What on earth just happened?

Transcription

1 Where now for executive remuneration? After an unprecedented year for executive remuneration, what does the future hold? Peter Boreham, head of executive remuneration for Hay Group in the UK considers probable trends and also what should happen if executive remuneration is to get back on the right path. What on earth just happened? 2009 was an extraordinary year. After years of double digit growth in executives total remuneration, salaries were frozen, bonus targets were found to be unachievable and investor pressure forced many companies to reduce share scheme awards. Meanwhile, investors adopted a new, more militant approach to their voting responsibilities. Shell lost the vote on its Remuneration Report, while other companies had to endure bruising consultation processes and saw their voting majorities much reduced. As a result, no one was happy: investors were outraged that some companies attempted to preserve pay levels that investors had approved in the good times and which clearly were no longer appropriate; some executives were bewildered to find that the music had stopped and their pay was going to fall; and the poor remuneration committee suddenly had to face an unprecedented set of challenges just when the rest of the Board agenda had become even more pressing than usual. Even the previously confident figure of the remuneration consultant was discomforted by the realisation that market data had been rendered almost meaningless.

2 2 Where now for executive remuneration? What did we learn in 2009? 2009 had a number of key lessons for everyone involved in executive remuneration. Market data has its uses, but it s no substitute for having a clear set of remuneration principles. Most businesses are, at least to some extent, cyclical and much of what passed for superior financial performance was in reality driven by an unsustainable economic boom. It s much easier to design remuneration packages that work in the good times than to design incentive plans that work in a wide variety of circumstances. Performance needs to be considered in both absolute terms and relative to the economic and market circumstances. The public will tolerate high levels of executive pay only if their own standards of living are on the increase. Bad practices in a few areas (for example many investment banks, expensive pension augmentations) can have significant consequences for the market as a whole. There are some signs that we may emerge stronger from this learning process. The Remuneration Committee members, HR professionals and company secretaries that we are speaking to are now very interested in considering whether there needs to be a new map for executive remuneration. Meanwhile, although some are still criticising the ABI and some institutional investors for a tick-box approach, we were encouraged to read Marc Jobling in the Times (20 October 2009) saying: Why do so many FTSE100 [long term incentive] schemes end up looking so similar when their business models vary so widely? Are the incentives aligned to the business? Are they clear? You have to be willing to question consensus thinking.

3 3 What will happen in 2010? The comments below assume that the global economy emerges from recession in early 2010 and that there is not a double dip or W-shaped recession. On this basis, we expect the immediate trends in UK executive compensation to be as follows: After a year of pay freezes for the top teams of most leading companies in the UK (and the US), it is likely that top salaries will start to grow modestly in The average level of increases is likely to depend on the economic outlook and there may be some variation by sector as different industries emerge from the downturn at different rates. However, we do not expect a return to the 6-8 per cent growth that used to be common in the UK. We expect lower average bonuses paid in early 2010 for 2009 performance compared to those paid a year previously with a wider spread of payments due to the different approaches adopted to target-setting and bonus curves and differences in company performance. That said, we expect many bonus payments to be higher than some investors and journalists expect. Indeed, we expect to see investor discomfort as a result of some companies paying significant bonuses despite a decline in the absolute level of profits. This reflects the failure of many companies to address the issue of cyclical exposure in the design of their annual bonus plans. The average level of increases is likely to depend on the economic outlook and there may be some variation by sector as different industries emerge from the downturn at different rates We expect to see more and more companies introduce bonus clawback provisions into annual bonus plans. Although this is currently seen as primarily an issue for financial services companies, we expect to see a wider use of clawback over the next year or two. However, the circumstances in which clawback can operate is likely to be quite narrow in most cases. We expect 2009 s high level of investor scrutiny to continue into 2010 with many investors reluctant to see a return to the perceived excesses of 2006 and Hay Group. All rights reserved

4 4 Where now for executive remuneration? What is likely to happen over ? Some longer-term trends over the next few years may be as follows: There is near-universal agreement that more of the annual bonus will be deferred into shares, not just in banks and the rest of the financial services sector. Whilst a greater focus on the long term may be a desirable outcome (see below), there is a risk of deferral becoming a tick-box issue with attention deflected from other more important considerations of design. After all, recent history (Lehman, Enron) tells us that high levels of share ownership and long term remuneration do not in themselves prevent inappropriate levels of risk-taking or poor corporate management. We expect to see the end of final salary pension provision for top executives. Even if the Government s current savage tax proposals (which could end executive final salary provision almost immediately in 2011) are watered-down, or companies introduce new approved arrangements, we expect these plans to wither on the vine. Many executives with significant final salary benefits are approaching retirement and in any case we expect the general trend to close final salary plans for existing members to accelerate. On balance we see this as a good thing at senior executive level. Plans paying a guaranteed two-thirds of final salary were introduced in times when real executive salaries, incentive payments and life expectancy were much lower than today and it is difficult to see a strategic justification for their survival into the 21st century. There will be tactical actions to mitigate the effect of the new 50 per cent tax rate, primarily by bringing payments forward where practicable. However, we do not expect most leading listed companies to make major structural changes to pay for their top executives as a result of this change, although executive pressure to do something may increase once the tax actually bites. We expect remuneration committees to take a critical look at the use of EPS in long term incentives. In the US EPS is a controversial measure as: it is easier to manipulate than some other measures; it is often closely correlated to profit metrics used in the annual plan; in many sectors has limited correlation to shareholder value; and can be distorted by share buy-backs. As a result, some UK companies and investors have also begun to explore other metrics such as cashflow per share and CFROI.

5 5 What do investors want to happen? Submissions to the FRC s review of the Combined Code have surfaced various suggestions as to what might be done to improve executive pay in companies that have their principal listing in London. We consider two suggestions from influential parties below: The NAPF and others have questioned whether the time has come to abolish the long term incentive. The argument is that many plans are misaligned to shareholder interests and underappreciated by participants. Instead executives would receive (presumably higher) salary and bonus only and be expected to purchase and hold a significant number of shares. We have concerns about this proposal. We agree that purchased shares are in many ways better aligned to shareholders than free awards; however alignment is still imperfect due to differences in diversification and there is a danger of executives taking on high levels of personal debt to fund consumption. The ABI and some individual investing institutions have called for long term incentives to be stretched over longer performance periods. The obvious danger here is of providing plans that have no motivational impact or offer exceptionally large payouts to compensate for the extended term. It should also be noted that not all investors operate to the same time horizons as ABI members. Whilst we have some sympathy for the concept of a long holding period after vesting, this does raise difficult practical challenges. and It would be desirable to see companies operate pay strategies and incentive plans that are specific to the sector, business strategy, maturity people strategy of the business Hay Group. All rights reserved

6 6 Where now for executive remuneration? What should happen? We comment here on what we would like to see happen. The extent to which this actually happens will depend on remuneration committees being prepared to approach remuneration as a strategic, value-adding issue rather than a compliance matter. It also means investors being prepared to support remuneration arrangements that differ from traditional norms but for which there is a compelling business case. If remuneration committees and investors are prepared to take a wider look at senior remuneration there are a number of desirable possible changes. Firstly, it would be desirable to see companies operate pay strategies and incentive plans that are specific to the sector, business strategy, maturity and people strategy of the business. At the moment, there is a tendency for companies to use market data and the requirements of investors as a de facto strategy. The consequence is a worrying conformity of pay mix and design with little differentiation between companies that may have vastly different performance and planning horizons, strategies, regulatory freedom and positions on the maturity curves. Secondly, we believe that there is a case for a re-weighting of CEO packages towards the longer term. In large companies, the CEO s role is primarily strategic and focused on creating long term shareholder value, but often the annual incentive (focused on short term operating performance) represents a third or more of a CEO s total remuneration. By contrast, for individuals two or three reporting steps down from the CEO we believe that the incentive balance should, in most businesses, be biased towards annual performance with less emphasis on share plans. Thirdly, the annual bonus needs to look beyond financial metrics. We believe that the top team s performance should be assessed against the critical factors that support future growth in shareholder value. This means a focus on relevant lead indicators for example, effectiveness of succession planning, governance rankings, and employee or customer satisfaction. There is also a need to reward the effective execution of strategic plans. The current focus on in-year profit means that a large chunk of pay is significantly influenced by external market and economic factors and also by strategic decisions taken several years ago, quite possibly by a different top team.

7 7 Where now? Executive remuneration is at a crossroads. There is a once-in-a-decade opportunity for executive remuneration to be reshaped in a way that will be better for investors and executives and will be easier to defend to the public, the media and politicians. The alternative is more of the same. But this risks companies failing to obtain the best possible return on their executive reward investment or worse further clumsy intervention by regulators or politicians. If you would like to explore what a new map for executive remuneration would look like in your business please contact Peter Boreham on or peter.boreham@haygroup.com Fourthly, the design of TSR-based LTIs in UK companies needs to be improved. At present, plans reward only for performance above median (and top-out at between the 75th and 80th percentiles). As a result there is a significant probability of earning nothing. There is also no payment differentiation between coming just below median and finishing in the bottom decile. It will take a bold remuneration committee to seek approval for vesting below median. However some influential individuals in the governance community have privately suggested that they would not be opposed to this in some circumstances. Fifthly, we believe there is scope for companies to be more thoughtful about benchmarking. We aim to be at the median is easy to say, but it is important for remuneration committees to understand the comparator group used and how the constituents in it differ. Making crude comparisons against all companies with similar turnover or (particularly) market capitalisation can lead to the inclusion of companies of radically different scale, business mix and complexity in the same peer group. Market comparisons can be a particular issue for companies that are amongst the largest (or smallest) in their sectors and for whom a median policy stance doesn t mean literally paying at the 50th percentile of the sector. Finally, we would like to see remuneration committees engage more in understanding the shape as well as the value of incentive plans. This involves modelling incentive plan payments in different performance scenarios and analysing the sensitivity of payments to different performance factors. Comparisons can then be made to the shape and sensitivity of payments in the plans of competitor organisations Hay Group. All rights reserved

8 8 Where now for executive remuneration? About Hay Group Hay Group is an independent global consulting business. Our UK executive remuneration team advises the Remuneration Committees of a wide number of companies, ranging from FTSE 100 to AIM, to those backed by private equity. Hay Group has over 2600 employees working in 85 offices in 47 countries. For over 60 years, we have been renowned for the quality of our research and the intellectual rigour of our work. We transform research into actionable insights. We give our clients breakthrough perspectives on their organisation, and we do it in the most efficient way to achieve the desired results. Further information For further information, please contact: Peter Boreham t e peter.boreham@haygroup.com