Even more worrying, rising pay, most of which is “performance related”, has not been matched by a commensurate rise in corporate performance. The pay of FTSE 100 bosses has grown by more than 400% over the past 15 years, but the value of the FTSE 100 index has barely shifted. It’s hard to escape the conclusion that, as Cliff Weight, director of the pay consultancy MM&K, suggests, “the traditional model of remuneration is broken”.
Ironically, the apparently inexorable rise in executive reward seems to be the result of attempts to contain it. Measures enshrined in a succession of corporate governance codes and associated legislation designed to align executives’ interests with those of shareholders, keep a lid on base pay, encourage transparency and restore simplicity, have had unintended negative consequences that have conspired to ratchet up reward regardless of how well an individual CEO performs.
Corporate governance experts doubt, therefore, whether the latest wave of reform, from the introduction last autumn of legally binding shareholder votes on pay policies and the requirement for greater disclosure on pay, to proposals that executives should not sit on each others’ remuneration committees and that bonuses could be clawed back if performance dips (both subjects of a Financial Reporting Council consultation), will have much effect.
Jo Iwasaki, head of corporate governance at the ICAEW, says: “I think we ought to be sceptical about the extent to which policy initiatives alone can resolve the issue, particularly as companies’ typical response is to stick to the letter of the law rather than adhering to spirit. And in terms of the institute’s own work, we have changed tack and started think about remuneration in a bigger context – that is, what exactly are we trying to fix?”
Even more worrying, rising pay, most of which is “performance related”, has not been matched by a commensurate rise in corporate performance
Governance experts point out that the thrust of reform has been designed to treat the symptoms of a more fundamental problem – that is, the way pay is structured. Until boards and investors grasp the nettle of what really drives executives to perform, they suggest, we will never put the high-executive-pay genie back in the bottle.
There is growing agreement that the main performance criteria among listed company boards – total return to shareholders (TRS) and earnings per share (EPS) – is one of the root causes of soaring pay.
These measures were selected by shareholders in 2002, when they were first allowed to make an advisory vote on pay, as being the measures most likely to align executives’ interests with their own. But CEOs’ pay last year was boosted less by their own performance than by the performance of the stock market: share prices soared as a result of quantitative easing. This general market effect basically “printed money for CEOs,” says Sarah Wilson, chief executive of Manifest, the proxy voting agency.
And CEOs owe the bounty delivered by the deferred bonuses and long-term incentives (LTIs) that today amount to seven times their base salary, to the 1998 Combined Code on Corporate Governance. This advised companies to be sensitive to the pay and conditions across the group when calculating executive pay, especially in respect of annual salary increases. At the time, base salary accounted for the majority of executive pay. Today it is around 20%.
The requirement for companies to disclose the pay of their best-paid directors has also had a ratcheting effect: everyone wants to be paid in the top quartile of comparator businesses or, at the very least, to huddle around the median.
Wilson believes the new requirement for companies to publish a single total pay figure for top executives will be equally unhelpful as that figure doesn’t reflect the value of deferred bonuses (which are growing dramatically) at the date they are awarded.
“Trying to find a simple solution has, arguably, led to may of the problems we now have,” says Wilson, who is critical of the one-size-fits-all approaches that are typically applied to the setting, awarding and monitoring of executive pay. So while, for example, the new Verum Index, which attempts to measure executives’ pay against their companies’ performance, is “an interesting snapshot”, it is in effect comparing apples with pears, because the companies it monitors are in different industries, facing different challenges and at different stages in their development, she says.
This charge of being too simplistic can be levelled at shareholders as well. “Too few roll up their sleeves and understand the company on an individual basis, rather than taking a tick-box approach,” says Wilson.
The increasingly globalised and arms-length nature of shareholding partly explains why more investors don’t get down and dirty with the companies they invest in, as does the growth of short-term traders who are only interested in profiting from share price movements. But others are trying.
Hermes Equity Ownership Services, which is charged by 36 pension funds managing around £200bn to monitor how companies behave, helped to produce a set of four principles last year that it hopes will underpin future pay schemes. Colin Melvin, CEO of Hermes EOS, enlisted the support of 44 chairmen of big company remuneration committees in coming up with the principles that, he says, “are now part of our conversations with companies”.
Bigger investors are also starting to engage more directly. One is USS Investment Management, the fund manager for the Universities Superannuation Scheme, one of the UK’s largest pension funds. Daniel Summerfield, co-head of responsible investment, admits: “Shareholders didn’t exactly cover themselves in glory before the recession. When companies were doing well remuneration was a secondary issue. We never really reflected properly on what was ‘right’. With hindsight, EPS and TRS measures were too generic. We are now looking for more appropriate measures and targets rather than off-the-shelf solutions.”
And by appropriate, he means measures that reflect a company’s strategic objectives and value drivers. For example, GlaxoSmithKline, where the development of new drugs is a critical value driver, links remuneration to the success of its drugs pipeline. Other companies are now building measures, such as customer satisfaction and employee engagement into their performance-related pay criteria.
Summerfield says: “Companies are very good at explaining their value drivers and strategic objectives, so why not develop systems that incentivise management to deliver those both short and long term? The fact that the line of sight between such reward objectives and company strategy is much clearer than the traditional TRS/EPS link ought in itself to be more motivating,” he points out.
“What’s more, focusing on the drivers of shareholder value is far more likely to deliver long-term shareholder value than strategies designed to ‘maximise’ shareholder value, which often achieve the opposite,” Summerfield argues.
There is still a strong argument for CEOs to have some skin in the game – but this should be in the form of shares that they hold long-term.
You could pay twice as much for an outside chief executive than one you promoted from within, and 25% of these people are failures
CEOs are often characterised as greedy and out of touch with the real world, but Tom Gosling, head of reward at PwC, which produced a report with the London School of Economics in 2012 on The Psychology of Incentives, says the idea that executives are motivated by big pay packets is just one of many myths that have grown up around executive pay.
“If I had to point the finger at just one thing that has led to the rises over recent years it would be the simplistic acceptance of the principle that you get what you pay for and if you want more you have to pay for it,” he says. Most CEOs are as motivated to do a good job as most (considerably less well-paid) heart surgeons, but the huge financial incentives on offer for CEOs (what Gosling describes as “extrinsic motivations”) can crowd out their “intrinsic motivations” he explains. “Then you have to start relying overly on financial reward.
“Unfortunately, for many people, pay is a proxy for status, and PwC’s research also shows the perception of ‘fairness’ – that is, CEOs think they need to be paid as much if not more than the CEO down the road – is a critical factor in driving it upwards.”
Deborah Gilshan, corporate governance counsel at RPMI Railpen, says the pension fund works with pay committees “to deconstruct some of the arguments”. Nor do Gilshan and her colleagues accept unquestioningly the notion that high performance merits high pay. “Even for good performance there is a point where a sum of money becomes too much,” she says.
But how much is too much is the million-pound question. And the answer, again, comes down to the nature of the individual business. “You can’t be prescriptive,” says Manifest’s Wilson, “but common sense [on remuneration committees] is very uncommon.”
Some have argued for more specialist expertise on remuneration committees, or even another regulator. But Weight is clear: “What you need is good boards with good strategies. Remuneration is a window on the corporate governance of a company and on the soul of a company.”
In other words, executive pay reflects not just the culture of an organisation, but also the way it is run. And well-run companies keep a lid on executive pay through good succession planning.
Weight says: “You could pay twice as much for an outside chief executive than one you promoted from within, and 25% of these people are failures.”
The idea that chief executives are a small group of uniquely talented individuals who are very difficult to replace is another myth contributing to high pay. Research from the University of Delaware shows that internal hires perform better than external recruits because the former have a thorough understanding of the company and its culture.
But CEOs are not interested in succession planning, claims Weight: “They are more interested in their own personal power.”
And while there are undoubtedly some superstar CEOs, he says it is teams, not individuals, who achieve corporate goals. “And if a board emphasises the team effort, you get a very different culture and a very different reward climate.”
Gosling agrees. “The generally poor performance of companies at succession planning is a significant feature in ratcheting up pay.”
But at the end of the day, does it matter what we pay 100 chief executives? Well yes, say the experts – for a range of economic, business and social reasons.
Andrew Smithers, a leading City economist and author of The Road to Recovery, blames the bonus system for the UK’s financial crisis and weak recovery. He explains that the overweening focus on the share price means investment and research and development are sacrificed in favour of buying back shares and paying high dividends. This, he argues, harms an economy that needs corporate spending to rise and take some of the strain in reducing government deficits.
For businesses, high executive pay can affect engagement (hard-working employees who have suffered pay freezes are unimpressed by the bounty their bosses accrue) and reputation (rewards that are deemed ‘unfair’ go down poorly with customers and opinion formers).
There are also growing societal implications. “Big companies set the tone for everyone on pay,” says Luke Hildyard, head of research at the High Pay Centre. “Other companies, firms of accountants and lawyers, all use executive pay as a benchmark, and FTSE100 pay is therefore a good proxy for how the richest stratum of society has pulled away from the rest.”
The ICAEW’s Iwasaki believes companies need to act as more responsible corporate citizens. “The debate around executive remuneration illustrates a situation where companies have subscribed to sector-specific norms while breaching wider social norms,” she argues, and calls for businesses to take a more proactive stance in terms of establishing “more socially acceptable” pay policies.
Nevertheless, the overall prognosis on executive pay is one of cautious optimism.
Some companies continue to side-step the rules in order to pay their executives what they want to pay them (witness the number of banks side-stepping the new EU roles on bonus caps by rewarding their people with allowances or shares), while others (not least the Co-operative Group) are left with egg on their faces when their CEOs defect, despite the high salaries that were supposed to keep them loyal. But Summerfield is encouraged by the improved dialogue between investors and remuneration committees, and by the growing discussion about more imaginative performance incentives. “I’m a glass-just-over-half-full person,” he says.
PwC’s Gosling is more bullish, suggesting that the current round of handwringing comes at a time when the tide is already turning. “In companies themselves there is a groundswell of opinion that performance pay is not all it’s cracked up to be, and that equality throughout the organisation is an important cultural factor,” he says.
But if executive pay has reached its zenith, it requires strong-minded and well-informed remuneration committees, supported by involved shareholders, to administer the medicine. And while executives may need a reality check on their own value, boards will have to find ways other than pay to affirm their worth.
If more equitable levels of executive pay, linked more closely to the value drivers of a business, seem like a distant nirvana, an article by David Kraus in the Harvard Business Review in 1976, just a decade before pay inflation took off, shows how quickly and unexpectedly the world can change.
Kraus wrote that “the worth of the American executive, as measured by his pay, has declined in both relative and absolute terms of the past decade”, with consequences for attraction and motivation. He concluded that “compensation compression and relative decline in executive pay are probably here to stay”.
Businesses might have avoided much of the turbulence of the past 30-odd years had Kraus been even half right.