How is executive reward decided?

Executive reward has come under scrutiny in the downturn. Sam Barrett looks at how remuneration committees decide what to apportion the high-fliers

Scan the newspapers and you are certain to come across a story about a top executive receiving a fat pay packet. Such remuneration packages often comprise annual salaries in excess of £1 million; seven-, sometimes even eight-figure bonuses; and perks that can include anything from travel in the company’s private jet to allowances for gardening.

But although there are many examples of boardroom excesses, the process used to remunerate the UK’s top executives is one of the most transparent. Katharine Turner, UK practice leader of executive compensation at Towers Watson, says the way in which executive directors’ remuneration is determined in UK-listed companies is well established.

“When it comes to executive pay, the board’s remuneration committee makes decisions about both the structure and levels of reward,” she says. “These committees comprise non-executive directors, so that no individuals are involved in setting their own pay. The process behind this and levels of executive remuneration have to be as transparent as possible. Many companies that are not listed and are not bound by the same standards of corporate governance as listed companies adopt a similar approach.”

An executive’s package is typically made up of four components: base pay; short-term incentives, which are generally set for a year or less; long-term incentives; and other benefits, which could include a car, pension, health insurance and other insured benefits, as well as more unusual executive perks.

Pay levels among peers

A number of factors determine how each of these elements is set. Pay levels among peers is important. Karen Horne, chief operating officer for human capital at Ernst and Young, says: “When a company is setting pay, it will always look at the market to see what other organisations are paying. It is a sense check. It does not want to be paying too much, or be caught napping and pay too little and find itself with a retention problem.”

Although some of the figures can seem obscene, possibly ramped up by market pressures, Mark Hoble, a partner at consultancy Mercer, says that in most cases, executive remuneration packages are justified. “There is a shortage of people who can run companies in this country,” he says. “The stories that make the news are the exception. Remuneration committees operate well in the main; good practice just does not make the news.”

What a company is trying to achieve will also affect how the package is structured. James Berkeley, director of Berkeley Burke, says: “In organisations where dramatic change is required, often the easy answer is to use reward as the catalyst for the desired improvement. In these instances, it would usually be paid as some form of cash or short-term incentive.”

This type of structure can be seen in many boardrooms, with longer-term incentives being used to drive change. For example, Adam Crozier, the new chief executive at ITV, will receive a basic salary of £750,000 a year, which is less than his predecessor, but once bonuses are added, his package is bumped up to £14.4 million over five years, including a £5 million long-term bonus if he is able to improve the business’s fortunes.

Affordability of reward packages

Affordability is another issue when constructing reward packages. A prime example was in the dotcom boom, when cash-strapped start-ups lured employees with the promise of share options potentially worth thousands of pounds.

Horne says it is also sensible to ask the executive what he or she expects. “Most care about the business and their reputation, so this can give a good insight. I have known a number of chief executives who have taken a pay freeze because the organisation was unable to give other employees pay rises.”

As well as grappling with these factors, remuneration committees also weigh up the risk involved with the package they put forward. This takes several forms, including talent risk, where the package will not attract or retain the talent required, and behavioural risk, where the incentives engender behaviour the organisation does not want to see. They also have to think about reputational risk. Turner explains: “Remuneration committees have to think about a range of stakeholders when making decisions on executive remuneration and the need to ensure they are not about to set pay in a way that damages the organisation. They need to follow the Goldilocks principle. The structure and level of remuneration need to be neither too high nor too low, but just right.”

Getting the figures right

For listed companies, getting the figures right is essential. Dan Wilson, director of consultancy at NorthgateArinso, says: “The regulation is likely to get stricter as far as executive reward goes among the FTSE 100 companies. Large payouts, especially where there is not the performance to justify it, will be restricted.”

But whether or not regulation does get tougher, shareholders are looking closely at executive reward and any company seen to be acting unfairly risks negative public and shareholder relations. Rob Burdett, principal at Hewitt New Bridge Street, says: “Shareholders are taking a hard line. Companies will have to justify every penny they pay executives. If base increases, any large bonuses are paid or long-term incentives increased, shareholders will want to know why.”

For example, the Daily Mail and General Trust was criticised earlier this year by two corporate governance consultancies, Pirc and Manifest, when it published its remuneration report. Among the concerns, which the consultancies urged shareholders to vote against, were the size of bonuses and the editor’s pay deal, which includes a two-year rolling contract.

Aligning remuneration with shareholder return

Where remuneration committees work well, executive remuneration is designed to align with shareholder return.

“Many companies aim to design pay arrangements that motivate executive directors to perform well, thereby giving shareholders good returns,” says Turner. “If the shareholders get a good result, then the management team should be rewarded accordingly.”

However, this alignment may have slipped a little during the market slowdown. Although many executives are being rewarded for preventing companies from sliding further, their input is not feeding through to shareholder profit.
As well as disgruntled shareholders, poorly-structured executive reward packages can have a negative impact on other employees in the organisation. “It can very demotivating when an executive’s pay rise is disproportionate to that of other employees,” says Wilson.

Fair pay structure

He recommends that employers operate a fair pay structure, giving employees a better understanding of what they are paid and why. This approach also enables staff to see how they can develop within the organisation and earn more.

Towers Watson’s Turner agrees, pointing out: “As long as the principles underpinning the determination of an employee’s pay [levels] and that of the chief executive are the same, then one might argue that employees should not get disgruntled.

“Tournament theory says it is good for organisational performance for employees to have something to aspire to.”

When do pay rises become ineffective?

Salary is just one part of an employee’s total reward, but it is not necessarily the main motivator. All sorts of other matters, ranging from experience and the prestige of working for a particular company to the benefits package or the office culture, will keep an employee motivated and productive.

But gauging when a pay rise becomes ineffective is tricky. Mark Hoble, a partner at Mercer, says although success is often more of a motivator among executives than money, the size of reward does help to keep score. “It can come down to some very fine differences,” he says. “If an executive is paid the same as a peer, they will not like it. They will want more, even if it is only a few thousand pounds more.”

Similar mechanisms come into play lower down the scale. Rob Burdett, principal at executive remuneration consultancy Hewitt New Bridge Street, says: “Employees want to know they are fairly paid, but other factors, such as training and better office facilities, can be just as important.”

Providing training to help with career development can work well, enabling staff to see how they can progress through the organisation. Although part of the appeal may be a higher salary, greater staff satisfaction can be achieved by knowing they are appreciated and valued.

Flexible benefits plans can also work. Allowing employees to put together a package of benefits that suit their needs can be a very positive indication of the employer’s attitude to its staff.

As well as considering whether a pay rise will be an effective way to motivate staff, in these cash-strapped times it is also important to weigh up whether it could actually have the reverse effect. Dan Wilson, director of consultancy at NorthgateArinso, explains: “A very low pay rise can be challenging because it can demotivate employees, especially if organisational performance is good. If a firm takes this action, then it must be confident that employees are happy and feel rewarded in other ways.”

Rewards can be free

The current economic climate means few employers can afford to throw money at staff with pay rises and big bonuses. But with a talent war possible as the economy recovers, organisations must make sure their employees feel motivated.

Because of this, ‘free’ rewards such as more time off, unpaid sabbaticals and flexible working hours are becoming more popular. Dan Wilson, director of consultancy at NorthgateArinso, says: “An extra day off or flexible working arrangements can be very valuable. It also says a lot about the culture of the organisation and how it values its staff.”

The concept of a ‘free reward’ is taken a step further in a report by McKinsey and Company, Motivating people: Getting beyond money, published in November 2009. In a survey of executives, managers and employees, it found non-financial incentives, such as praise from a manager, attention from leaders and opportunities to lead projects, were seen as more effective motivators than the financial incentives of bonuses, pay rises and stock options. For example, although cash bonuses were seen as effective by 60% of respondents, 67% saw praise from a manager as effective.

The changing shape of bonuses

Executive bonuses are an effective means of rewarding performance, and their size and nature are shaped by economic factors, as well as pressure from shareholders. For example, Ernst and Young’s Executive remuneration survey shows there was a 10% fall in the size of the bonus that FTSE 100 directors received in 2009. FTSE 250 companies saw a larger fall, with bonuses down 25%. And with many of these bonuses set before the recession, the chances are that 2010 will see a further fall.

But although payouts might be falling, Karen Horne, chief operating officer for human capital at Ernst and Young, says bonuses will not disappear. “Bonuses have not fallen out of favour with the market, they are just more focused on the achievement of particular targets,” she explains. “In the current climate, companies probably need their executives to be even more focused and bonuses are a good way of achieving this.”

Rather than being targeted on profit, it is now much more common to see bonuses being set around areas such as reduced operating costs and debt management.

Also, and particularly in the current tough economic climate, it is becoming more common for executives to defer their annual bonuses. Katharine Turner, practice leader of UK executive compensation at Towers Watson, says about half of executive directors now defer between 40% and 50% of their bonus, usually for a period of three years. “We have also seen remuneration committees designing pay arrangements which place more emphasis on variable pay, both short-term and long-term,” she adds. “This trend has been emerging over several years.”

With business secretary Lord Mandelson entering the fray and with calls for Stephen Hester, chief executive of the Royal Bank of Scotland, to give up this year’s bonus – £1.6 million in shares – this could become an even more common occurrence.

Share options as a form of bonus have also come under more scrutiny during the downturn. Generally awarded as a percentage of salary, the slump in the stock market has raised issues for those using share options as a reward. Lower share prices mean an executive would receive more shares, which, according to Horne, could mean the company has to buy shares rather than use those it has reserved for the purpose.

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