The exec price tag: Reforming executive pay

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UK executive pay is reaching staggering levels. Does HR need to tailor a better reward and incentive fit?

Pity the average FTSE 100 CEO. In 2017 they had to work two-and-a-half days to earn what the typical UK full-time worker earns in an entire year. But this year they had to work a whole three days – until 4 January – to earn the median UK gross annual salary of £28,758.

It’s difficult for most to feel sympathetic to this plight. While many might be surprised to learn that the average FTSE 100 CEO pay packet fell by a fifth last year (down from £5.4 million to £4.5 million), and that it also fell the year before, this won’t go far in placating ever-heightening disquiet around executive pay.

Nor will this modest drop go far enough, in many people’s books, in reversing the longer-term trend. The average pay of a FTSE 100 chief executive has risen from £1 million in 1998 to more than £4 million today, according to the Department for Business, Energy and Industrial Strategy (BEIS)’s long-awaited consultation response on corporate governance, published in August last year.

The very existence of this consultation provides a strong indication of the current mood. The CIPD’s Pulse survey in 2015 revealed that 71% agree that UK CEO pay levels are generally too high; 60% agreed that this demotivates employees, and 54% that it’s bad for an organisation’s reputation.

And government is listening. Hot on the heels of the corporate governance whitepaper’s proposals to force all listed firms to reveal the pay ratio between bosses and workers, to publish the names of those firms where a fifth of shareholders were opposed to executive pay packages, and measures to ensure the voice of employees is heard in the boardroom, came a Financial Reporting Council (FRC) consultation on revising the UK’s corporate governance code.

Proposals include widening remuneration committees’ remits so they oversee pay and incentives across the wider workforce, and that executives be required to hold on to bonuses paid as shares for at least five years. Building on promises made from the off in her leadership bid back in July 2016, Theresa May, in launching the above whitepaper, warned that the “excesses and irresponsibility” of a minority of executives is undermining public confidence and “damaging the social fabric of our country”.

Promising to tackle corporate excess has become a must-have element of any political campaign; both in the UK and further afield. Public outrage at high-profile corporate failures such as the Sports Direct saga, BHS, and now Carillion – where bosses secured some £4 million in handouts in the run up to it going into compulsory liquidation – has undoubtedly intensified exec pay scrutiny.

The public and education sector is by no means immune. In November Bath University’s Glynis Breakwell stepped down amid growing controversy over vice-chancellor pay (her £468,000 package made her the UK’s highest paid).

How can an individual ever be worth £48.1 million a year, the person on the street quite reasonably demands. And how can it ever be reasonable that it would take the average worker 160 years to earn what a FTSE 100 CEO earns in just 12 months?

These are complex and politically charged questions. But it’s an area, experts agree, requiring urgent attention from government, shareholders, RemCos and HR directors alike.

Where experts diverge, however, is on how the problem should be fixed, which of the proposals outlined above are good ones, and whether regulation is the solution. In fact many argue that the problem of ‘excessive pay’ is not quite what it seems – a crucial debate to understand before venturing forth with solutions.

Defining the problem

It can’t be denied that executive pay has risen at breakneck speed over the last few decades. A comparison of CEO pay with other top earners’ sheds light on this. In 2003 CEO reward was typical of those earning more than £1 million per annum, reports the CIPD’s 2015 The power and the pitfalls of executive pay paper. But within 12 years it was around twice as high as other £1 million-plus earners.

A key, and perhaps unexpected factor, could be pay transparency. Sandy Pepper is professor of management practice at the London School of Economics and Political Science (LSE). He explains that while noble in theory, various measures rolled out to oblige firms to report on senior pay – starting with the Greenbury report in 1995 – have ratcheted levels upwards.

“One of the risks with disclosure is that things become one-way,” he says. “If you’re a chief executive and you see the disclosure of your peers, you’re not going to go to your RemCo and say ‘I’m willing to surrender 10% of my pay’. But if you’re being paid 10% less you’ll say ‘I want 10% more’.”

The problem with disclosure is that every CEO wants to believe they’re in the ‘upper quartile’, and every board that they’ve appointed a high-performing CEO, explains Charles Cotton, senior performance and reward advisor to the CIPD. “Organisations feel they have to be paying top dollar to their leader because otherwise their leader isn’t perhaps as good as they could be. But not everybody can be upper quartile,” he says.

This constitutes a vicious cycle. Even where a firm isn’t consciously trying to place its CEO in the upper quartile of pay, organisations’ tendency to copy what everyone else is doing has led to this ratcheting effect. “The starting point for pay has been ‘well this is what everyone else is doing so we should probably do that,’” reports Steven Young, professor of accounting at Lancaster University Management School.

Compounding this is the fact organisations often don’t compare themselves to meaningful groups of peers, says Stephen Perkins, professorial research fellow at The Global Policy Institute. His February 2017 Response to the greenpaper on corporate governance reform, co-authored with Brian Dive, details the way ‘statistical orthodoxy’ around exec pay has been distorted.

In carrying out a valid market survey, ‘it is important to have at least one leading player from all the key industries, with each being of comparable size [and] complexity’, the paper states, going on to describe though how companies have ‘broke[n] this fundamental rule of statistical reliability by setting up a club of similar companies in one industry only, which measure only a small part of the executive market in the UK’.

“Companies use peer groups of 10 to 15 companies and look what the CEO is paid there, but those are self-selected and heavily biased towards larger companies,” adds senior lecturer at the MIT Sloan School of Management Robert Pozen.

Managing director of Pearl Meyer Simon Patterson backs this up. FTSE 250 companies commonly look to FTSE 100 firms for what they should be paying to attract and retain a good CEO, he reports. “So people running FTSE 250 companies are creating what I call ‘wannabe pay programmes’,” he says. “They want to be paid like FTSE 100 CEOs, but they’re running businesses that deliver about a tenth of the value.”

Lack of logic

What this phenomenon starts to reveal is the extent of confusion around what the problem with exec pay is. While it’s typically the seemingly exorbitant salaries of FTSE 100 chief execs that hit the headlines, the bigger issue sits slightly lower down, Patterson points out, where FTSE 250 leaders – though not paid as highly – are paid well over the odds in relation to value created.

So the problem (according to Patterson and many others) is not actually the quantum of CEO pay packages. It is rather the logic – or lack thereof – behind them.

Very high pay packets aren’t necessarily as scandalous as they might seem, explains Tom Gosling, leader of PwC’s UK reward practice and executive fellow at London Business School. While experts diverge on whether the oft-cited ‘market rate’ logic is a meaningful one, Gosling points to its merit. Certainly many companies currently compare themselves to other firms in misleading ways. But there is truth to the argument that in a global market for a limited pool of top bosses pay will necessarily sit at a certain level, he says.

“Companies have become bigger and more complex, so it’s not only a harder job but crucially more valuable too; the stakes are higher as companies are six times bigger in real terms,” says Gosling. “That longer-term context is often not understood.”

That the average FTSE or otherwise CEO gets paid the amount they do isn’t necessarily the real problem then. What the general public and politicians should be up in arms about rather than quantum is the lack of value created by some highly-paid CEOs. “I think a debate only focused on the amount is a waste of time,” muses Alastair Robertson, chief people officer at Kingfisher. “Instead we should be looking at the why and how, and the value someone creates.”

“What’s the worst thing a CEO can do to his or her firm? It’s not being paid too much but failing to innovate,” agrees professor of finance at London Business School Alex Edmans. “So we need to move the conversation on from a pie splitting to pie enlarging mentality… CEO pay is only on average 0.6% of a firm’s value so it’s much more important to change the incentives so that CEOs grow the pie.”

The difficulty here, however, for firms that do boast sound incentive mechanisms to ensure ‘pie growing’ behaviour, is that such schemes are often lost in translation. It’s easy for those skimming headlines to confuse reward with incentives, points out Warrick Beaver, global head of HR at Thomson Reuters.

“A challenge is that the reporting on a complex subject may not be fully comprehensive or the ‘whole truth’,” he says. “Within executive compensation will be a mix of base salary and a bonus target, but the balance is likely to be stock – which won’t vest for at least three years.

“Who knows what the share price will be then; it may not vest in full and if the CEO leaves they are quite likely to have to pay back a portion of their share vestings. The public doesn’t see the whole story over the entire reward period. So to communicate that an executive’s 2017 pay is £2 million can be misleading.”

Smoke and mirrors

The problem with exec pay opacity is not, however, just one of the general public ‘not getting it’. Complexity of the ‘how’ of exec pay is the key factor at the heart of this often being a smoke and mirrors endeavour – with levels and mechanisms poorly linked to performance and ‘pie enlarging’ behaviour. “If you look at a typical remuneration report I’m not sure the individuals who receive them actually even understand the incentives,” comments Young.

Gosling outlines the radical shift that’s occurred in executive pay. “If you go back to the late ‘90s a CEO’s package would be a third salary, a third final salary pension, and a third bonus or stock options,” he reports. “Now it’s a third salary and two-thirds bonuses and long-term incentive plans (LTIPs). That’s a massive structural shift, which has been driven mainly by shareholders wanting more performance-based pay.”

So the biggest worry with companies blindly following each other on exec pay is not just that they unquestionably copy remuneration amounts. But that they also copy each other when it comes to the ‘how’.

“The problem is that we’ve tended to emphasise the techniques [in isolation from their desired results],” claims Perkins. A key part of the problem, his February 2017 paper states, is the limited technical capabilities of many RemCos. ‘Insufficient attention [has been] paid to… who should sit on [RemCos] and what should be their level of competence in this critical field,’ it states. ‘Their collective performance has been a matter of growing concern. There is little evidence of statistical reliability in the manipulation of data that underpins their decisions.’

The High Pay Centre’s 2015 No Routine Riches report adds to this alarming picture of pay scheme sophistication failure, specifically around performance-related pay. It found that between 2000 and 2013 only 1.3% of the disparity in bonus payments for FTSE 100 CEOs could be attributed to differences in pre-tax profits, despite this being the main measure used in bonus schemes. It found that 73% of fluctuation in LTIPs could not be credited to changes in either earnings per share or total shareholder return for any year in the period 2004-13.

Edmans’ research on LTIPs concurs. “The philosophy behind LTIPs is sound – to link pay to performance. But it does so in a needlessly complicated way, that allows for gaming and fudging,” he writes in a March 2017 London Business School article.

‘Despite the name, evidence shows that ‘long-term’ incentive plans lead to short-termism as the end of the evaluation period approaches,’ he states in this piece, explaining that if the stock price is just below £4 the CEO may, for example, cut R&D to boost earnings and get the short-term stock price over the hurdle. If the CEO gambles the stock price might only fall to £3, but the LTIP wouldn’t have paid off anyway so the downside is limited. And if the gamble succeeds the stock price rises to £5 and the CEO cashes in.

Consultants are also partly to blame for schemes becoming illogically complex, reports Young. “The problem is: where do people look for advice? From a compensation consultant or a senior NED – all of which starts from the point of: it’s relatively complex and involves a lot of money,” he says.

“There are so many vested interests and advisors making money on the arbitrage and selling money around,” says one HRD who did not want to be named. “But actually they’re trying to sell you new and complicated ways of doing things.”

Fixing exec pay

So the most important step in ‘fixing executive pay’ appears to be reducing complexity. “For any level of staff the best thing you can do is make pay reasonable or as generous as you can afford, make it fair, and then make it simple,” says St Mungo’s Broadway HR director Helen Giles. “All these bonuses and incentives… it complicates it and creates an admin nightmare.”

What’s needed, says Giles, is much greater focus on behavioural economics and the psychology of money at exec level. While lessons have been learned over the years in terms of behavioural economics and pay lower down the business, these are rarely applied across to senior individuals, highlights Geoff Tranfield, group HRD at IMI.

“We all did this as the Ladybird Book of HR, that effectively money doesn’t motivate you but it can demotivate you,” he points out. “I believe the best CEOs are far from singly motivated around money.”

“I think that the financial economics way of constructing incentive plans that the world has followed doesn’t take into account how people actually feel and behave,” agrees LSE’s Pepper. “If we designed things more in tune with this rather than mathematical economics we might come up with some better answers.”

Pepper points to his research, which found that the more risk-based the measure someone is paid with the more they discount its value. “Execs subconsciously discount the value of LTIPs; if you pay people in an instrument they don’t value then they want more to compensate,” he says.

“The more risk-based pay you introduce into the compensation plan the higher the payment has to be to compensate,” agrees Lancaster University’s Young. “So the paradox is the more we push in the direction of performance-related pay, the more we’re going to have to live with very high rewards.”

“We shouldn’t be thinking people at the top of their professions are so motivated by money,” adds Pepper. “They’re motivated by all sorts of things. It’s much better to recognise that and pay people in a simpler, more normal way.”

Unfortunately research into exec motivations around money is still curiously lacking, he says: “It would be great if behavioural economics could do for exec pay what behavioural finance has done for the investment community. There’s huge amounts of research into investment practices but nothing like the same amount on pay.”

Getting incentives right

Others point out, however, that while maybe too much focus has been placed on incentives, and while the majority of CEOs are motivated by factors far beyond pay, there is still a role for performance-related reward – if done right. “It’s not that incentives don’t work; that’s the wrong conclusion,” asserts Pearl Meyer’s Patterson.

“I operate on a simple principle of: if you tell people what you want you stand a significantly increased chance of getting it. And incentive programmes can help you encourage the right focus,” says Phil Wills, associate director of PARC (the Performance & Reward Centre).

The first step should be to define what sort of company performance you want, says Wills. “A board and RemCo will need to define the performance model. ‘Do we want short-term profit? Are we in a turnaround or survival situation? Or are we an established company looking to develop a sustainable business model?’ Because you can’t automatically say long term = good, short term = bad.”

Then it’s about determining what kind of CEO behaviours will achieve this performance, says Wills, and crucially how to measure them. Though most exec remuneration practice currently relies on purely financial metrics it’s important to use a range of indicators beyond these.

While a firm shouldn’t unquestioningly opt for long-term exec pay targets the majority could do with moving in this direction. LBS’ Edmans is a strong advocate of replacing LTIPs with cash and shares with an at least five-years’ holding period. “Saying ‘we’re giving our CEO shares that they can’t sell for five years’ sends a strong message,” he says. “It means there’s no short-term complex bonuses or thresholds no-one understands.”

“Much better than LTIPs is if CEOs are paid a salary and then paid cash bonuses they’re required to invest a certain proportion of into the company,” adds Pepper. “So they buy shares rather than are given them.”

Thomson Reuters’ Beaver points out, however, that such change will require a significant mindset shift from investors. The ecosystem within which exec pay is considered is still highly near-term focused, he points out.

“There’s research that shows companies forego investment opportunities that would deliver long-term returns purely to hit short-term performance targets,” he says. “So we need a new, shared understanding of the relevance of thinking in terms of longer-term performance.”

Regulation the key?

The question is whether investors, shareholders and RemCos are likely to see the logic and motivation for reform themselves. Or whether this is a matter for government. Pepper feels it is. “There needs to be some kind of intervention to get us back on track because it won’t happen by itself,” he says.

The issue otherwise is that shareholders perhaps don’t have enough incentive to change things. “[Past] governments have said it’s a problem for shareholders but of course there’s a sort of collective action problem in that even if you’re a very big shareholder you might only own 3% of the shares at one company. So the proportion of a CEO’s excess pay that you’re bearing is not a huge sum of money,” says Pepper.

“Therefore, but for the public outrage argument perhaps, it would not be your first point of interest if you’re looking to improve the financial performance of your portfolio.”

“If you look at the bulk of shareholders in the FTSE 100 my guess is they’re American and have very different views about how people should be remunerated, which doesn’t tie up necessarily with our politics,” says MIT’s Pozen. “I suspect that one of the challenges is that there’s always a difference of opinion between the RemCo and shareholders on this.”

Pepper adds that the argument that shareholders are beholden to market forces, and that these must be left to play out in a liberal market economy, is a tenuous one. “This is the way markets sometimes fail in other circumstances and cartels and monopoly situations develop; and the government designs a law to try and sort them out,” he says.

So do current government proposals within August’s corporate governance whitepaper, and indeed those made by the FRC back in December, hit the mark? Certainly there are praiseworthy and potentially helpful elements, say some.

The FRC’s proposal that executives be required to hold on to bonuses paid as shares for at least five years, as outlined by Edmans and Pepper, is welcome for many. As is its proposal that RemCos take on a much broader remit to oversee pay and incentives across the wider workforce.

Businesses must recognise, points out Kingfisher’s Robertson, that discontent around exec pay has arisen in large part from workers becoming increasingly dissatisfied with their own lots. People are much less likely to feel disillusioned with CEO remuneration when happy with their own, he points out. “What’s really important is that when people go home at night they’re not worrying about whether they can put food on the table or pay their rent,” he says.

Edmans agrees. But broadening the RemCo’s remit “must not be at the expense of focus on working conditions beyond pay,” he stresses: “This is positive as long as the responsibilities don’t extend just to worker pay but general conditions – so training, flexitime, promotion opportunities…”

Other proposed measures are more contentious. Take the corporate governance reform whitepaper’s proposal to require companies to report their CEO and average worker pay ratio.

While ratios “might be a useful mechanism to consider the hierarchy and relationships in a business”, says director of the High Pay Centre Stefan Stern, they must be applied “intelligently and reasonably”. Otherwise a supermarket’s ratio compares unfairly to a professional services firm’s for example, which will be lower not because the CEO is more fairly paid but because employees are paid more.

The problem with regulation in general is that companies can get round it, feels Edmans. “With any legislation you can just manipulate things,” he says. “The way you can improve your pay ratio for example is to outsource your low-paid employees or convert them to part time – or by paying a higher salary rather than providing good working conditions.”

Other experts are similarly sceptical. “The answer is not regulation. That routinely solves the problem that existed five years ago,” says Patterson. “I wonder with legislation whether it’s designed too much on catching exceptions rather than improving the performance of the many,” muses Kingfisher’s Robertson.

The problem ultimately with anything mandated by the UK government, points out Tranfield, is that it will be exactly this: UK-focused. “More than 90% of our workforce is non-UK and the vast majority of our senior management is non-British,” he says. “The UK government therefore might be able to deal with the press narrative, but I’m not sure it’s necessarily going to teach organisations to be responsible internally.”

The onus for many is on business to drive executive pay reform itself. Tomas Chamorro-Premuzic, professor of business psychology at University College London and Columbia University, is hopeful that firms will realise the reputational rationale of doing so. “If organisations are smart they’ll know there are PR benefits,” he says. “So I think maybe we’ll get there.”

If businesses aren’t persuaded by positive PR they should be by negative, says Stern. He points out that a government under continued public perception pressure around corporate excess could feel compelled to become increasingly – and unhelpfully – hands-on.

“The point is that it’s up to companies now to make the most of [current regulations],” he says. “They’ve got to prove they’re serious about getting a handle on top pay… Because the government hasn’t suggested anything scary yet; it’s reasonable proposals. But it’s possible a Labour government, for example, would be more intrusive.”

The role of HR

Which is where, potentially, a switched-on HR director can play a key role. “It’s always easy from the outside to tell HRDs to be braver, but I think that’s about right,” says Stern. “If HR can’t do it no-one else is going to.”

The crucial role for HR in all of this is to both highlight the behavioural economics evidence for approaching exec pay differently, and to create a more challenging dynamic at board- and RemCo-level. “Sometimes there’s this accusation that the RemCo is too cosy,” says Tranfield. “In my experience the best RemCos are where there’s challenge between the NEDs, the RemCo chair and management. But equally it’s constructive.”

Gaining a strong ‘in’ with the person whose pay you’re deciding can go a long way, feels Gosling. “I think a good HRD can play a really important role in bringing the CEO with them,” he says. “An HRD who’s a trusted confidante can help the CEO see the bigger picture and move beyond issues of personal ego.”

Pozen adds the importance of working with a different consultant for exec pay than for other business matters: “That’s important because if you take a general consultant they’re going to feel their loyalty is to the individuals in the company not the committee.”

The HRD also has a crucial role to play in ensuring board diversity, says Stern. “If boards have been filled with a certain sort of chap who’s already been CEO then it’s probably a much cosier conversation,” he says. “If there’s cognitive and social diversity you might have a more challenging and interesting conversation.”

Greater focus on succession planning is also a key area for HR, feels Patterson. Indeed his firm’s UK CEO Value Index data reveals that CEOs promoted from within are paid 20% less than those hired externally and, crucially, add 6% more value. “The answer in my mind is to push younger talented individuals into senior roles more quickly,” he says. “Therefore they rise and fall with the success of the enterprise.”

“Hiring superstar CEOs often means companies over-pay for talent,” agrees Chamorro-Premuzic. “So they could think more creatively whether they have a good succession plan… The chances the person stays and does a good job are then higher as well.”

HR can also play a vital role in communicating executive pay to the wider workforce, translating excessive- or abstract-seeming figures into a logic everyone understands. “HR’s role is thinking about that visibility and helping senior leaders to describe their vision and value,” says Andy Dodman, chief operating officer at the University of Sheffield. “It’s making sure the leadership is well communicated.”

A knotty debate

The extent to which exec pay should be lowered and simplified so that no translation process is required is a contentious issue. Whether a pay package in the millions or hundreds of thousands is fundamentally absurd is a knotty matter of philosophy and politics – and so highly subjective. Which means so too is the debate around the helpfulness of regulation.

“It’s hard for people to understand someone being paid more in a year than they would ever make,” says Chamorro-Premuzic. “In the same way people struggle to accept that four people in the US earn 50% of the wealth in the country. That leads us to political views.”

However, no matter where you sit philosophically and politically on what is an ‘appropriate’ level of pay for one person, the need for exec pay to become less opaque and more evidence-based is undeniable. If businesses aren’t persuaded by avoiding negative publicity, perhaps they will be by the need to incentivise senior leaders to do a better job, and ultimately create more value.

So perhaps it’s time for HRDs to take the lead and prove the case for more strategic, behavioural economics-informed thinking around CEO pay levels and mechanisms. This may never completely quieten public discontent around the amounts top individuals take home. But it may help steer the national conversation in a more meaningful, nuanced direction. And, just as importantly, ensure employees and shareholders alike are content with their lots.

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