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COMMUNITY UPDATE

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It seems that not a day goes by when the pay of the business world’s leaders isn’t being questioned in the media. Indeed, largely due to the economic downturn, we are living in a time of unprecedented scrutiny of executive remuneration with stories of incentive schemes that encourage undue risk-taking and of 'disgraced' executives receiving vast ‘rewards for failure’ encouraging a swathe of regulatory reviews and heightened levels of shareholder activism.
 
All this leaves the Remuneration Committee with one of the hardest jobs on the board.
 
Furthermore, this scrutiny is likely to continue as the inflation rate is expected to out pace the average wage increase, significantly impacting the standard of living of the average person. FTSE 100 bosses now earn 88 times the median wage, compared to 47 times 10 years ago. In 2010, rewards at top companies increased by 55 per cent to an average of £4.5 million.
 
Those on the ‘Remco’ are thus challenged to deal with executives that have become accustomed to large rewards and, consequently, must balance two factors – attracting (and retaining) the right talent whilst also motivating them to deliver shareholder value. As one Criticaleye Associate recently pointed out to me, “becoming a non-executive is great, just don’t join the Remuneration Committee!”
 
Rob Burdett, Principal at Hewitt New Bridge Street says, “To many, this criticism and heightened activism has come as something of a shock as, before the recession, a degree of consensus appeared to have emerged regarding how best to structure an executive’s pay. While there was some disquiet that levels of total remuneration were increasing, comfort was taken from the fact that this was mainly through higher potential bonus and/or larger long-term incentive awards. Pay was becoming more performance-related.”
 
However, due to the current environment, Remuneration Committees have much to contend with when framing their executive remuneration policies. There has been an increase in executive reward regulation, with the FSA being the key player. “While the FSA's Remuneration Code only purports to have direct applicability to financial services companies, some of the Code's recommendations are likely to be embraced more widely.  A key theme of the FSA - and other commentators - is the issue of ‘risk’, with companies across all sectors now encouraged to disclose how it is reflected in their pay practices,” says Rob.
  • As a result of the FSA regulations, many companies have felt the need to conduct a formal ‘risk audit’ of their remuneration policies. These ‘stress tests’ need to ensure:
  • There is a sensible balance between fixed and performance-linked pay (ie, packages are not over-geared, thereby encouraging risky decision-making)
  • The performance-related elements of pay do not encourage 'short-termism' by a heavy weighting on annual bonus
  • The targets themselves are (where possible) risk-adjusted and appropriate input is sought from the Audit Committee on these targets. 
     
There is appropriate means of redress if there is an overpayment of bonus
 
Furthermore, changes to the Companies Act now require Remuneration Committees to explain how they have taken broader all-employee pay and conditions when setting executives’ remuneration. “The issue of the relationship between the pay of directors and the workforce has begun to attract greater prominence. Unfortunately, the problem with disclosing information on the relationship between executive and workforce pay levels is that it is very difficult to make robust comparisons between sectors, and even harder to apply a 'one-size fits all' judgement as to what constitutes an appropriate relationship between, say, the CEO's package and average employee pay. This is because the relationship of course varies enormously between sectors,” says Rob. These discrepancies are driven by the different skill requirements needed by individuals in varying sectors.
 
“The major challenge facing Remcos is the link between pay and performance. While general consensus has been reached in recent years on the principles governing best practice in structuring executive pay - mainly the link between pay and performance - putting this into practice has remained elusive. The common mantra is superior pay for superior performance but, more often than not, superior pay is being received for rather average performance. It is rarely the other way around. In some instances, very generous payments are made for exceedingly poor performance,” says Joe Darby, Non-executive Director, Premier Oil plc.
 
Joe suggests that there are many reasons for this:
 
  • Bonus targets are not tough enough. There was once a time when bonuses were only paid for performance better than the base budget and plan or for achieving some significant strategic goal. Now it is more common for half or more of the maximum bonus to be paid for achieving the base budget and plan. This means that bonuses have essentially become part of base salary.
     
  • The rate at which overall levels of remuneration are increasing. A reason for this is companies' desire to remain competitive in their sectors and enable them to 'hire, retain and incentivise' their executives. This has resulted in the ratcheting up of executive remuneration packages to levels that are now probably too high. Perhaps the competitive element should be de-emphasised and the objective of 'ensuring that pay is fair and reasonable and related to value-added with proper reflection of risk' be given much more prominence.
     
  •  The use of relative measures in share schemes which often allows awards to be made where performance relative to a comparator group is above the median, but where absolute performance has been poor and, in some cases, value eroded. In this regard, the award of performance shares as opposed to conventional share options aggravates the problem. One way around this is to impose additional conditions relating to absolute performance.
     
  • Inappropriate executive employee contracts with terms providing for over generous payments where such contracts may be terminated early, even for very poor performance leading to take-over, government bail-out or major refinancing. Contracts must be tightened to prevent payments in such circumstances or to provide Remuneration Committees with the right to exercise restraint.
“Regardless of whether the economy is in a downturn or not, the challenge for Remuneration Committees remains the same: how to reward executives for meaningful performance in the delivery of their company’s strategy.  In response to increased scrutiny and the reputational damage associated with ill-conceived incentive schemes, this means re-considering what it is that executives are being incentivised to do, and a good starting point would be to establish the nature of the value that achievement of the company’s strategy will create, how that is to be measured and how progress to deliver it can be evaluated,” says Jeremy Small, Group Company Secretary, AXA UK plc.
 
The spotlight on executive rewards has brought a number of undesirable consequences. Ruth Cairnie, Non-executive Director, Keller Group plc & Vice President Commercial Fuels, Shell says: “First, pay has become over-stated as the single transparent way to recognise senior executives. It is much more difficult to articulate and measure all the other ways of valuing, and adding value for, executives. Thus, pay risks becoming an obsession – at the top end it is very doubtful that money itself is a motivator but the implied recognition definitely is.
 
“Second, the intense scrutiny has led to schemes built on whatever objective, auditable measures of performance are available, leading to the emphasis on short-term financial performance. Longer-term schemes, deferrals, etc, are good ways to protect longer-term vs short-term profit, but there is the risk of too much convergence and the approach being too linear. As well as financial indicators, performance should include progress on key strategic objectives, culture change or whatever the most critical issues for the long-term health of the specific company are. Each will be different.”
 
Rewards
 
Remuneration Committees are looking at how to measure and reward performance. Companies are now challenging the approach of traditional long-term incentive plans (regular annual awards made that vest three years after grant, subject to EPS and/or relative TSR targets) and looking at more innovative approaches. Key to this is the creation of an incentive structure that will lead to sustainable performance that is realistic in the longer-term.
 
 “The use of private equity style 'value creation' plans is being considered by some companies, where a larger 'one-off' award is made with an absolute target set (perhaps based on share price, profit or some other metric). Once this absolute target is achieved, executives can share in any out performance - possibly on an uncapped basis - with rewards delivered in either cash or shares,” says Rob.
 
Rewards need to take into account a company’s circumstances. If they do not, the pay policy will not resonate with executives and, in turn, will neither drive nor reward the right behaviours.
 
 “It is incumbent on the members of Remuneration Committees to use their judgement to decide what will incentivise their executives to deliver the strategic ambitions set by the board.  This means tailoring schemes to their specific circumstances and taking much less notice than has been the case previously of the arrangements that other companies have.  I hope that we see real and sustained innovation in the creation of performance targets that are truly tailored to reward outperformance because it is that which shareholders should really recognise,” says Jeremy.
 
Irrespective of the specific approaches adopted by companies, there are some key issues that virtually all Remuneration Committees will need to address, given the current economic, political and regulatory climate:
  • Are annual base salary reviews necessary, or does this just fuel a pay ratchet?
  • If above target bonuses are paid year-on-year, are the targets tough enough?
  • Do both the bonus and long-term incentive targets reflect corporate strategy?
  • Has the issue of risk been fully taken into account (while recognising that not all risk is necessarily 'bad')?
  • Do award levels (whether they be bonus out-turns, long-term incentive grant levels and/or vestings) genuinely reflect the overall circumstances of the business (including recent financial performance, current share price and expected future growth)?
  • Can the pay policy be justified to all stakeholders – investors, customers, suppliers and the workforce as a whole? 
Ruth says, “The biggest challenge facing Remcos is to have the courage to drive what works best for the individual company in setting the right performance measures, the right level of ambition in targets and fairness and integrity if discretion needs to be used in evaluation. The right approach cannot be determined by consensus across the whole market.”
 
If this topic interests you, Criticaleye will be hosting a Masterclass on Remuneration Committees in March. For further reading on remuneration trends please refer to Hewitt New Bridge Street's new report
 
Please get in touch if you have any comments about the issues raised here.
 
I hope to see you soon.
 
Matthew