The process used by major companies to set levels of executive pay needs to be overhauled, as current approaches are too complicated, and the outcomes too uncertain, research conducted by the Institute of Business Ethics (IBE) has found.
The earnings of company executives have increased rapidly in recent years, and often bear little relation to the wages of their employees.
According to the High Pay Centre, a UK think tank, the average FTSE 100 CEO earned £4.96 million ($7.08 million) in 2014, up 20% from £4.13 million ($5.9 million) in 2010. On that basis, in 2014 FTSE 100 CEOs earned approximately 183 times as much as the average UK worker.
This disparity is a concern for external stakeholders. A recent IBE survey found that excessive executive pay was the second most pressing public concern about business behaviour after corporate tax avoidance.
Meanwhile, a February 2016 survey conducted by the Rock Center for Corporate Governance at Stanford University in Stanford, California, found that 74% of Americans believe that CEOs are vastly overpaid. The majority of respondents (62%) advocated a pay cap for chief executives. Those who believe in limiting CEO pay would do so at no more than six times that of the average worker. However, chief executives in the US currently earn 210 times as much as the average worker.
The lack of a clear correlation between performance and pay is another pressing issue. Examples of high rewards for average performance and even cases of failure being rewarded have been widely reported, further eroding trust among customers and morale amongst employees. It also damages the organisation’s reputation with policymakers and regulators, according to Fair or Unfair? Getting to Grips With Executive Pay, by Peter Montagnon, associate director, IBE.
Establishing a more objective and transparent process would be a significant step towards rebuilding public trust in business, the report says.
Flaws in current practice
The IBE report found that, in many companies, executive pay is not based on the right incentives, lacks a clear connection with performance, and often promotes short-term decision-making.
At present, remuneration committees (referred to as compensation committees in the US) tend to take into account the size and performance of the company, the executive’s experience, and the complexity of any strategic challenges the company is facing. Attempting to reconcile a sense of fairness with the market rate for executives in the sector provides a challenging dilemma. With few established guidelines, the process relies heavily on the judgement of the awarding committee.
The research recognises that some boards do attempt to calculate the net present value of the packages they approve. However, it is difficult for committees to know exactly what they are awarding, as the time frames and proportion of the award dependent on performance can have a wide range of eventual outcomes which are not easy to forecast.
The recommendations outlined in the report include the following areas:
Align targets with strategy: Targets should be realistic, practical, and aligned with the company’s strategy. Committees should ensure that incentives are in line with the company’s risk appetite. It is also important that they are difficult to manipulate in the aggregate.
Link bonuses and culture: Montagnon suggests that executive pay should be linked to culture and behaviour. Though positive contributions to culture are hard to measure, the report puts forward some objective indicators which could be compiled into a corporate culture metric, which could in turn be incorporated into a balanced scorecard.
These indicators include customer satisfaction, staff turnover, and the organisation’s health and safety record, as well as any regulatory breaches including cases brought to an employment tribunal. Distribution of bonuses would depend on minimum standards being met on each of these criteria.
Focus on the long term: Longer time horizons for rewards encourage the company to deliver more sustainable returns. Conversely, research shows that short-term incentives encourage executives to cut back on investments such as R&D expenditures, to bolster the share price and maximise reward.
“The more remuneration committees try to manipulate short-term behaviour, the less likely they are to succeed. If their focus is on long-term and sustainable growth in cash generation, they will be setting their company and its executives on a course for success,” the report states. “That may mean encouraging executives to hold shares and, subject to cover limitations, allowing them to receive dividends, which in turn would reduce reliance on bonuses.”
The litmus test of the decision-making process is whether the committee can explain and communicate the pay award in terms that are accessible to the general public.
Questions for the remuneration committee to ask
The IBE report sets out the following questions as a framework to help committees reach their decisions and ultimately establish fairer and more sustainable executive pay.
What is the purpose of the package? Is it aimed at sharing success or at producing incentives to perform? If the latter, will the incentive work in the way executives want it to?
- Is the remuneration committee clear about why it has set a given quantum? What are the judgements that went into this decision?
- Will the executives’ effort to maximise reward lead them to impose excessive risk on the company?
- Can the remuneration committee really be confident that it understands the value of what it is handing over, especially the share-based element of the package? If not, why did it approve the package?
- Who has set the comparator group of companies for pay benchmarking purposes? Was the process properly independent of the executive?
- What was the direct or indirect role of the executives in setting bonus targets? Are these suitably stretching?
- If the targets are not disclosed, are the reasons for this genuine?
- Does the remuneration committee pay attention to succession planning so as to ensure that it has a range of options when a new chief executive is appointed?
- Is the remuneration committee comfortable with the balance between fixed pay and variable pay, especially in situations where the company needs to be turned around?
- Does the board question executives who failed to build up a significant holding of shares bought with their own money?
- Is the remuneration committee sensitive to pay and conditions elsewhere in the company? In particular, are top executives receiving conspicuously preferential treatment at times of corporate or sectoral difficulty?
- Are the executives awarded for embedding a healthy culture which reduces corporate risk?
—Samantha White (email@example.com) is a CGMA Magazine senior editor.