What is executive remuneration in high definition?

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1 Executive remuneration in high definition Article one a high definition approach to relative TSR Our latest series of papers turns a high definition lens to different aspects of executive reward. This first article examines the use of TSR. What is executive remuneration in high definition? Sensible remuneration strategy is often undone by poor execution. When looking at the remuneration policies of new or potential clients, we often find that an apparently sensible remuneration strategy is undone by poor execution. This usually has its roots in low definition thinking too many remuneration committees are satisfied with a set of fine sounding policy statements without realising that these are being undermined by the reality of how they are applied. The good news is that these problems are not difficult to fix. The solution is to dig a little deeper, to ask the why? question and to prod and poke the policy to see if it is robust: in other words to look at executive remuneration in high definition. This article is the first in a series turning a high definition lens to the use of TSR in executive reward Hay Group. All rights reserved

2 Executive remuneration in high definition It is not always obvious what alternative investments are. You need to use high definition thinking. Choosing a TSR comparator group why it matters For some companies, there are very good reasons to use relative TSR as a performance measure. For example, in mature businesses that are cyclical and/or that are significantly impacted by external factors, relative TSR is an excellent way to assess the achievements of management in the prevailing market, economic and regulatory context. Therefore relative TSR often plays a significant part in the reward plans for mature companies in the mining, oil and gas and banking sectors. However, not all such companies take a high definition view in selecting and implementing a comparator group even though the choice of group can have a big impact on plan outcomes. In other circumstances, organisations use relative TSR quite reluctantly on the grounds that their investors require it or at least the organisation assumes. In these circumstances, it is tempting to employ low definition thinking and not spend much effort on choosing a peer group. However, some high definition thinking should allow an organisation to reduce the level of random noise in the comparator group which may in turn make them more appealing to executives who are typcially suspicious of the TSR element. Incidentally, whether companies are right to assume that investors require relative TSR is open to question, particularly given the declining proportion of the UK market held by traditional institutions. We discuss this further in our paper Executive pay to suit your business. We would also note a change in the mood music coming from the ABI the ABI s current stance is that organisations need fit-for-purpose remuneration structures rather than a me-too market-driven approach. Developing a comparator group When relative TSR first became a common measure in the mid-late 1990s, the usual approach was to base the peer group on the most obvious alternative investments for a shareholder. This reflected the origins of relative TSR in the relative performance-driven bonus plans operated for fund managers themselves. In the early days this often meant simply using the FT-SE100 or some other very broad comparator. However, hindsight and experience have exposed this as low definition thinking. Such broad comparator groups include a high degree of randomness due to the very different degrees of volatility and cyclical exposure faced by different sectors and businesses. In addition, when we look at the stock market in high definition, we see that the UK shareholder base has become more diverse than 15 years ago and it is not always obvious what alternative investments are. For example, consider investors in Barclays Bank in early What were the most obvious alternative investments? With this richness and diversity in both the shareholder base and the nature of companies, it becomes necessary to think about relative TSR in a different way. In essence, this means considering which businesses face broadly similar economic, market, regulatory and operational challenges. Investor UK insurers and pension funds Overseas insurers and pension funds Sovereign wealth funds Hedge funds Retail investor Alternative investments UK banks UK blue chips International banks UK blue chips International blue chips Property UK stocks with significant upside UK dividend stocks Unit trust Building Society deposit 2010 Hay Group. All rights reserved

3 Often relative TSR produces payment driven by random factors. This will generally include direct business competitors and/or businesses with a similar profile in terms of products, sectors and locations. Size can also be a factor, but wider size variations can be accepted for TSR than would be appropriate when selecting a peer group for market benchmarking purposes. Of course not all businesses have competitors that look like them or which face the same challenges. For example, in some highly consolidated sectors there may only be a handful of competing firms, and some of these may not be listed on a stock market. In these circumstances, assuming that TSR remains a valid metric, it becomes necessary to choose on the basis of factors such as: correlation: how well does the historical TSR of different sectors correlate to our company/sector? volatility (Beta): how does the historical share price volatility for different sectors compare to our company/sector? As an example of this approach, last year a Hay Group client introduced a relative TSR metric based on the FT-SE Mid 250 but with certain miscorrelated sectors excluded. Testing a group Having developed a potential group of comparators, it is important to model and test this group. This means tracking TSR for the potential comparators over several overlapping historical performance periods and computing what the plan would have paid in these scenarios. This modelling allows the following key questions to be addressed: do the performance outcomes fit with what we believe about the historical performance of our business? in a small group, are any comparators miscorrelated? Why is this? Does the miscorrelation invalidate the outcomes? Is this likely to recur? in a larger group, are any sectors miscorrelated to us and our main competitors? in a global group, are any countries miscorrelated? Hopefully, this modelling will show that the proposed group is suitable and/or will highlight any modifications that are necessary. However, it is possible that the modelling will produce a set of notional historical payments that seem to be driven by random factors rather than the performance of the business. In which case, either the proposed comparator group needs to be significantly revised or the use of relative TSR as a measure needs to be re-thought. Some remuneration committees are nervous about moving away from relative TSR due to the preferences of investors. However, if the decision to move away is as a result of the modelling then it is possible to take an evidence-based approach to the debate with investors. It is unlikely that the investors will have done this sort of modelling for your company themselves.

4 Weighting the comparator group Some companies may have a small number of highly relevant comparators and a larger number of companies with whom they have some similarities. In this case, the aim is to make sure the comparator group is large enough to be robust without it being dominated by the less relevant comparators. The answer here is to weight the comparator group such that the most relevant companies have a bigger impact on the result. Ranking, smoothed ranking or percentage outperformance There are three main ways to assess performance against a comparator group: simple ranking. This is the simplest and most common approach and would be the low definition default choice. However, payments are sensitive to the level of clustering of comparator companies. Therefore, incremental improvements to TSR may have very large or very small impact on vesting percentage outperformance. Here full vesting occurs for TSR of median plus 10 per cent (say) per annum, with linear interpolation used between median and this level. This approach avoids material differences in vesting arising from small differences in performance. However, this approach does require a percentage outperformance target to be set for full vesting smoothed ranking. This is a compromise option between the two approaches described above. The TSR of the median and upper quartile (say) companies is calculated with vesting between these points being calculated by linear interpolation. Again this avoids material differences in vesting arising from small differences in performance. In our view, simple ranking works best for very large comparator groups. Otherwise the other methods are preferable. If the comparator group is very small, the percentage outperformance approach is generally best. Treatment of international comparators In low definition it does not matter whether TSR of international comparators is converted to a consistent currency or based on nominal returns in the local market. However, in high definition it is clear that these approaches can produce very different answers. (If using consistent currency, the choice of that currency does not make a material difference). In general, for multinational companies (who are the most likely to use an international comparator group) we would recommend converting all returns to a consistent currency for the following reasons: using consistent currencies provides an accurate reflection of the relative returns that would have been achieved by an investor who chose to invest at the start of the plan period in all the companies in the comparator group and who converted all proceeds and valuations to his or her own currency the local currency approach is technically flawed since high inflation in that country could inflate nominal rates of return. So could currency devaluation for a company with substantial foreign earnings. A high nominal return in such circumstances may not be an indicator of good management performance for multinational companies, measuring TSR in consistent currencies is likely on average to even-out the effects of currency fluctuations on profits and local currency share price. Many investors prefer this approach.

5 Other details Some of the details of TSR comparisons are beyond the scope of this paper. However, any high definition approach requires active consideration of the following issues: start and end dates. In general we believe that TSR should be measured from grant date to vesting date. However, some companies measure performance over the financial year share price averaging period treatment of companies leaving the comparator group. When not to use relative TSR As we state at the beginning of this paper, relative TSR is most relevant for mature, cyclical businesses. Conversely, relative TSR is of limited validity for the following types of companies: businesses targeting substantial growth businesses in a turnaround situation businesses which are not competing with other businesses for customers to any meaningful extent (biotech for example) Grow or die businesses (start-ups, upstream oil exploration, mining exploration and biotech for example) In these companies, what matters is absolute performance. If relative performance is to be used at all, it might be used as a multiplier on the LTI rather than as the primary measure. TSR below the top team Historically, many businesses used the same LTI performance hurdles for the whole executive population. In general the idea was to ensure that, we re all in this together. However, this low definition thinking undermined the value of long-term incentives for many executives below top team level. And this was particularly acute in organisations that use relative TSR for the whole executive population as roles below executive committee level can rarely impact it. Today, high definition thinking is leading organisations to consider the extent to which LTI plan design can and should vary within the executive population. This allows a more tailored approach to LTIs with the consistency being balanced against line-of-sight. Relative TSR is not always popular with executives and this is likely to remain the case for as long as UK investors insist on their distorting and dysfunctional requirement of no vesting below median. And for some businesses (or for some roles) perhaps it would be best to move away from relative TSR. However, it is likely and appropriate that mature, cyclical companies will continue to use relative TSR in their LTI plans. In which case, there is no doubt that more robust and better modelled approaches to TSR will improve the alignment of plan outcomes to business performance and thereby increase the credibility of this measure. We therefore hope that more businesses will take a high definition approach to this issue. Peter Boreham UK director executive reward T E peter.boreham@haygroup.com 2010 Hay Group. All rights reserved

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