Pay gone astray: the failure of executive incentive schemes.

Author:Powdrill, Tom
Position::Report
 
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Introduction

Executive remuneration has recently re-emerged as a significant political issue. The continued growth in boardroom pay, whilst the economy has flat-lined and many working people have faced a squeeze on their own living standards, has proved inflammatory. Even business leaders now worry that executive reward is out of control, and urge radical reform (Darrington, 2012).

Notably, this year has seen an unusually high level of shareholder opposition to executive remuneration policies at UK companies. More company remuneration reports have been rejected by shareholders this year than in any other since the introduction of a mandatory shareholder vote on executive pay in 2002. Although a total of six defeats for the year to date means that it's still only a fraction of the total, there have been some very high-profile corporate casualties, including Aviva and WPP. These defeats are also indicative of wider opposition. Analysis by PIRC has found that the average vote against a remuneration report is around 8.5 per cent this season. That compares with an average vote against of just under 6 per cent last year, and a little over 3 per cent back in 2008 (PIRC, 2012).

Institutional investors are undoubtedly at least in part reacting to political pressure to rein in top pay. David Cameron has criticised excessive pay in the UK's boardrooms, and made clear earlier this year that he wanted to give shareholders more powers to tackle it. Separately Business Secretary Vince Cable has exhorted institutional investors to do more, and initiated a new round of shareholder-focused remuneration reforms. Whilst his original set of proposals have been scaled back, Cable has pressed ahead with plans to introduce a new binding vote on remuneration policy, which should further strengthen the hand of shareholders (Department for Business, Innovation and Skills, 2012).

The state of pay

The underlying trends in executive pay that shareholders, and policymakers, are reacting to are important in this discussion. To take some headline figures, according to Incomes Data Services, FTSE 100 directors saw an average 49 per cent increase in total reward from 2010 to 2011, to just under [pounds stealing]2.7 million. However, the story here is not one of spiralling executive salaries. IDS found that the average increase in base pay during the period was actually just 3.2 per cent (IDS, 2011).

The reality is that the large part of the growth in executive pay in recent years has actually been in performance-related rewards, rather than salaries. According to IDS, cash bonuses were up by 23 per cent, from an average of [pounds stealing]737,624 in 2010 to [pounds stealing]906,044 in 2011, which in turn suggests that share awards are a significant part of ballooning executive reward. This is a trend that extends well beyond one-year's figures. PIRC has looked at the average cash bonus actually paid to a FTSE 100 director as a percentage of salary over a 10-year period from 2001 to 2010. It increased from approximately 80 per cent to around 130 per cent.

The growing pay-outs under cash and share-based incentive plans reflect the fact that these schemes have become increasingly generous. Research by the High Pay Commission shows that the average maximum bonuses available and maximum potential grants under share-based long-term incentive plans (LTIPs) have broadly doubled between 2002 and 2010 (High Pay Commission, 2011). As a result, for many executives base salary now accounts for only a relatively small part of the total potential package.

This outcome is also what we ought to expect, given current attitudes toward pay in both the corporate and investment worlds. There is a mainstream consensus in corporate governance that directors' interests need to be aligned with those of shareholders, and that performance-related pay, increasingly share-based, is the way to achieve this. Essentially, this is rooted in an agency theory view of the world, where directors may pursue their own interests, rather than those of the company and its shareholders, if incentives are not correctly structured. As such, incentive schemes are seen as a behavioural tool to ensure alignment occurs.

In one sense, then, the current structure of executive pay is in line with best practice. One might even have argued a few years ago that the 'success' in achieving alignment was evidenced by the tailing off in shareholder opposition to remuneration policies immediately prior to the financial crisis. No company remuneration reports were defeated in either 2007 or 2008, and votes against were at a low ebb.

Problems with performance pay

However, all is not right with performance-related rewards for directors, and its growth has not been without problems. Already we have seen a shift in the nature of performance-related rewards provided. Originally, it was believed that offering directors share options was the best way to align interests. However, this approach has fallen out of favour in the UK, because of the fear that options can create perverse incentives. LTIPs have now displaced options as the principal share-based incentive schemes. More recently, LTIPs themselves have been criticised for not being sufficiently long-term in nature.

Concerns have also been expressed in the financial sector that short-term cash bonuses may have incentivised inappropriate risk-taking, and as such remuneration policy may have played a contributory role to the crisis. There has therefore been a further round of remuneration reform, with a greater focus on long-term performance targets, payment in shares, and the introduction of clawback policies.

In addition to a shift to more long-term assessment periods, there have been various other attempts to reconfigure the targets on which...

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