U.K. report highlights challenges for compensation committees
By Sarah Dobson
When it comes to compensation, the myth of the “superstar CEO” continues to drive excessive pay, as companies are desperate to attract and retain top talent — even if it doesn’t always lead to improved corporate performance and they have other options.
That’s according to a report out of the United Kingdom that delved into the weak spots of compensation committees and executive pay, along with making recommendations for improvement.
“There’s some kind of belief that if you are paying your chief executive top dollar, they must be the best. And, therefore, it sends a message out to investors that you’ve got right person for the job — even if that person doesn’t necessarily deliver,” said Charles Cotton, senior adviser for performance and reward at the Chartered Institute of Personnel and Development (CIPD) in London, U.K.
“The success of the organization seems to be attributed to achievements to one or two individuals at the top of the organization, and what we believe is that increasingly success is linked to… individuals in the whole organization — it’s a collective endeavour.”
“If you just focus all your rewards on a few people at the top, then the people in the rest of the organization after a while see this as unfair because they’re working very hard and they’re getting very moderate pay rises and bonuses whilst those at the top are getting significant pay rises and bonuses.”
There’s no doubt there’s been an inflation of compensation, especially since details of remuneration for top executives has been published annually, said Yvan Allaire, executive president of the board of the Institute for Governance of Private and Public Organizations (IGOPP) in Montreal.
“They thought it would shame people into not being so greedy — it did exactly the contrary. It gave a basis for comparison: ‘If so and so was paid so much, and that company is smaller than our company, why is he paid more than I am paid?’’’ he said.
“Of course, it’s been used by consultants as the basis to set remuneration… that’s the weak link but (companies) can’t can get out of it because they’re afraid they will lose key people.”
When everyone’s reporting against each other, it has that ratcheting-up effect on pay, said Jonathan Foster, vice-president at Accompass in Toronto.
“It comes back to that super talent — (boards) want to make sure they’re able to externally be competitive, but they also have to ensure all compensation is internally aligned,” he said.
“Compensation has significantly increased over time — I’m not denying that gap has widened — but also it has increased based on the necessity to have it be more performance-based. When it’s not guaranteed, we have to put more of an incentive in place; the more performance we put in there, the larger the carrot is.”
However, it’s important to differentiate between disclosed compensation and actual paid compensation, said Foster.
“Much of the reporting that’s out there, and what we see in the headlines, is around disclosed compensation… A lot of times, these awards aren’t actually paid out. Unless the performance is achieved three years down the road, the executives aren’t actually receiving those equity awards, or they’re worth a lot less than they’re being disclosed alongside the returns provided to shareholders.”
Diversity and expertise
Another problem with compensation committees is groupthink and a lack of professional diversity. This means members are drawn from narrow professional backgrounds, and there’s an absence of people management expertise, according to RemCo Reform: Governing Successful Organizations that Benefit Everyone, based on a survey of 20 remuneration committees and HR/reward teams, along with consultations with various stakeholders such as trade unions and academic experts, followed by a research seminar with another group of stakeholders.
A lack of diversity can mean people are not challenging decisions, said Cotton of CIPD, which released the report in partnership with the High Pay Centre in London.
“Because the people who are in these remuneration committees come from similar professional backgrounds as the executives themselves, they may not question what’s going on. So, what we’re saying is the membership of the committees could encompass a much wider range of backgrounds and perspectives that are perhaps less instinctively sympathetic to very generous CEO pay awards, and more challenging the assumptions regarding the risks and impact of losing the chief executive over his pay.”
However, the discussions in the boardroom and with the compensation committee are getting much stronger, said Foster, “and we’re starting to see on more boards the inclusion of that HR skill set.”
Along with more women signing on, “directors are much more cognizant as to the liability they face, and the individual voting against them, if comp decisions aren’t appropriate,” he said.
“Discussions in the boardroom are being enhanced and the focus on governance is continuing to increase, especially as we see lawsuits coming out. But, at the end of the day, I’m not sure that pay gap is going to be diminishing anytime soon.”
While some boards are extremely talented, others rely heavily on external consultants, said Foster.
“At times, the external consultant is making it too overly complicated in order to continue to hold that role.”
Most compensation committees are highly dependant on external consultants, said Allaire.
“They’re the ones running the numbers, doing the simulation, suggesting names of comparable companies. They come to the board with the thick document which has all of that… and there you are, you’re supposed to be informed enough, knowledgeable enough, experienced enough to start challenging,” he said. “People will question this and that but, in general, the dependence is pretty high.”
Complex packages
That highlights another challenge for compensation committees: The pay-setting process has become very complex, according to the report. Many pay plans, for example, involve more than 20 different performance targets, measured over one- to five-year time frames, with each subject to different weightings, said Cotton.
That means the work of remuneration committee is resource-intensive, with contributions needed from HR, finance, legal, investor relations, the board and PR, along with external consultants and shareholders, he said.
“The way that executives are compensated, how their performance is recognized, is very complex. You’ve got lots of papers on things like deferment, and paying people in cash and shares and clawbacks, and it can be difficult for even the executives themselves to appreciate the value of these bonuses, and medium- and long-term incentives.”
Certainly, the whole process could be simpler, said Allaire.
“It has evolved as a response to pressures that the consultants… put on boards to have a compensation system that links to performance.”
In the past 10 years, particularly, the systems have meant, for example, a person is given stock in the first year and it’s linked to performance over three years, but then the next year, she is given more, so there are overlaps.
“That’s where it becomes complicated,” he said, citing company documents explaining compensation going that have grown from four to 36 pages.
To say there’s too much complexity is an understatement, said Foster.
“Pay packages at the executive level have become so complex over the last decade… with this whole focus on pay for performance.”
While it sounds great philosophically, many executives don’t fully understand how the incentives program works, or what they have to do to change it, he said.
There was a time it was just about a base salary and bonus at the end of the year, said Foster.
“Now, base salary is the smallest component in these executive plans. You have large annual bonuses but then you have a blend of these deferred units — whether it be stock options, restricted share units, performance share units, deferred share units, cash bonuses, retention awards — that have overcomplicated the entire process.”
Recommendations
As a result of the various challenges, the report makes several recommendations, such as companies establishing formal “people and culture” committees that show how pay practices relate to the strategy for people management and corporate culture.
“In the U.K., a lot of it is typically measured in terms of financial outcomes, such as profit, earnings per shareholder, return, etcetera. Now we recognize that these are important measures but there are also other important measures such as how you manage, develop and reward your employees, as well as how you treat your customers and clients,” said Cotton.
“What we’d like to see is a broader range of measures being used to assess not only executive performance but performance of the whole organization. And then that would be used to inform pay decisions for everybody within the organization.”
Long-term incentive plans should also be replaced as the default model for executive pay, said the report, with a less complex system based on basic salary, with an incentive to deliver a sustainable, long-term performance provided by a much smaller, restricted share award.
It’s about figuring how to get back to providing a fair wage for the executive role and responsibilities, while understanding that a portion of that has to be tied to the longer term to ensure sustainable growth versus one-time growth initiatives, said Foster.
“How can we make the programs simpler while still ensuring there is some sort of tie to shareholders over the longer term, but not having this ratcheting-up effect of performance measures on top of performance measures, which just lead to larger and larger payouts?”
But it can be difficult to prolong the terms, depending on the industry, said Allaire. In retail, for example, three years is a long time, while in aerospace, it would be considered short.
“In general, yes, the terms are too short but it’s not that easy to continue monitoring performance over a longer period of time,” he said. “People leave also; people change positions; there are practical issues in doing that, although it is desirable.”
The report also recommends succession planning and the development of long-term executive capability be explicitly included the committee’s remit, along with organizational fairness in relation to pay.
“If the people in the room weren’t so focused on the executive pay, they could be looking at things like succession talent, the pipeline,” said Cotton. “There’s a concern that if the executive goes, there’s nobody behind them to step into their shoes. But if the organization has got a talent pipeline… that shouldn’t be such an issue.”
Most boards view their CEOs as instrumental to the success of the organization, and say they don’t know what they’d do without them, said Foster.
“When we start to hear that — and we understand it is a tight labour market, it is externally competitive… ‘We have to pay at these levels to hold this individual because that’s market-competitive’ we always skip back to ‘Does it make sense internally for the organization?’ Because if, at the end of the day, this individual is going to walk, there’s also that hit-by-a-bus situation, and we’ve got to ensure succession planning is important, and we are able to continue as a going concern without any one select individual at the organization.”
