Back in the early 1980s, when chief executives tended to get bonuses of around 20 per cent, it was their base salaries that generated the headlines. Nowadays, when the greater part of an executive’s remuneration often comes from cash bonuses, shares, golden handcuffs, pension top-ups, options and long-term incentive plans – it is their performance-related reward that interests us. Perhaps it would be more honest to say that it irritates us, as the complexity of these awards can seem deliberately opaque.
This distrust of executive performance-related pay (PRP) has not been helped by perplexing million-pound rewards for executives who are perceived to have “failed” in their tasks. Shareholders at Sainsbury, for instance, were so unhappy with the £2.4 million bonus awarded to chairman Sir Peter Davis after the supermarket chain lost market share that he was forced to resign. And Shell came under fire for handing pay-offs worth £2.5 million and £1 million to two senior directors who resigned over the scandal caused by the over-statement of its oil reserves.
And when experts start to question the status quo too, then maybe it is time for a rethink. Sir Andrew Likierman, professor of management practice in accounting at London Business School (LBS), believes executive reward has several key failings.
At a recent London Business School/SBC Systems debate he pointed out that there is often little hard statistical evidence for the impact of an executive’s performance and, in addition to many performance measures being perceived as arbitrary and incapable of being benchmarked, executives can receive high PRP simply because an organisation benefits from an upswing in the economy.
Add to this Likierman’s contention that relatively few remuneration committees are brave enough to pay less than the “median” rate for executive pay, suggesting that most are paid above true market rates and, he says, we might as well give a chief executive base pay alone, based on market rates and, if they “fail”, then sack them.
“There are huge and often dubious assumptions in making the link to reward,” he says. “The most defensible approach [and one which avoids the difficult performance measurement issues] is to focus on recruitment and retention. However, if the link to performance is regarded as essential, the measurement problems involved must be taken into account. Not all of these can be solved, so the outcome will be a scheme which involves trade-offs, not right answers.”
The inaccuracy of PRP is not a secret among reward professionals and perhaps the time is not long off when some employers will seek a return to base pay. In the meantime, most are ploughing on with the imperfections of PRP.
Graham Drewett, BP’s UK reward and benefits manager, is certainly aware of the challenges. “External pressures will influence the performance of the business. The chief executive might have done a brilliant job, but that may not be reflected in the external results and there will often be a lag factor – good performance may have a result largely in a different year.”
But, he adds: “Although a solution may be to reward with direct relation to immediate performance, that may encourage short-term thinking.”
CIPD president Vicky Wright, an expert in executive compensation who also attended the LBS debate, believes that while there is a wide difference in pay between high- and low-performing companies, in the mid-range there are discrepancies.
“At these [mid-performing] companies there are people who can produce very good performance, but do not get paid very well and there are people who produce average performance who are better paid,” she says. “One of the problems with the measures that institutional shareholders want to see in share plans is that they have a high level of “misread” to them. This can mean that sustainable higher-performing companies tend to get less than a turnaround company.”
Another area of inefficiency occurs when remuneration committees feel that paying over the odds for a chief executive is worth it.
“We did some research with remuneration committee chairs on chief executive pay and their biggest worry was the loss of executive talent,” says Wright. “If you have got a high-performing executive you are very worried about losing them. There is an element of remuneration committees wanting to be able to face the chief executive and say ‘I think you are paid the right amount of money.’ They do not want pay to be an issue.”
And because the consequences of getting it wrong can be costly, many remuneration committees favour experience, rather than appointing someone young and relatively cheap.
In spite of these problems, Wright believes that executive pay is past the point of no return and cannot go back to base pay alone.
“Paying someone a base salary of £3-4 million would not be acceptable to shareholders,” she says. “It could mean paying too much for average performance. Ideally you would want to pay people significantly less for not performing, but not to the extent of sacking them.
“My own view, from more than 20 years’ experience, is that variable remuneration for executives has resulted in them taking some of the more difficult decisions about the longer term.”
Wright, like many consultants, is looking for ways to improve the way executive pay is calculated. She is working with Watson Wyatt, where she is a senior consultant, on research that is hoped to show a clear correlation between the success of a company and the relative size of its PRP.
Elsewhere, PricewaterhouseCoopers (PwC) is involved in work that aims to show how a company’s key performance indicators are linked to executive pay. Companies too are making their incentives more transparent. Over the past two years there has been a marked increase in the number that use non-financial measures such as health and safety figures, customer satisfaction levels or employee engagement as a factor in calculating executive pay. Imperial Tobacco, for instance, uses measures of employee productivity and environmental targets when calculating elements of executive bonuses. Meanwhile, 20 per cent of the bonus for Shell directors is decided on whether the firm has met sustainable development targets, which include the number of work-related injuries.
Some of this is driven by the growth in the publicity around corporate social responsibility, but part of it is that reward professionals are getting better at what they do – and at admitting past mistakes.
Tom Gosling, a partner at PwC, says: “Looking only at financial measures is like a driver looking in the rear view mirror. It is important to look at leading indicators of the health of the business. Well over half of bonus schemes now use these kinds of non-financial metrics. PRP is certainly getting better. We are moving out of a period of being particularly bad at it.”
Non-financial targets tend to differ by sector. In financial services, customer and employee satisfaction levels are an important indicator of future revenues, while in sectors with long-term projects, reaching a key milestone might be a non-financial target.
Financial targets are also becoming more specific and varied. Cost reduction, operating margins or turning the business around in a short time frame (as used by Sainsbury and Cable & Wireless) are all popular.
As Gosling says: “It certainly used to be the case that the design of long-term incentives was entirely driven by looking at what everyone else did, without any real reference being made to the specific circumstances of the company. That has now changed. We are now seeing far greater use of performance measures and designs that are bespoke to a particular company’s circumstances.”
How KPMG engaged staff on performance-related pay
As well as changing public and shareholder perceptions of the fairness and transparency of executive reward, some employers are making strides in changing their employees’ perceptions too.
Over the past two years KPMG has sought to improve employees’ perceptions of performance-related pay. This was triggered by a survey that found that only a third believed there was a good link between performance and reward.
“We have devolved some of our decision-making away from the centre and the most senior managers, to people who are managing closer to the performance. We have given them the structure and guidance to make the decisions,” says Samantha Gee, KPMG’s head of reward. “We also give quarterly updates on how the bonus pool is growing. Now it is a motivator rather than a surprise.”
Elsewhere, KPMG is communicating more about how it comes up with its annual bonus pool figure, from which all bonuses are paid out, and clearly states what the performance goals are at the start of the year. A KPMG director can expect a bonus of anything between 40 per cent and 100 per cent of their salary in a good year and the company is keen to increase these differentials.
Overall, KPMG’s plan seems to be working. The company’s internal people survey showed that perception of performance-related pay was the most improved indicator in 2006, with half of all employees seeing a clear link between performance and reward. The 2007 figures are not yet in, but Gee expects to see further improvement.
Executive pay measures: the statistics
Only 20 per cent of FTSE-100 companies now rely solely on measures of financial performance in their annual bonus schemes, according to PricewaterhouseCoopers’ annual report on UK executive pay for 2007.
Measures of customer satisfaction, employee engagement, health and safety, market share, environmental standards and risk management are all now also being used to help determine executive reward.
Total shareholder return and growth in earnings per share remain the primary performance conditions in UK plans, though other measures, including return on capital employed, strategic project milestones, costs, cashflow, revenue growth and operating margin are being used.
Other figures in the review show that FTSE-100 chief executives’ pay increased by 8 per cent – well above pay settlements and increases for the average employee. And that one-third of board directors in FTSE-100 companies received above 80 per cent of their maximum bonus potential, while 5 per cent of board directors received no bonus whatsoever.
Samantha Gee, KPMG’s head of reward, will be speaking on making performance-related pay work at the CIPD’s Annual Reward Conference from 5-7 February at London’s Olympia. www.cipd.co.uk/cande/reward