There was understandable outrage when Income Data Services announced earlier this year that directors’ pay in 2011 had been hiked by 49 per cent. Coming at a time when pay increases generally are well below inflation, this was seen as another indication of the rich doing well at the expense of the poor.
But two days later IDS sheepishly admitted that 49 per cent is “far from the whole truth”. They explained that a few people making large gains on share options can disproportionately influence the average increase figures. IDS went on to admit that the median salary rise (a more commonly used measure) was 2.1 per cent and the median increase in total earnings was 16 per cent.
Of course the media and the politicians saw only the first announcement and there can be little doubt that it contributed to the view that executive pay is out of control and something has to be done about it. The response from the Government is to promise legislation that will increase the powers of shareholders to reign in executive rewards and termination payments.But this focus on the magnitude of executive pay means that there is too little attention being placed on how pay is structured and the behaviours that this drives.
The trend in executive pay has been to create alignment between the rewards for executives and shareholder interests.This is achieved principally through share options, restricted stock awards or long term incentive plans based on total shareholder return.There are two key problems with this approach.
Firstly, these incentives place a huge premium on share price movements. It causes executives to become fixated with the share price. But share prices are volatile, driven by many factors outside the control of managers and are only loosely connected to company performance over the three to five year horizon of an incentive plan. Rewards linked to the share prices are likely to oscillate between windfall gains and unjust penalties. More worryingly, they place a huge premium on short term financial engineering over sustainable business building.
Secondly, the growth in executive incentive plans comes at a time when serious doubt is being cast on the effectiveness of incentives in raising performance. The psychological evidence is very strong that incentives are effective at raising performance only for ‘algorithmic’ tasks that require little thought, judgment or creativity. With higher order, ‘heuristic’ work it seems that incentives can actually lower performance by interfering with more powerful intrinsic motivators that drive us all. Incentives certainly influence behaviours but beware the law of unintended consequences.
Shareholders and remuneration committees need new thinking on what they want from executives and how they judge their performance. Instead of rewarding financial engineering they should encourage stewardship, where executives are judged on business building and whether the organisation they pass on is in better shape than the one they took over.
This means executive performance should be judged against a mixture of financial and business building measures. Financial measures might include Economic Value Added or EBITDA. Business building should include the value of brands, human and intellectual capital.
This will make life a good deal harder for remuneration committees. Instead of commissioning a complex formula and then sitting back and letting the formula decide executive rewards, committees will have to use their business acumen to make judgements. They will have to explain and defend these judgements to shareholders, the wider public and if necessary, tough it out with executives.
A stewardship approach that required remunerations committees to explain their judgements would be more transparent than current incentive plans with their byzantine complexity. It could not only lead to simpler measures of executive performance but could also drive the right behaviours in the boardroom.
Stephen Brooks FCIPD, is an expert in people management at PA Consulting Group
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