Work to be done on executive pay

THE NEXT 12 months look set for significant change to the way executive remuneration is reported and potentially radical changes to the way it is managed and structured.

The government recently released a consultation paper on disclosure requirements, which proposes replacing the current business review and directors’ report with a strategic report and an annual directors’ statement. The strategic report will provide shareholders with high-quality disclosure of the link between company performance and the remuneration of company directors and senior executives.

Another paper invites discussion on a wide range of measures aimed at curbing escalating pay where this is not correlated to performance. In the press release accompanying this paper, Vince Cable stated that “there is a widening gulf between company performance and pay which is simply not sustainable. Concern over this is not just coming from government. Investors, business groups and captains of industry have all told us that this is a real problem and needs to be addressed.”

Our research on executive remuneration in FTSE-350 companies highlights a number of positive changes in pay structures, such as increased deferral, clawback and share ownership guidelines. But it also reveals salary increases have typically been higher than average increases for other employees. Bonuses also continue to be paid out at levels significantly above target on a regular basis.

In 2009 and 2010, the financial crisis and the recession led a significant number of companies to implement pay freezes for directors. When we were looking forwards to 2011 at this time last year, we anticipated salaries would increase, but increases would typically be at the 2% to 3% level. However, the median increase for main board directors has been 4% in FTSE-100 companies and 3% in FTSE-250 companies so far in 2011.

Almost one third (31%) of directors in FTSE-100 companies and 19% in FTSE-250 companies have received increases above 5%, which is significantly above inflation and the increase in average employee earnings. This is particularly surprising, as remuneration committees should be careful to avoid falling back into the cycle of increasing directors’ salaries at an executive rate.

Investors have reacted quite strongly, raising salary increases as an issue in proxy voting reports for almost 30% of companies holding an AGM so far in 2011. This is likely to continue to be an important issue over the coming year.

Weakest link

Remuneration committees should determine remuneration for executive directors in the context of the wider employee population and treat executives in the same way as other employees. Salary increases should be considered only where there is a real and compelling reason for them and should be limited to the general level of increase for other employees, unless exceptional circumstances exist.

Our findings on bonus payouts make it difficult to refute the accusations that the link to performance is not strong enough. Over the past decade, the bonus potential has more than doubled (the median bonus potential is currently 150% of salary in FTSE-100 companies and 200 per cent in the top 30 companies). And yet, the median payout has consistently been at 70% to 80% of the maximum over this period.

Although bonus payouts were lower over the 2008/2009 period, reflecting the impact of the recession, the median payout was still higher than might have been expected. Apart from this period, our data suggests more than four out of five FTSE-100 companies, and more than two-thirds of FTSE-250 companies, have paid out more than target bonus every year for the past five years.

Of course, these numbers mask significant variability in the payouts of individual companies, but this does suggest executive directors have a very real expectation of receiving at least target bonus each year. This suggests targets, and expectations, need to be recalibrated.

Some of the measures we believe remuneration committees should be considering include:

• Tying annual bonuses to the key performance indicators to ensure executives are incentivised to drive the business strategy. But include hurdles to be achieved before any payout is triggered to avoid the possibility of paying out the bonus on one measure that is not merited by the overall performance of the individual or the company;
• Setting annual bonus targets in the expectation that there will be no payout unless overall company performance warrants it. Ensure pay-outs above target require significantly better than good performance and the maximum should only be expected perhaps once every five years;
• Deferring a substantial proportion of bonus for three to five years;
• Being more prepared to use judgement to ensure pay-outs are fair and reasonable in light of all relevant factors.

Long-term awards have also increased considerably in size over the past 10 years, but appear to be more strongly linked to performance than annual bonus. In FTSE-350 companies, most directors no longer receive grants of options, but typically receive an award of performance shares with a face value of between 150% and 300% of salary in FTSE-100 companies and between 125% and 150% of salary in FTSE-250 companies.

Given the size of these awards, it is important to ensure they really incentivise long-term performance. Long-term awards should be tailored to support delivery of the company’s long-term strategy, but with safeguards that awards will only vest where a threshold level of financial and/or market performance has been achieved. Remuneration committees may also want to consider longer performance periods, or further retention periods to better support long-term stewardship. And remuneration committees should be more prepared to use judgement to ensure the vesting is fair and reasonable.

Some of the positive changes in remuneration structures are encouraging, but our findings on salary and, in particular, bonus arrangements suggest there is work to be done. There are clearly many challenges in having substantial elements of reward based on performance but this is still the right answer for most companies. We should not abandon the principle of performance-based pay simply because it is difficult to get right.

It is time to take a hard look at how remuneration is structured and paid, and whether this is fair, reasonable and effectively linked to the long-term strategy and success of the company.

Stephen Cahill is a partner in the remuneration team at Deloitte