Nick Martindale 6 Sep 2018 03:27pm

How to ensure executive pay is held to account

Businesses around the world are coming under pressure to make executive pay open and justifiable. Different countries are at different stages, but the direction of travel is one way, as Nick Martindale reports

Caption: Image: Getty Images

The issue of just how much executives receive for their work is never far from the headlines, and has come under increasing scrutiny since the global financial crisis, with many pay packages seen as excessive.

“It’s become so overwhelming that it’s overshadowing every positive thing around commerce,” says Elizabeth Richards, head of corporate governance in ICAEW’s Technical Strategy Department. “We’ve gone beyond thinking it’s just a market forces issue. The problem is systemic and highly corrosive.”

The topic is one of many which has fed into a wider feeling of disconnect in society, believes Luke Hildyard, director of the High Pay Centre, a think-tank set up to research and monitor pay levels at the top-end of the scale.

“We’re seeing more extreme politics with populist parties on the right in Europe, Trump in the US and Brexit in the UK, and they have all tapped into the idea that there is an elite doing very well for itself and a section of the population that is not being treated fairly,” he says. “The issue of pay difference is on policymakers’ and business leaders’ minds across the developed world.”

Acknowledging the gap

Mark Reid, global head of executive compensation at Willis Towers Watson, identifies four elements as part of the journey countries tend to go on. “Governments start by saying they need to introduce some frameworks and processes, so they separate boards into executives and non-executives, create remuneration committees and have independent non-executives who are responsible for the pay of the executives,” he says.

“We passed that point in the UK 20 years ago but there are still lots of countries that are just introducing that first step of governance, and a lot of Asian countries are still at the point of introducing that sort of structure.”

This is followed by pay disclosure, where pay levels are made public, and then a move to give shareholders a vote. “In many cases it’s voluntary or advisory or every few years and has no real teeth,” he says. “The most recent step is additional disclosures of pay ratios, requiring organisations to publish some multiple of the CEO’s pay to the broader workforce. You can map all the countries on that spectrum, but the direction of travel is the same.”

The US is perhaps the most advanced country in terms of pay ratios, with companies publishing the ratio between CEO and the median worker’s pay for the first time in 2018. The study, called Rewarding Or Hoarding? included data from 225 public companies and revealed a differential on average of 339 to 1, with the most extreme case being 5,000 to 1, although differences in how businesses report these mean it is early days in terms of how much use this will be to those looking to ensure fair pay settlements.

Choosing an angle

The US, though, is generally more comfortable with the idea that high performance should be well rewarded. “It’s fair to say they have a much lower view of quantum,” says Kit Bingham, a partner in executive search firm Odgers Berndtson.

“There are issues around pay for performance but this idea that there should be a cap doesn’t really come up, so for a CEO the sky is the limit. They’re much more open, socially and politically, to truly huge pay packets.”

The UK, too, will introduce pay ratios in 2020 for quoted companies with more than 250 employees. These companies will be required to disclose the ratio of CEO pay to the 25th, 50th and 75th percentile for full-time equivalent remuneration of UK employees.

“This goes further than we were expecting, because having three ratios provides greater insight into the distribution of wealth throughout the workforce,” says Richards. “We think pay ratios will generate a new type of conversation as they have for gender pay gap reporting. Ratios will provide better insight, which will prompt more informed debate.”

The Netherlands has implemented pay ratios from this year, adds Peter Boreham, European practice leader, executive reward, at Mercer, while the EU Shareholder Rights Directive, due to come into force in 2019, will harmonise the whole of the EU on a similar regime to that of the UK, where pay policy is subject to a binding vote at the AGM and actual pay is subject to an ex-post advisory vote. Not everyone is convinced all this will add much in the way of meaningful information, however.

“Trying to make comparisons between financial services, where you’ll have many people paid more than the CEO, and a retailer, which employs a lot of workers on or around the minimum wage is completely pointless,” says Bingham.

“So comparisons between sectors will be meaningless. Is there a case for comparing Sainsbury’s against Tesco, similar companies from the same sector? Possibly. Does it really tell you anything about executive pay or the performance of the business or the management of the company? I don’t think so. It’s political kneejerk rather than valuable transparency.”

Another approach in the UK towards reining in excessive levels of pay has been to give more power to shareholders, including the introduction of a binding vote for listed companies in 2013, under which pay has to be voted on every three years. “This has given shareholders the power to drive initiatives around pay, and they have realised that if they work together they can drive change in the market quite quickly, which isn’t the case under an advisory arrangement,” says Reid. “That contrasts with the US where the ‘say on pay’ vote is advisory and occasional, and is materially less effective from a shareholder perspective.”

This has certainly had an impact, agrees Boreham. “It has become much easier for the non-executive board members to say to a CEO that they can’t give them a particular package because it will involve a vote at the AGM which they don’t think they can win,” he says. This is likely to have more of an effect than pay ratios, he says, which can be distorted by elements such as sharebased reward. Other areas have a different approach.

The Nordic approach

The Nordic countries have different strategies but generally do not see the huge differentials in pay that are common in places such as the US and UK. “It’s not a huge discussion in the Nordic states,” says Trond Olsen, partner and Nordic PAS (people, advice and services) and reward leader at EY. “People understand there should be a difference between a CEO and the regular worker so we don’t see that much publicity around it.”

In Norway, the government owned Sovereign Fund invests in many businesses, which has ensured a high degree of shareholder influence, adds Olsen, while Sweden, Denmark and Finland will all be affected by the new EU rules. Perhaps as a result of the more egalitarian nature of Scandinavian society, the make-up of pay also differs, says Olsen, and this can also have a deflationary effect.

“Generally in the Nordics the average CEO will have 50% of remuneration as base pay, which is significantly higher than in the UK or Germany where it could be 30% base, 30% as short-term bonus and 30% as long-term incentives,” he says. “There’s not that much risk involved, and that’s the most challenging part for the Nordic approach; in the good times no one complains but in downturns then people say the cost is higher than it should be due to the way it’s structured.”

Considering the repercussions

Other approaches, meanwhile, have focused on particular industries, with the financial sector coming under particular scrutiny since the global economic downturn. “There’s now a high level of regulation across Europe, particularly in the UK where we have the Senior Managers Regime, and even outside Europe the G20 countries have got a level of regulation that is more principle-based,” says Claire Morland, a principal at Mercer Kepler. “In the EU you have the 2:1 variable-to-fixed pay ratio which has had a lot of publicity,” she adds.

“That has had plenty of unintended consequences including pushing up fixed pay to help meet the ratio, but it does act as a cap. We’re also now beginning to see some disclosure around ‘Malus’, so cancelling deferrals or the claw-back of bonuses in high-profile events, so the regulation really does have teeth and is beginning to bite.” Yet there are risks with attempting to tackle excessive pay. One is that those organisations could struggle to attract the best individuals, who could potentially drive performance and shareholder value. But this isn’t an argument that washes with Hildyard.

“The potential candidate pool for strategic positions in big companies is not so fixed that companies have to outbid each other to attract them,” he says. “If you’re reduced to having to pay £10m or £20m to recruit some superstar CEO, it’s to some extent a succession planning failure.” There is a danger, though, says Bingham, that companies are unwilling to try to do something different in an attempt to align pay with performance.

“One of the problems with executive pay is that every incentive scheme is a plain vanilla, standard one that shareholders are familiar with, which gets voted through so they stay beneath the radar,” he says. “Whether that scheme is in the best interests of the company and whether the metrics are truly aligned to what they’re trying to achieve as a business is secondary to staying in the middle of the pack.”

He’d like to see more use of restricted stock, where executive rewards are tied into shares, and thus aligned with the interests of shareholders. Boreham, meanwhile, believes there is a concern that certain parts of the economy – listed firms and the financial services sector, for instance – come under more scrutiny than others.

“The whole debate around executive pay focuses on a very specific part of the market, but there is a swathe of individuals who are very highly remunerated who are a bit under the radar,” he says. “That could be people running private equity-backed businesses; people in private equity firms themselves, hedge funds, venture capital, law or accounting firms.”

The general trend towards tackling excessive pay, however, is likely to continue, as pressure on businesses from governments, media and society increases.

“A lot of it stems from campaigners and media commentators drawing attention to pay and inequality, and calling out particularly egregious or unfair pay awards,” says Hildyard. “There won’t be a stroke of the pen signing a decree on this but we will see companies’ pay practices evolve.”

Boreham, though, is hopeful the introduction of the new EU regulations will introduce a period of stability around executive pay. “The current regulations on the whole are working; pay in the UK has levelled off since the 2013 regulations came in,” he says. “We’re already at a point where a typical UK compensation disclosure in an annual report is about 25 pages long. I think that is enough.”

Action plan for boards

ICAEW has developed a 10-point framework designed to help firms take steps to tackle excessive executive pay, as part of its Connect and Reflect initiative. “We need to get beyond using fancy words and graphs, and complicated share-based schemes which no one really understands, and the idea that this is hopeless and can’t be changed,” says Elizabeth Richards, head of corporate governance in ICAEW’s Technical Strategy Department. “It’s a negative cycle that we need to try to break out of.

We feel that our action plan for boards and our inspirational examples demonstrate a way forward in what has become an entrenched space.” The recommendations are as follows:

• Treat everything as if it is public.
• Recognise all the reasons why pay is important.
• Look at the entire pay structure.
• Talk about fairness.
• Use simple language.
• Lift the lid (on what executives do).
• Have real conversations.
• Admit mistakes.
• Set out your pay principles.
• Persist and be patient. Accountants are encouraged to share their thoughts on excessive pay, and other topics including employee directors, social media, governance and whistleblowing. Join the discussion at icaew.com/ connectandreflect

The UK will introduce pay ratios in 2020 for quoted companies with more than 250 employees, which will be required to disclose the ratio of CEO pay to the median worker on the 25th, 50th and 75th percentile for full-time equivalent remuneration of UK employees, and justify any change