Under pressure

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The current climate has thrust executive compensation into the spotlight. Fragile economic performance puts intense pressure on management to create value and, as a consequence, executive incentives and rewards take centre stage, particular when viewed against the backdrop of falling real wages for many employees.

The cycle of popular outrage over pay levels and the perceived weak link with performance mirrors the economic cycle. When markets are rising and times are good, the focus on pay lessens, but when times are tough and there’s a perception the pain is not being shared equally, the same old concerns remerge. So, where do we currently stand on executive pay and what lessons have been learned?

There has been progress in several key areas. First, reporting transparency has improved dramatically in many jurisdictions. The UK leads the world in this. Investors have more information than ever on the level and mechanics of executive pay and it is, therefore, unsurprising that the debate shows no sign of relenting: informed criticism is the natural outcome of more clarity.

Second, the link between pay and performance is now stronger than ever. Performance-based vesting conditions and peer group benchmarking are the norm for long-term rewards in the UK. Executives’ ability to benefit from uncontrollable upward market movements has been curbed.Third, there is a noticeable trend towards greater use of deferred bonus plans as a means of combating managerial myopia and excessive risk-taking.

But despite all that, the fundamentals remain questionable. Take recent bonus forfeits such as Lord Wolfson at Next. Whether or not such actions represent a noble gesture or an opportunistic PR exercise, they are cause for concern. On the one hand, high-performing CEOs should not feel pressured to forego rewards that correlate with value creation (Next’s share price almost doubled over the vesting period). On the other hand, poorly performing CEOs should not receive such payouts in the first place. Whichever way you look at it suggests a problem.

Consider also the pressure on executives to repay bonuses (see Co-op Bank and Diamond Foods Inc.). While clawbacks placate the media, they merely serve to highlight inadequate compensation arrangements. Shutting the stable door after the horse has bolted – and destroyed the yard – is hardly a solution to the incentives problem. The key to effective compensation is establishing incentives that ensure executives only take appropriate risks in the first place.

Similarly, while performance-vesting conditions are a step forward, the devil is in the detail. Vesting conditions based on earnings-per-share (EPS) growth are typically undemanding: judged against analysts' expectations, the average EPS growth target has a 90% probability of being achieved, resulting in very little impact in reality. It's a question of substance over form. 

The prevalence of dubious performance metrics such as EPS and total shareholder return (TSR) raises further questions. The link between EPS growth and shareholder
value creation is dubious at best. Meanwhile, TSR fails to reflect expected returns properly.

The bottom line is that progress is being made in key areas but the pace is slow and the changes incremental. Corporate self-interest should be sufficient to drive further improvement because the alternatives, like mandatory caps on pay, are in no one’s interest. It is surprising that boards often seem reluctant to take the initiative. The failure of boards to anticipate and deal with the reputational consequences of sensitive payout decisions is both naïve and self-defeating, not only for their firm but for the executive pay debate more generally.

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