The gulf between the pay of executives and their workers is becoming a great divide, and isn't just about jealousy, it is structurally damaging industry.
Executive pay is rising at over 10% per annum whereas pay of workers in general is rising about a quarter as fast. The resulting pay gulf has caused widespread dissatisfaction. This dissatisfaction is not merely the politics of envy, it reflects a real underlying problem.
Clearly, remuneration committees, which are responsible for setting executive pay, need to address this. Existing approaches to executive remuneration are badly flawed from every perspective. From the perspective of level, pay is out of control; from the perspective of structure, pay is inappropriate; and from the perspective of process, the approach usually adopted to formulating executive pay simply compounds the problems of the past.
The level of pay is out of control. No effective control is, in many businesses, exercised over the pay of the chief executive. US expert Grael Crystal has traced the growth in the ratio between shop floor and executive pay in America. In 1973, the ration was 45:1; by 1991 it had risen to a ration of 140:1 and by 2002 had exploded to 500:1.
Furthermore, the level of pay received by a chief executive is driven more by the size of the company he or she runs than by its performance. Rather than simply branding any highly paid executive a fat cat, PA Consulting Group distinguishes between those who have sustained high performance in their company and delivered high returns to shareholders and those who have not.
The expected return to shareholders is the cost of equity (Ke). Any CEO who delivers a total shareholder return (TSR) in excess of Ke has created value; conversely, if the TSR is below Ke, he or she has destroyed value. Over the long-term TSR minus Ke measures the extent to which a chief executive has created or destroyed value.
The chart below shows four categories of executives. The 'heroes' deliver superior returns to their shareholders, and are well rewarded for doing so; the 'villains' take the high rewards, but do not deliver the results which would justify them; 'saints' deliver outstanding results but receve only moderate rewards; and 'sinners' do not perform but have the grace not to extract enormous rewards for presiding over mediocre performance.
As the chart indicates, executives of all four varieties abound. If executive pay were under control, the number of companies outside the elliptical region would be small.
The structure of executive pay is badly flawed. To achieve pay-for-performance, base pay should be moderate, and variable pay, related to performance, should dominate rewards. Unfortunately base pay has been rising fast, and almost all other elements of compensation are currently tied to base salary. This is true for elements such as pension and life insurance, but unfortunately is also true for the supposedly variable pay such as bonuses and options, which are often capped as a multiple of base pay. Clearly, any executive who wishes to be well paid should focus on pushing up his or her base salary.
The performance measures used to reward top executives are often inappropriate. For example, during the technology boom, many businesses measured and rewarded senior executives on the basis of earnings before interest, taxes, depreciation and amortisation (EBITDA), claiming that this represented cash flow from the business. In a sense this was true: EBITDA does broadly represent the cahs which comes out of a business (ignoring working capital movements), but unfortunately it takes not account of the cash that goes in the form of capital investments and so on. The results were predictable.
The composition of executive pay also fails to create alignment with the interests of shareholders. Too much pay is paid in the form of cash, share options and unrestricted shares and far too little in the form of restricted stock.
The process of scheme design is the root cause of these problems. The accepted process by which schemes are designed is as follows. First, a benchmarking exercise is undertaken to understand the state of the executive remuneration market. A scheme is put forward which mirrors those in peer companies. The resulting scheme conforms to the guidelines set down by shareholder organisations such as the Association of British Insurers (ABI). Finally the scheme will be reviewed again in a year's time. Each of these elements is a source of problems.
First, the benchmarking. Most organisations aim for median pay or above. For many companies this exercise will represent a clear opportunity to nudge pay upwards as, by definition, half of all companies will be below the median.
Secondly, the shareholders' guidelines, paradoxically, make the problem worse. The ABI, for example, has avoided giving guidelines in absolute terms and presents most of its suggested caps on reward as multiples of salary, fuelling the upward spiral.
Finally, for a long-term scheme to prove its worth, it must be left in place, essentially unmodified. Annual changes in the structure and level of schemes distort any long-term incentives for executives and suggest a lack of confidence in scheme design.
So what should the remuneration committee do? Take control. It is time for a fundamental rethink on executive remuneration, and this means that the resulting schemes may need to look very different from those they have seen in the past. Remuneration committees must change the way they approach reward. And they need to think about the alignment with the interests of shareholders.
