the man on the right is doing. If they find they are doing much the



TOAD OR BUTTERFLY? 493

same thing, "God's in His heaven- All's right with the world!" We now may have a slight suspicion that traditional wage and salary administration is a beautifully elaborate device to avoid fundamental thinking about a very complex problem, and we may be right. That it is inadequate when it is most needed-in determining the total compensation of key top executives-is shown by recent experiments in tailoring compensation packages to individual executives.2 These experiments prove only the very great difficulty of devising an individualized package. That the task is difficult is no reason, however, to ignore the problem; it won't go away because we prefer not to recognize it. Moreover, if it is necessary now at the top, it will be necessary tomorrow lower in the hierarchy.

To the employer, the total compensation package is normally a standard- ized commodity, but a little differentia- tion may be allowable on an exceptional basis for the favored few at the top of the executive pyramid. The larger the corporation, the greater the pressures toward standardization and toward bu- reaucratic administration. The commodity is considered a "good" commodity and its competitive price is "right" because they have been checked out ob- jectively by area and industry surveys.3 All that remains is to sell the package

2See "Executive Compensation: Individualized Plans," Business Management, Vol. 29, No. 4 (January 1966), pp 55-56. For another point of view, but one which also brings out the weak- nesses of "orthodox" compensation practices, see Arch Patton, "Executive Compensation by 1970," Harvard Business Review, Vol. 42, Sep- tember-October 1964, pp. 137-146.

8That this is merely the blind leading the blind will be considered an indelicate observa- tion by all right-thinking wage and salary administrators. The relativities may be right, but where is the benchmark?

to a relatively captive body of consumers. If the package is reasonably in line with area and industry practice, this task should not be too difficult. And yet, the questions remain: If it is all so objective, so reasonable, and so straightfor- ward, why is the compensation manager so heavily criticized by his constituents? Why is there constant, lurking dissatisfaction with the working of compensation programs which on the surface are competitive and equitable?

The direction in which the answer may lie is indicated when we look at the employee's attitude to the compensation package. This he regards as something to which he is entitled but over which he has no control except through the drastic, and frequently impossible, expedient of quitting his job. Thus, if the package is "right," the employer gets little or no credit. He is merely doing what is expected of him. Consequently, there is no real motivation in a standard compensation package. There are, however, many possibilities of negative motivation or dissatisfaction if the employee feels- rightly or wrongly from an objective point of view-that the compensation is not right:

(a) in absolute terms; (b) relative to the compensation of his

peer group in the firm, community, industry, and potential labor market; or

(c) relative to his expected standard of living at the moment and in the fore- seeable future.

Human nature being what it is, these problems would exist even if the compensation manager had all the attributes of God; but when he is merely under the delusion that he possesses them, an inherently difficult situation becomes an impossible one. And, as we shall see in a moment, the nature of the modern




business corporation is such that it cre- ates an environment for the compensation manager in which the temptation for him to play God is almost irresistible.

The Dilemma

Although corporate managers claim to have gotten away from the old-fash- ioned paternalism of the individual proprietor, the modern business corporation as it has evolved over the past thirty years is deeply committed to a paternalistic philosophy. It has adapted its operation so successfully to the modern Weltanschauung that it has become a private welfare state administering ever-extending programs of employee benefits: paid vacations and holidays, employer-financed retirement plans, employer-financed insurance programs of an infinite variety (e.g., death, sickness, accident, medical, dental, and salary con- tinuance), and (for some) company auto- mobiles, memberships in country clubs, subsidized vacations, and various other decorative trimmings. When a company policy is evolved, that is it. These benefits are given to the employees and they are expected to be grateful by pulling their weight and doing their bit for the company. Management feels hurt when things do not turn out to be the best in this best of all corporate worlds.

What has gone wrong? We can find the answer by taking a little deeper and broader view of the problem. Ideology in the American community, and even more in business, is still deeply influ- enced by the myth of the rugged individualist. Our inherited folklore is dominated by the hero who, alone, tri- umphs over great odds in subduing hos- tile Indians or some other "enemy."4

4We conveniently forget that on the frontier there was no place for the individualist. He

Contemporary folklore (mostly absorbed via the horse, space, and medical operas of TV) reinforces the inherited folk pattern through all ages, from childhood to retirement. This individualistic thought and emotion pattern is further consolidated by the heavy emphasis in the public schools and colleges on the conventional treatment of the natural law philosophy of the Declaration of Independence and the War of Inde- pendence in which the origins of a state are sanctified by an appeal to the in- alienable rights of individuals. In our most impressionable years, we thus have our minds and emotions worked over repeatedly to shape our personality into a socially acceptable attitude of belief in the sacredness of the individual and in the legitimacy of rebellion against arbitrary rule.

Then we go to work. We are suddenly immersed in a world in which there is no nonsense about democracy, which is structured on an hierarchical pattern, and which operates on authoritarian principles. Management is polite about it, of course. In a well-run corporation, the mailed fist is carefully covered by a well-padded and elegant velvet glove. Nevertheless, the American business corporation is organized around power, no matter how skillfully disguised. Most of us, not destined to be captains of industry, discover sooner or later that the way to a comfortable livelihood is not to rock the boat but to go along with the establishment and show sparks of originality from time to time which are free from those "dangerous thoughts" that would result in drastic change. This is not to deny the existence and the enormous importance of the occasional

would have been scalped, devoured by wild beasts, or would have starved to death.




maverick of genius who transforms the way of life of an entire segment of business. But most of us, alas, are not men of such innovating strength. For us, conformity to the mass mind of orthodox competency is the guaranteed pathway to the fashionable suburb; the country club; the second (or third) automobile; the second home by the lake, the sea- shore, or in the mountains. Conformity gains the approbation of our superiors, who have largesse to dispense, and our peers, who let us know that we are "reg- ular guys" fit to be admitted to the "in" group through which comes all advance- ment. We've got it made.

Or have we? The sharp contrast between a bred-in-the-bone ideology and the actualities of business organization inevitably breeds conflict. The socially acceptable channels through which it may be externalized and mitigated, if not resolved, are limited. We cannot rebel against the corporation; we cannot rebel against our boss; but it is permis- sible to complain about salary, within reason, or about the inadequacy or the inconvenience of the benefits program. The wage and salary administrator or the employee benefits manager thus becomes a lightning rod for the grounding of storms which he has not originated. The basic clash is between the employee, indoctrinated with an individualistic ideology, and the benevolence of a paternalistic power which regulates the most vital facet of his life: his ability to provide a livelihood for himself and his family. The wage and salary administrator who simply follows traditional patterns and uses accepted techniques simply cannot win. He is the innocent bystander who is a convenient receptacle for the brickbats thrown by the two

sides. He is intimately involved in a quarrel which is none of his making.

But what if the traditional technique were revolutionized by giving the individual employee the freedom within certain broad constraints to make up his own compensation package tailored to his own needs and desires? Could it be that it is the uniformity and the uni- laterally determined nature of the compensation package, rather than its value, which is a major cause of discontent? The company store has been abolished in other areas. Why should it be re- tained in compensation? Why should we tell an employee he must spend X percent of his total compensation on certain purchases which, with our superior wisdom, we have decided are best for him and which, in our opinion, will maxi- mize his satisfaction? We insult his in- telligence, interfere with his freedom of choice in spending his total compensation, and expect him to be positively mo- tivated as a result. Then we feel hurt when he fails to show that gratitude which we think appropriate.

Clearly, we ought not be surprised that compensation as traditionally handled turns out to be more of a dissatisfier than a motivator. If we really believe in the importance of individual preferences and in the value of a free market in solving most effectively the economic problems of society, and if people are inculcated with these beliefs, we must expect trouble if part of an employee's income is arbitrarily cut out and he is told that management shall decide how he spends this part of his income. He is simply being denied in practice the principle of individual freedom on which our civilization is based. M\Ioreover, it is being denied over a not inconsiderable part of his total compen-




sation. Employee benefits can no longer be accurately described as fringe benefits, but constitute a very substantial part of total compensation-perhaps 30 percent or more. Before we examine how to make the total compensation package compatible with the basic philosophy of maximizing individual freedom, let us examine the quantitative aspects of non-freedom involved in employee benefit programs or "hidden compensation."

Hidden Compensation

We are all familiar with the "standard package" of employee benefits: paid vacations; paid holidays; employer-financed (in whole or in part) retirement income; employer-financed (in whole or in part) medical insurance; and employer-financed (in whole or in part) life, supple- mental accidental death or disablement, long-term disability insurance.

To these may be added such frills as paid time off for special reasons; paid leaves of absence for professional ad- vancement or research; tuition refund benefits; use of company cars; paid attendance at business or professional meetings; paid country club, chamber

of commerce, and professional society memberships; company scholarships for an employee's children; travel privileges; purchase of company products at dis- count; and so on. There is great variety in the provision of the more exotic fringes.

Taken together, the value of these benefits makes up a very substantial part of total compensation. How important they are is difficult to say because of the great variations in company practices and because for many of them their value to the employee is greater than their cost to the company. This discrepancy arises because in purchasing insurance, for example, the employer's cost reflects the benefits of bulk buying while the employee does not pay income tax on the benefit. If he bought the equivalent for himself, first, it would cost him more because he would be buying at retail; and in addition, he would have to pay income tax on the income used to buy it. The employee thus gets a double break.

While we cannot draw up a universal example, it is not too difficult to set out a hypothetical example as in the follow- ing table.

Table. Value of "Hidden Compensation."

Employee Age and Income

Age 30 Age 40 $5,000 $10,000

A. Paid time off Vacation cost ....................................................... $ 200.00 $ 600.00 Employee contribution ............................................... -0- -0-

7r2? days, holidays . ................................................... 150.00 300.00 Employee contribution ............................................... -0- -0-

Other days off .. .................................................... 5 0.00 120.00 Em ployee contribution.-0- -0-...............................................

Subtotal A ...... $ 400.00 $1,020.00




Table (cont.).

Employee Age and Income

Age 30 Age 40 $5,000 $10,000

B. Group insurance coverage Life

Amount varies with earnings-total cost ..... $ 103.86 $ 249.30 Employee contribution ......................... 25.20 100.80

Accidental death & dismemberment Amount varies with earnings-total cost ............. .. ..... 6.25 12.50 Employee contribution ....................... ...................... .60 3.60

Weekly accident & sickness 1st day accident, 8th day sickness, 25 weeks Assume $60 weekly benefit-total cost ...... .......................... 77.40 103.20 Employee contribution ............................................. -0- -0-

Family hospital-surgical Total cost ............................... 240.00 240.00 Employee contribution (average) .................. .................. 72.00 72.00

Family "major medical" Total cost ........................................................ 126.24 147.35 Employee contribution ............................................. -0- -0-

Salary continuation insurance 60% of 1st $600 monthly salary plus 40% of excess, lifetime accident,

age 65 sickness-total cost ....................... 121.25 305.50 Employee contribution ...................... ....................... 32.50 65.00

Business travel accidental death $15,000 benefit-total cost .......................................... 15.00 15.00 Employee contribution ............................................. -0- -0-

Voluntary accidental death Optional from $10,000 to $100,000 (assume $10,000 and $20,000 this

illustration)-total cost ........................................... 12.50 25.00 Employee contribution ............................................. 8.40 16.80

Retirement income $27 per year of service plus 1.2% of final average salary in excess of

$4,500-total cost ................................................ 250.00 850.00 Employee contribution ............................................. -0- -0-

Social security Cost differential-self-employment tax .................. 97.40 128.70

Subtotal B .............. ....................................... $ 911.20 $1,818.65

C. Other benefits Country club membership ........... ................................. -0- 350.00 Employee contribution ............................................... -0- 200.00

Chamber of commerce membership . ............................. 75.00 75.00 Employee contribution . .............................................. 32.50 -0-

Attendance at professional meetings .................................... 115.00 400.00 Employee contribution ............................................... -0- -0-

Subtotal C ....... S 157.50 $ 625.00

Total A, B, and C ............................................... $1,468.70 $3,463.65




Thus, for the $5,000-a-year man, hidden compensation represents a tax-free addition of 29.38 percent to nominal compensation; for the $10,000-a-year man, the corresponding figure is 34.64 percent. And, as we have noted, this understates the true pecuniary equivalent because, first, the company can buy many of these items at bulk rates while the employee would have to buy at retail and pay more (even if he could buy the item at all, which is improbable with some of the group insurance benefits). Second, there is the tax saving as- pect. At a tax rate of 15 percent, the $5,000-a-year man would need to earn an additional $1,689 to buy the package, even at bulk prices, or a 33.78 percent addition to his nominal salary. At a 25 percent tax rate, the corresponding figure for the $10,000-a-year man would be $4,329.57 or a 43.30 percent addition to his salary.

These are very substantial amounts. It is perfectly natural that personnel managers should expect employees to show gratitude, loyalty, enthusiasm, and a positive attitude towards their work in return for such largesse. Yet, in spite of the "hard sell" of many corporate communications programs devoted to employee benefits, we still find the compensation package taken for granted at best; while not infrequently it becomes a source of irritation and a focus of discontent. Personnel men are puzzled, hurt, and indignant at employee ingrati- tude.

But now we can begin to see why employees do not react as expected to lavish benefits packages. In the two examples above we are saying, in effect, to the first man: "Your value to us is $6,689 a year, but we are going to pay you only $5,000 in cash and give you a carefully

devised benefits package which we have decided is best for you and which is equivalent to an additional pre-tax income of $1,689." To the other man, we say the same thing, in effect, except that the figures are $14,329.57-$10,000 in cash and $4,329.57 in kind. "You are competent enough to work for us, but you are not competent enough to organize your private life to be trusted with your full earnings." So, for the lower-paid man, we spend 25 percent of his total earnings on his behalf, leaving 75 percent to be spent according to his own wishes; for the higher-paid man, we decide that although he is more valuable to the company, he is even less competent in organizing his private life, so we spend 30 percent of his total compensation on his behalf, leaving him with only 70 percent to be spent at his own discretion.5 And we have moved away from paternalism? The truck system of wage payment is illegal?

Let us spell out again the "message" we put across by our deeds rather than by our words, and we know which of these alternatives speaks the more loud- ly. We are saying, "You, John Doe, are incompetent, in our opinion, to be trusted with spending 25 percent of the total earnings to which you are entitled because of your competent performance in discharging your responsibilities to the corporation; and you, Richard Roe, cannot be trusted to spend 30 percent of your total earnings. Therefore we, with our superior knowledge and greater wisdom, will spend these amounts on your behalf." We are giving this brutally frank message to men caught in a conflict between those principles of the

Paradoxically, because of the bite of a pro- gressive tax rate, the more valuable we consider a man to be, the more we derogate from his freedom to spend his total compensation.




sacredness of individual liberty, which were inculcated in them from their in- fancy, and the actualities of the business corporation as a system of power. The potentiality of alienation is already strong; in the traditional compensation program, it is merely invited to become actual.

If things must work out this way, the outlook for the future of wage and salary administration is indeed bleak. Discon- tent and friction are inevitable. The more sophisticated the programs and policies, the more ingenious and ambi- tious the wage and salary administrator and the employee benefits manager, the more likely the discontents are to grow in proportion as employee benefits programs become more elaborate; for, as they proliferate, they automatically reduce the area of freedom which remains to the employee in spending his total compensation. We seem locked in an impossible situation. But are we? What would happen if we were to take se- riously the philosophy of individual choice in a free market and apply it to the compensation problem?

The Market Principle in Compensation

In conformity with free market principles, ideally the employee should be given the choice of receiving his entire total compensation in cash, subject to withholding income taxes, and allowed to buy as much or as little in the way of benefits as he may wish. We cannot go this far, however, if only because the government insists that firms buy collectively OASI and Medicare benefits. There are also other benefits which as a practical matter must be mandated at a minimum level, such as a minimum vacation (for health reasons); statutory holidays; and a minimum amount of life,

accident, and health insurance (to obtain the benefits of bulk purchase). In principle, however, it ought not be too difficult to work out a minimum benefits package. At the other extreme, it will not be practicable to allow the employee to take his entire compensation as benefits. He needs to be paid at least enough monetary compensation to quali- fy him under OASI and Medicare. Imagine the glassy-eyed stare of disbelief of an Internal Revenue Service auditor if he were to come upon an executive vice-president receiving, say, $6,600 in salary and yet having "fringe" benefits valued at $50,000.

Within the very wide limits set by the constraints just mentioned, we can work out in principle a solution to our problem by introducing the freedom of choice of the free market into our total compensation program. We can also demonstrate unambiguously that any mandated benefits program, no matter how good within the financially possible limits and no matter where we set those limits, will inevitably fail to optimize the satisfaction of any employee except by accident, and that unless we make the utterly unrealistic assumption that all employees have identical preferences in their desired mix of cash and benefits, any mandated plan will dissatisfy more employees than it will satisfy.

Let us consider Chart 1: OM = ON total compensation; cash payments are plotted on the vertical axis; and the value of benefits is plotted on the hori- zontal axis.

If there were no legal constraints, financially it would be a matter of indifference to the firm whether the employee received OM (all cash and no benefits) or ON (all benefits and no cash) or any combination of cash and benefits deter-




Chart 1. Optimizing the Cash/Benefits "Mix."

50 M

S -A\,\ 40

30

Cash 20

10

0 F H K. R

10 20 30 40 50

Benefits

mined by a point on the MN line, since the sum of the segments of OM and ON cut off by the intercepts from a point on MN will always equal OM which equals ON. MN thus gives us the "total compensation frontier." The firm will not be willing to pay for this job a total of cash plus benefits repre- sented by a point to the right of MN. The employee will be acting irration- ally if he accepts a combination repre- sented by a point to the left of MN. Thus a mutually satisfactory bargain will be indicated by some point on MN.

The constraint of a legal minimum of benefits (or cash payments) can be introduced quite simply. NR represents

the minimum benefits package; SM = RN. Therefore the maximum cash payment is OM - SM = OS. (This could have been worked the opposite way by starting with a minimum cash payout and getting the maximum benefits payout.)

The effect is to reduce the operational part of MN to PQ. Thus, PQ gives us the limits within which the mix of cash and benefits can be varied. MP and QN become irrelevant. It is a matter of financial indifference to the firm which point on PQ the employee chooses, as the cost to the firm is the same for any point.

It is not a matter of indifference to the employee, however. We can easily




show that there is only one point on PQ which will satisfy an employee. Each person has his own valuation of the relative worth to him of cash as against benefits. A simple indifference curve can be drawn on which any point shows the same total satisfaction derived from al- ternative "bundles" of cash plus benefits. For reasons well known to those who have been exposed to a course in introductory economics, these curves will be convex to the origin and slope downward from left to right.6

Curves I, Ia, and lb represent the preference map of an employee who is biased in favor of cash rather than benefits. Like all of us, he would prefer more of both if it were possible, so progress in the sense of greater total satisfaction is indicated by a movement from the southwest to the northeast of the diagram. Curve lb would be preferred by him, but it is beyond the "total compensation frontier" (any point on it will result in a combination of cash and benefits which will total more than OM or ON), hence this curve is not a possible one at the total compensation level given. Curve Ia is an irrational choice, because any point on the segment of Ia bounded by PQ will give a lesser value than OP or OQ except one point and that is an unstable position.7 There is

5This is the principle of diminishing mar- ginal substitution. As units of commodity X in exchange for commodity Y are given up, the subjective value of the remaining stock of X increases at the margin while the subjective value of additional units of Y falls at the margin. Hence, the rate of exchange of X for Y changes with each move in the direction of requiring more units of Y to compensate for the loss of one additional unit of X as X is continued to be exchanged for Y. Thus the curve slopes downward to the right and also flattens.

7The point, marked U, is where Ia cuts MN. At this point the value of the "bundle" equals OM (or ON). But by moving upwards along

always, however, one indifference curve which just touches MN. Curve I is such a curve and point A is the point of tangency of MN to the curve. This is the only possible optimum solution. Given a total compensation equal to OM (ON), it is within the segment PQ of MN-so the firm is satisfied-and it is the highest indifference curve which can be attained by the employee, thus it is the most satisfying mix of cash and benefits he can obtain at this total compensation level. Any combination of cash and benefits other than OE (cash) and OF (benefits) will give him less total satisfaction.

The same line of argument can be employed for curve II, which represents the preference map of an employee who balances cash and benefits evenly. His optimum position is given by B, and his preferred mix is OG (cash) and OH (benefits).8

Curve III represents the preference map of an employee who is biased in favor of benefits rather than cash. His optimum position is given by C, and his preferred mix is given by OJ (cash) and OK (benefits).9

MN, the employee can put himself on the higher indifference curve (I). The one other unstable equilibrium point is ruled out in this example because of the constraint of RN (SP) minimum benefits. With this constraint, la becomes in fact vertical at T so its extension as drawn (though representing the employee's preferences) does not represent a practicable possi- bility. If it were possible, it would, by analogous reasoning, be as unstable as U. Movement down MN would then bring the employee to the higher indifference curve (I).

8For the sake of keeping the diagram simple, we have not drawn curves corresponding to Ia and lb for these employees. It would simply repeat the explanation already given as to why the point of tangency of an indifference curve with MN is the only possible optimum solution for that employee.

9"bid.




We have thus demonstrated three propositions. Within the boundary limit set by any given value for total compensation,

(a) there is for each employee a unique optimum solution to the problem of his preferred mix of cash and benefits;

(b) this solution is different for different employees, depending on the position and shape of their indifference curves;10 and

(c) any other mix will give an employee less total satisfaction.

It is clearly improbable that any mandated program will give this optimum solution; and if it should by chance give the perfect solution for one employee,"- it will be "wrong" for the oth- ers. It could only be "right" for all employees on the assumption that all employees had identical preference sched- ules-which is absurd.

It follows that the problem of providing a satisfactory compensation package can be solved only by giving an employee a market choice so that he can get his preferred mix of cash and benefits.

Within the benefits package, the same type of problem exists. It is solvable by the same technique. Value of vacation could be put on one axis and increased health benefits on the other and so on for any pair of benefits. The process would be tedious, depending on the number of comparisons, but the principle remains unchanged.12

"This will depend on tastes, family circumstances, age, and so on, which are given data.

"uWe have spoken in terms of individuals. If this is thought to be too unrealistic, Indif- ference Curve I, II, III, and so on, can be thought of as representing groups of employees in roughly comparable circumstances, e.g., those starting their career, those some way along, and those close to retirement.

"It is not suggested, of course, that the employee go through all these geometrical ma-

The basic answer is also unchanged: to obtain optimum satisfaction, the employee must be allowed to choose his pattern of benefits within the benefits package. A move must be made from a mandated split of total compensation and from a mandated benefits package to a system in which the employee can freely choose (a) how much of his total compensation he wants to take in cash and how much in benefits, and (b) what commodities he wants in his benefit package. In this way freedom of choice is restored to the individual to spend his income in the way he thinks best, thus removing a major source of conflict.'3

The Total Compensation Supermarket

To translate the abstract analysis into a practical operational plan, a "total compensation supermarket" can be cre- ated and the total monetary value of a position to the company determined.'4 The employee is then given "credit" for that amount, less the value of the minimum benefits package, to be spent in the "supermarket." As wide a choice as possible is offered to him: cash, deferred compensation, extended vacation, company automobile, insurance of every conceivable variety, tuition benefits, so-

nipulations to find his preferred position. Our model represents the pure logic of the situation, assuming perfect knowledge, perfectly rational behavior, and no frictions or imperfections. The validity of such models as an aid to clear thinking is well recognized. The problem of applica- bility is a separate issue taken up later in this article.

'3There still remains the other crucial problem of how to determine the value of total compensation for each job, but that is a separate problem. The value of total compensation is taken as the datum here.

"-As noted in the preceding footnote, this is essentially a separate problem from the one considered in this article.




cial and club memberships, and so on.15 It is not the purpose at this point to

spell out the detailed stock of the supermarket from which the employee can choose. There is almost no limit to the variety which can be provided by an imaginative compensation/benefits manager. He can be given some idea, however, of how heavy his inventory should be in certain categories. Its pattern will depend largely on the age of employees, the number of their dependents, and their position on the growth curve of their career with the company-all matters known from their personal rec- ords without any invasion of their pri- vacy. This point can be understood better if we look at the relation between income and needs.

Man's needs are physical and psycho- logical. For our purposes, the physical needs can be ignored, as the in- comes of the people being considered are more than adequate to provide for essential physical needs, i.e., food, shelter, clothing, etc.'6 Any needs above the physical subsistence level are psychologi- cal and will give rise to an individual preference scale, the result of the individual's ordering in terms of subjective valuation of the commodities available. In constructing his preference scale he will be partly inner directed, partly other directed. One set of drives will come from self-esteem and will be mani- fest by a desire for those items which are prestigious, such as a luxury office,

15The need for extending the range and im- proving the quality of the items in the supermarket will present a new challenge to the ingenuity of the compensation manager and the employee benefits manager.

"6It is only when we get close to the conventional "poverty" level that physical needs would have to be considered, and this article is not directed to the compensation problems of low paid workers.

membership in an exclusive club, a de- luxe automobile, and so on. Another set of drives will come from concern to provide adequately for his family, both in the present and in the future, and will be shown by a desire for an income to support his family in that style of hous- ing, clothing, entertainment, and recre- ation which the consensus of his peer group decides as appropriate for his position in the corporation, plus provision for retirement income and adequate insurance protection against death, crip- pling accidents, disease, or similar dis- aster. The precise mix of the commodities which satisfy these drives vary from man to man and result in his cash income/benefits indifference curve. We need not pry into the reasons for his indifference curve; they are strictly his own concern. We accept his revealed preference as a datum.

It must be noted, however, that the same individual's indifference curve will change its shape and position over time. Insofar as the individual expects a stead- ily rising standard of living in proportion to his years in the corporation's service, his curve will maintain the same shape but will move in a southwest to northeast direction. Insofar as he grows in value to the corporation, the compensation frontier will also move to the right. If his expectations are matched by his growth in value, there will be no problem in keeping him happy. His total compensation will move along path A-B on Chart 2 and he and the corporation both will be satisfied. If there is a discrepancy in the two growth rates, however, so that he is at C and thinks he should be at D, there will be trouble. If he is at D and would have been satisfied to be at C, he is being overcompen- sated and the company is wasting its




Chart 2. Choice under Fixed and Variable Cash/Benefits Ratio.

Total Compensation Frontier

Cash/Benefits Indifference Curve

//B F

B~~~~~~~~~~B

C

A B' Cash

A/

CU A"

Benefits

dollars. The supermarket technique will not solve this problem of adequacy or appropriateness of total compensation.

As our hypothetical employee grows in value to the corporation, he will also, however, change his desired mix of cash and benefits. The compensation supermarket technique will solve this problem as can easily be seen from Chart 2. If the company has a fixed package of cash/benefits compensation, the employee can move only along A-B, and the company is in trouble. If his preferred mix changes, however, and the company has the flexibility given by the compensation supermarket concept, his changing tastes or needs can easily be accommodated. In principle, an infinite

number of choices could be made available to him. To simplify the exposition, a very simple but realistic model has been set up in Chart 2.

The parallel lines sloping from left to right represent the total compensation frontier at various levels of total compensation. The three contract curves, A-B, A'-B', and A"-B", trace out paths of mutual satisfaction between employer and employee. A-B is a situation where most of total compensation is taken in cash, A"-B" is where most of total compensation is taken in benefits, and A'-B' is an intermediate mix.'7 A-B

""In principle, there is an infinite number of contract curves between AB and A" B"; only one has been drawn.




is a fairly realistic split between cash income and benefits income as repre- sented by a normal, "enlightened" firm.'8 In this situation, the only possible path of total compensation is along A-B. The firm is assuming that the same mix of cash/benefits remains desired by the employee throughout his working life. If this assumption is not true, then no matter how enlightened its compensation and benefits policies and programs are, it will be in trouble. The employee offered D may prefer to be at D' or D" and so on. If the compensation mix can be varied so that he is at his preferred point on a given compensation frontier, he will be made as happy as possible at that level of total compensation. He now has a choice of mix given by a point on a compensation frontier within the limits of C C" F" F.

His freedom of choice in spending his total compensation income is now restored, and he can vary the mix of cash income and benefits income as his felt needs vary with age, temperament, health, family circumstances, and so on.

Some Practical Difficulties There are clearly many practical dif-

ficulties in implementing the total compensation concept. We have already noted the constraints imposed by the legal requirements of a minimum salary for OASI and Medicare qualification and by the necessity for having "all in" or "none" presented by certain types of insurance. The rates at which group insurance can be purchased are also affected by the number, age, and sex composition of the group. The interest of the major- ity in obtaining low-cost insurance must be balanced against the benefit of free-

"8Such a firm might have the benefits program as set out in the table.

dom of choice for the individual. A com- promise will be necessary and an individual will probably have to take a minimum amount of insurance and stick with it.

Less obvious but equally serious problems are the tax and communications aspects of such a policy. The various choices of a cash/benefits mix at the same level of total compensation have very different tax implications for the employee. Careful, detailed counseling on the tax aspects of his choice will have to be provided the employee. This will mean close liaison between the corporate personnel department and the corporate tax department, which may not be easy to achieve. From the tax department's point of view, the task is merely another peripheral chore loaded on an already overburdened staff.'9 From the personnel department's point of view, the provision of sound, comprehensive, and timely tax advice to the employee is of vital importance to the successful operation of the program. In this connection, we must also recognize a hidden danger: the possi- bility of legal action against the company by an employee or his estate for damages resulting from faulty counseling, real or alleged. In costing out the program, something for this contingency must be allowed.

The program will also result in a difficult general communications problem. First, the whole idea is so novel that an intensive sales or educational campaign will be needed to launch it. This difficulty, however, will probably not be too great if the program is first introduced for a limited number of top echelon executives and then allowed to trickle down. In fact, some motivational bonus

:9Ex hypothesis all tax departments are over- worked. It is sometimes true.




could probably be gained during the introductory period from the prestige of belonging to the "free choice" group. Second, there is, however, the problem of making sure that each individual employee fully understands the choices before him and all their implications. This problem will be particularly acute with younger executives who have a tendency to underestimate their future requirements for health and retirement benefits.

One difficulty which has been suggested is that of correctly pricing the job for the company when the total price is made up of such a variety of substi- tutable components. This is not a serious difficulty. It is analogous to pricing out the benefit components in a union contract. A price is put on each individual component, and there are X number of dollars to spend (total compensation for the job). Any style edifice can be built, provided X dollars are not exceeded, which is an extremely tedious chore but not difficult.20

The simple pricing difficulty mentioned above does, however, point to a much more difficult and subtle pricing problem: getting an agreed fair price for the job between employer and employee. Under the present conventional system, there may be differences of opinion but both sides know what they are talking about and are speaking the same language. They may argue whether the job is worth $10,000 a year or $10,500 a year, with the standard package of fringe benefits being understood. A clean-cut quantitative comparison is being made. With the total compensation technique, this comparison still has to be made;

'OThis would seem to be a place where an EDP program could be of tremendous help. An enormous number of simple computations would need to be made-a task easily handled by EDP.

but, in addition, an agreement has to be secured on the correct dollar equiv- alencies of an infinite number of com- binations of cash and benefits. The clos- er we come in actuality to the theoretical maximum of choice, the more difficult this problem will be. It is inherent in one of the basic advantages of the technique, i.e., the cost to the employer of the benefits package is less than its market value to the employee. If we were merely thinking of the wholesale/retail price differential, which is one reason for the saving, there would be no great difficulty. The really tricky problem is that benefits bought for the employee by the employer are bought with pre-tax dollars, while benefits bought by the employee for the employee are bought with after- tax dollars. Moreover, the less of his total compensation he takes in benefits, the greater the tax bite, not only abso- lutely but relatively. May not this give rise to complaints by the employee who favors more cash and less benefits that he is being asked to trade a benefit worth $X plus $Xt for $X in cash? The problem of working out the true cash equivalency in salary dollars of each item in the benefits package can rapidly become extremely intricate as the cash equivalency of each item will vary with the pattern into which it is fitted; and in principle, there are as many patterns as there are number of employees. The value of each package is made up of the sum of the values of the parts, but the value of the same part will vary from package to package.2' This is a problem which could be worked out by

21The problem will be recognized by econo- mists as analogous to the aggregation problem in computing national income under varying assumptions of the distribution of personal in- comes. If there are significant variations, the aggregates are not strictly comparable even in a statistical sense.




EDP programming to devise a workable program which, while not a perfect solution, would be good enough to use. This problem of adjusting for the different tax burden on two individuals receiving the same total compensation but choos- ing different cash/benefits packages seems the most difficult one in the practical application of the total compensation concept.

Another cause of difficulty may arise from the fact that employer reasons for providing a benefit do not necessarily appeal to employees; indeed, they may be distasteful to employees. The vesting period for a pension plan, for example, aims at holding down turnover rates; to the employee, however, it is a limita- tion on his freedom to take advantage of changes in the supply and demand conditions of a competitive labor market. Present practices in regard to standard packages of employee benefits increase the degree of imperfection in a very imperfect market. The initial use of the total-compensation concept by a small number of firms would give those firms a recruiting advantage. If the idea gains general acceptance, however, firms would no longer be able to make as much use of the differences in their benefits package as recruiting bait. Compe- tition for high-level employees would tend to become straight price competi- tion, which would be good for employees. It is not quite so clear that it would be equally good for all employers. As things are, a recruiter can "fuzz the edges" of what is being offered and can get away with it most of the time, with most applicants. With the total- compensation technique, this will be much more difficult to get away with; i.e., the total price will be X dollars; how this is divided will be for the em-

ployee to decide. With possible job of- fers on the basis of a straight dollar comparison, the job applicant will find a rational choice easier to make. This is good-for the applicant. But might it not give to the financially strong firms an even bigger recruiting advantage than they already possess?

The Compensation Manager's Job

Some obvious results of applying the total-compensation concept will be to make the compensation manager's job more complicated, change his orienta- tion, require more liaison with the corporate tax department and with the EDP group, and necessitate organiza- tional changes in the personnel department. These changes will make his job more interesting and more important. The compensation manager will become less of a technician and more of a plan- ner and counselor.

With the total-compensation program, one man must be in charge of salary and employee benefits-a manager of compensation and benefits planning. He will need an ample staff of compensation and benefits technicians to price out the individual packages and adminis- ter the individual plans. In this connection, it is extremely important that the payroll department be given prompt, comprehensive, and unambiguous instruc- tions. Basically, the manager of compensation and benefits planning must be re- lieved of all routine work or he will not have the time needed to think about the contents of the packages, merchandise the idea, and counsel with employees. Ca- pacity for fundamental brainwork and skill in human relations become crucial qualifications for successful performance of his job. He must be able to




(a) price each job in competitive terms and in value to the corporation;

(b) conduct continuous investigation into available or potential benefits to extend the variety and enhance the at- tractiveness of the benefits offered;22

(c) understand the total compensation philosophy so well in terms of economics and motivation that he can present it convincingly to top management, super- visors, and affected employees;

(d) counsel employees on the full implications of the cash/benefits split of their total compensation for the future as well as for the present (The time dimension of income takes on an added significance under the total-compensation plan. The employee must plan the mix of his total compensation over his employable lifetime and review and, if necessary, revise the mix on an annual basis. This annual review of his financial health should become as routine and as valuable to him as the annual checkup of his physical health. The compensation manager must provide an adequate counseling service or much of the benefit of the plan may be lost.); and

(e) organize a staff adequate in size and quality to do all the things now done by a competent wage and salary and employee benefits department plus the additional research, computation, and counseling demanded by the total compensation technique.

It cannot be stressed too much that the successful adoption of the total compensation technique will depend on the transformation of the compensation manager's job into one much more complex and demanding.

22Like the good manager of a supermarket, he must keep his shelves better stocked than those of his competitors.

Summary and Conclusions

Conventional wage and salary and benefits administration has reached the end of the road. It is a major source of dissatisfaction, disincentive, and friction between employer and employee. Even with the most competent administrators, this is true because conventional programs in these areas are vitiated by an inherent conceptual flaw: they accentuate the conflict between the individual employee's frame of reference and the employer's frame of reference. This conflict is not superficial but is deeply rooted in the clash of two contradictory value systems-one individualistic, the other authoritarian. The solution is to base the compensation system on the same principle of freedom of choice in dis- posing of one's income among a variety of market possibilities as is postulated in the basic model of the free market.

It can be logically demonstrated that there is only one point on a cash/benefits indifference curve which will satisfy an employee within the limits of the employer's total-compensation frontier. A workable technique can be devised to translate this analysis into operational terms. This technique implies a redefini- tion of the compensation manager's job and a restructuring of the relevant parts of the personnel department. The compensation manager must become a plan- ner, coordinator, and counselor rather than remain a technician.

That the transformation from a "standard-benefits" policy to an individu- ally tailored policy based on the employee's unique needs and wishes and implying a variable cash component will be difficult is no reason for not moving. Conventional policies cannot solve the basic problem, they accentuate it; and it is imperative that a solution be found.



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Toad or Butterfly?: A Constructive Critique of Executive Compensation Practices

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