• This autumn’s remuneration committee (remcos) meetings will be weighing up the internal and external factors influencing a company’s performance, then balancing this against the need to reward executives without upsetting shareholders who have also been hit by falling share prices.
• Executives get greater comfort from their annual bonus because the measures are often factors they can directly influence.
• Remcos are increasingly including internal financial measures (such as return on capital and free cash flow) as part of the performance target for share plans.
• The weakness of total shareholder return is that it is a comparator measure based on share price, so it very much depends on the date the shares were awarded and other external factors that executives can’t influence.
• Recalibrating performance measures for long term incentive plans often involves consulting shareholders to avoid potential problems when disclosing in the year-end report.
Remuneration committees need to meet both executive and shareholder expectations, says Debi O’Donovan.
A key cause of the credit crunch has been employees chasing large incentive bonuses in the investment banking and mortgage sectors with little regard for the fallout of their actions.
Ironically, the resultant economic downturn is now impacting incentive schemes across all sectors as employers try to hold onto senior staff in a climate that has sent share options underwater, shrunk DC pension pots and made earning a bonus look as likely as Amy Winehouse going teetotal.
Little more than a year on from the start of the credit crunch and we are seeing increasing numbers of companies reworking their executive remuneration plans. Research conducted by Towers Perrin for the Sunday Times showed that 80% of the FTSE 100 firms which had reported their 2007/08 numbers by 30 June have seen the value of their CEOs’ shares and option awards decline by an average of 30%. This trend is creating a dilemma for remuneration committees (remcos) who need to hold on to top talent just when their reward values are dropping, while setting realistic and motivational targets through to 2010.
This autumn’s remco meetings are going to be all about weighing up how much a company’s performance is due to external factors and how much is due to the performance of the management team. And then, if management is deemed to be good, keeping the execs fairly rewarded just when shareholders are feeling sore from taking a knock from deflated share prices.
It is expected that there will be more use of remco discretion to pay bonuses that reflect either an upward or downward trend to bring in a reality check at the year-end. Sue Bartlett, senior consultant – executive compensation at Watson Wyatt, says: “That could be in either direction, to improve the bonuses or reduce them; whether the focus is on keeping staff who have performed well even though the results haven’t come out as well as hoped, or avoiding shareholder approbation if bonuses appear to be unacceptable to shareholders who have suffered a substantial loss in the share value.”
However, both shareholders and remcos are sensible enough to realise that share plans need to be motivating and that there is no point in setting targets that are unachievable. The good news for execs is that bonus payouts have not dropped as dramatically in the past year as they did after the dotcom crash, although this is largely down to timing.
In the 2001/02 cycle the bad news started to hit after most executive incentive decisions had been made, so many bonus targets were not met at the end of the financial year. “There was a really big drop off – the market data shows a really big fall in the size of bonuses that year. They quickly recovered the following year even though the economy wasn’t much brighter, because most bonuses are set according to budget,” says Bartlett.
This time not only have companies had time to set budget-related targets, but executive teams have also approached remcos to ask them to recalibrate bonus schemes. “What that means is that annual bonuses get looked at. Executives often get greater comfort from their annual bonus – in the sense that the measures are often things that they can influence directly – than these slightly more intangible relative total shareholder return (TSR) type of measures,” says Mark Hoble, a principal at Mercer.
In addition, TSR comparator measures can be a blunt instrument. Mark Smith, a senior consultant at Lane Clark & Peacock, says: “At the moment the tools are quite crude – if an executive falls below the median then they get very little or nothing; if they hit the first target then they will get most of the payout. But it is hard to increase this amount if they go well above the target.”
There has been a recent trend for remcos to include more internal financial measures as part of the performance target for share plans, such as long term incentive plans. “A few years ago total share holder return was almost nirvana. Now what remcos are seeing is selective use of some internal financial measures for longer term incentives,” says Hoble.
The weakness of TSR is that it is a comparator measure based on share price. So an executive working for a company that has performed well over a sustained period may actually have done well by their shareholders. But they may still be marginally below median because other companies in the comparator group have been in a turnaround situation which has delivered a big increase in that period from a low base. “Of course there are underlying problems with using TSR as a performance measure because of the lottery element. It very much depends on the date the shares were awarded and other external factors,” says Bartlett.
TSR is now only likely to make up half the award, with the other half based on internal financial measures such as return on capital and free cash flow. And an increasing number of companies are adding in non-financial measures such as delivering a project on time and to budget†
Companies are looking at the performance conditions for future awards very carefully and are recalibrating them as needed. Whereas 18 months or two years ago remcos may have felt execs were able to deliver earnings per share of 10% growth above RPI, now remcos feel that execs would be doing well if they could deliver about 3% above RPI. “There is no point in [them] issuing awards that require 10% to vest, as it will have an immediate negative effect on the executives because they will say ‘there is no chance of achieving it’,” says Bartlett.
This often involves consulting shareholders, not necessarily via a vote to approve change in advance, but at least consulting the shareholders to make sure companies are not going to come a cropper when they come to disclosing in the year-end report.
So we can expect some pretty close scrutiny of the performance measures being set this reporting season, not least because they will have ramifications several years’ hence.
Hoble, says: “If corporate performance is declining generally then [shareholders] will want to see that reflected in executives’ packages. If the likes of the ABI don’t see that link between pay and performance, we might well see executive compensation coming up the political agenda again.
“At the moment the government isn’t really interested, but in the run up to the election they could get interested again if people are still walking away with very large packages even though the performance of their company is poor.”
Pension benefits for executives
The discrepancy in the reward packages for executives in defined benefit (DB) compared to those in defined contribution (DC) schemes has grown even greater with the fall in stock markets.
Mark Smith, a senior consultant at Lane Clark & Peacock, says: “Post A-Day, executives in a DC scheme are being getting offered contributions of 20-30%. So the contribution is half to a third of the value that a DB colleague is getting.” Largely, employers are not trying to match DB levels because of the punitive costs, and in time the problem will pass.
Mark Hoble, a principal at Mercer, says: “On the rare occasions where you do see special arrangements are only with chief executives that are still in a DC [that is] designed to give as much value as you would get out of a DB plan. But they are very, very rare.”
Alternatively, remcos bear the differences in mind when deciding on pay increases. “I have certainly known remuneration committees who say every £1 we give people who are in the DB costs a lot more than every £1 that we give to people in the DC plan, so it will be a lower [pay increase] to one than the other. I don’t expect they would communicate that very explicitly,” says Sue Bartlett, senior consultant – executive compensation at Watson Wyatt.
Rate of accrual for pension benefits for executives
Greater than 45ths 37%
Less than 60ths 11%
Employers’ contributions for DC for executives
Less than 5% 12%
More than 20% 12%
For more information on pay, bonuses, reward and share schemes: www.employeebenefits.co.uk/benefits/pay-bonus-reward