Executive pay: The battle to align risks and rewards

Executive pay: Eight top earners The annual meetings season has brought renewed anger over executive pay. This week, 75 per cent of shareholders at Barrick Gold , the world's biggest gold producer, voted against its pay plans, which included a $13m package for John Thornton, the chairman. Almost one-third of shareholders refused to supportHSBC's remuneration report at its annual meeting last week. And a smaller but significant 11 per cent of BP shareholders voted against resolutions on executive remuneration after the pay and bonuses of Bob Dudley, the chief executive, rose 25 per cent to £12.74m last year while shareholder returns deteriorated.

Talking ahead of Barrick's meeting, money manager Michael Sprung summed up the sentiment expressed by many shareholders who are speaking out against executive pay this spring.

"Their (Barrick's) approach the last few years does not seem to have served the shareholders that well," Mr Sprung said. "It seems to have served management quite well."

Talk to those involved in executive pay, whether as investors, academics or consultants, and it is striking how many describe the system as "broken". Even many board members feel that way. In a survey conducted by Mercer, the consultants, 54 per cent of UK-based non-executive directors polled described the executive remuneration model as "very much" or "somewhat" broken.

Asked whether he thought the system was working, Colin Melvin, chief executive of Hermes EOS, which represents institutional investors worldwide, says: "No, I don't think it is." Like many, he says the system needs fundamental reform.

Why do critics and shareholders object so strongly to the way top executives are rewarded? First, investor champions such as Mr Melvin say the way executives are paid has become overly complex, with too many cash and share-based awards, long and short-term targets and a profusion of measures of success, ranging from earnings per share to total shareholder return to return on equity. Mr Melvin says many chief executives and other top managers struggle to understand what is in their pay packages or how to hit their targets.

Even pay consultants agree with this assessment, saying the link between achievement and reward is frequently opaque. "Very often, executives don't understand the plan because it's too remote from them," says Sophie Black, UK head of reward at Mercer.

Above all, critics say, the amount of money top managers in the US, the UK and many other countries earn is unjustifiably high. Between 1978 and 2013, US chief executive remuneration, adjusted for inflation, rose 937 per cent, more than double the level of stock market growth and vastly more than the 10.2 per cent increase in the average American worker's pay over the same period, according to the Washington DC-based Economic Policy Institute.

The average US chief executive earned 295.9 times as much as a typical American worker in 2013, compared with 20 times as much in 1965. In the UK last year, chief executives at the biggest companies earned, in cash and shares, 120 times more than full-time employees. In 2000 they earned 47 times more, according to Incomes Data Services.

The AFL-CIO, the US trade union federation, says that while the chief executive-to-worker average pay ratio is higher in the US than anywhere else in the developed world, countries such as Canada, Germany, France and Sweden have even bigger gaps than the UK.

The ballooning of top-level remuneration has help fuel the debate about growing inequality. Donald Hambrick, professor of management at Pennsylvania State University, says executive pay has created "anger on Main Street that affects capitalism in general".

Apart from the damage to the image of business, high pay at the top does not seem to have done much for companies. Alexander Pepper, professor of management practice at the London School of Economics, said in a collection of essays for the High Pay Centre that studies since 1990 had either failed to demonstrate a positive link between executive pay and corporate performance or had detected, at best, a weak correlation.

How did executive remuneration become so complex - and why did pay levels increase as fast as they did? The complexity can be traced to concerns in the 1970s and 1980s about the "agency problem" - that those who ran companies would act in their own interests rather than in those of the shareholders.

One of the early ways in which companies attempted to overcome this was to award executives share options. By giving them the right to exercise the options at some point in the future, top managers would dedicate themselves to ensuring the shares performed well over a long period. The practice received a boost from a 1993 US provision limiting tax deductibility to $1m per executive.

The problem was that too many executives sold their shares as soon as they exercised the options. Critics argued that this encouraged excessive risk-taking as executives attempted to boost the share price when the options came due.

In a 2010 paper, Prof Hambrick and Adam Wowak wrote that share option schemes not only encourage risk-taking, such as supposedly transformative acquisitions - they may have also helped attract executives who were disposed to risky behaviour in the first place. "One can readily envision how 20 years of aggressive use of financial incentives . . . may have attracted a new breed of executive," they wrote.

Instead of share options reducing self-interested executive behaviour, they "may have led to an increased prevalence of exactly that trait in today's top management", they added.

A second factor that drove up remuneration was the demand that companies disclose what they paid top people. Like share options schemes, disclosure was promoted with the best intentions; who is against greater transparency? But, as with share options, disclosure had unforeseen consequences: a ratcheting up of remuneration levels as chief executives demanded that their pay be competitive with, or better than, that of their peers. "Everyone wants to be top quartile. Pay has become about status. It's not really the money," Mr Melvin says.

With disclosure and complexity came the need for advice. Boards and remuneration committees felt they had to hire consultants to tell them what best practice was elsewhere. "I think compensation consultants are a big part of the problem," Prof Hambrick says.

Consultants, critics say, helped produce greater complexity and a further ratcheting up of total remuneration.

They deny this. "We respond to market demand like any business. If the market demand wasn't there we would go out of business," Ms Black says. Mark Reid, managing director of Towers Watson, another consultancy, says: "All stakeholders have to take some responsibility. Shareholders have their guidelines and they are all subtly different. We don't take positions. We advise."

What can be done? Some argue that the worst abuses have been dealt with. Glenn Davis, research director at the Council of Institutional Investors, says share options today form a far smaller part of compensation packages. He cites research by Equilar, a US provider of corporate governance data, which showed that the median value of options awarded as part of pay packages in S&P 1500 companies halved between 2009 and 2013.

Instead, there has been a move towards longer-term performance-based share awards. Ms Black points, too, to provisions for companies to claw back bonuses and other awards from executives if companies perform poorly.

Optimists add that pressure from shareholders has helped to moderate or change pay packages. They have been empowered by the introduction of non-binding "say on pay" votes in the US and binding three-yearly votes on pay policy in the UK. Britain has introduced a requirement that companies provide a single figure for each director, showing what they have earned from all sources.

There is also pressure on companies to act on the vast disparity between chief executives' pay and that of the workforce. In the US, the Securities and Exchange Commission is planning to require companies to disclose the ratio between the chief executive's annual remuneration and that of the company's median-paid employee.

But not everyone shares the view that the tide has turned. Swiss voters, in a referendum in 2013, decisively rejected a proposal that would have prevented companies from paying their highest-earning employee more than 12 times the salary of the lowest earner.

Many expect that other efforts, such as the SEC's, will fail to achieve much either. Mr Reid says it will be difficult to compare the chief executive-to-worker multiples in different companies. For example, a company that outsources its manufacturing could have a lower ratio than one that does its manufacturing itself, even though their bosses might earn the same.

Critics say none of the reforms deals with the complexity and opacity in executive remuneration. Writing for the High Pay Centre, Peter Montagnon, former director of investment affairs at the Association of British Insurers, says "the awkward truth" is that "nobody really understands the value of share-based awards". He says: "There is little point in addressing excess by increasing shareholders' rights to vote on something they cannot honestly evaluate."

Instead he and Mr Melvin suggest a radical alternative: pay executives in cash and shares that they have to retain for a long period, certainly beyond their departure from the company. Mr Melvin says: "That's it. No bonus. No need for consultants. No need for performance targets, which might be irrelevant in a year or so."

Mr Montagnon adds: "Senior executives would be less likely to take a short-term decision with bad long-term consequences if they were locked in this way.It would provide a strong incentive to deal sensibly with succession planning. It would prevent both the need for clawback and the incidence of payment for failure, because a disaster that hit during or even after the executive's period of tenure would hit the value of his or her share portfolio."

Could such a reworking of executive pay happen? Mr Reid says he has some sympathy but is sceptical. "We're often asked to brainstorm for remuneration committees and we put that option, [although] not as simplified. Very few companies have reacted well."

There is no perfect executive remuneration structure. But with business's reputation still badly battered and resentment over outsized pay still high, critics from consultants to shareholders argue it is time for a new paradigm.

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