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Under fire

26 October 2015

Under fire - read more

Do complex pay schemes represent value, asks Simon Osborne

Complex executive pay schemes are coming under fire as regulators, shareholder trade bodies and, I suspect, companies are wondering if they represent value for money. These pay packages have become so hard to explain that not all executives who benefit from them understand how they are to be paid.

It used to be the case that you were paid a salary and when you delivered something that was significantly above and beyond the day job, you were paid a cash bonus for it. Not only is this an easy system to understand, it also has the added benefit of meaning that a bonus is not perceived as being part of someone’s salary. A bonus was won on merit, not just because you turned up for work. Exceptional performance was rewarded and mediocre performance was not. The initial charge to link executive rewards to performance was led by investors wanting to align directors’ interests with their own, but they are now recognising that long-term incentive plans (LTIPs) might not be the appropriate way to do so. LTIPs are hardly long term (with the best will in the world, three years can scarcely be considered long term) and they are not particularly reflective of whether or not an executive is doing an exceptional job – as share price is affected by more than just what a chief executive is doing at any given moment. 

Someone could be doing a good job but external factors beyond their control could send the share price into a tailspin. Conversely profits could be down, but an executive might still see his or her salary inflated by an LTIP. Recessions and recoveries have a massive impact on share price and it is difficult to link performance to such force majeure events.

Take the UK housebuilding sector. Share schemes that were introduced when there was a depressed economy and a low level of activity have jumped wildly since the recovery. Persimmon shares, for example, were hugely inflated by the effect of the Help to Buy scheme. What probably started out as a reasonable pay scheme has ended up being extremely costly because of favourable economic conditions rather than anything specific that the chief executive might have done.

In the UK, a panel of City executives – the Executive Remuneration Working Group set up by the Investment Association – is examining how to simplify executive pay. In particular, it is considering whether to scrap long-term share awards. I do not believe that awarding high-salaried chief executives bonuses in the form of shares really encourages them to perform better or stay longer at a company. When executives leave a company, they are more than adequately compensated for any potential loss of share income by the company they are joining.

Is paying a bonus even the answer at all? Expectations in some industries have become so distorted that they have a hissy fit if they are paid less than the GDP of an emerging nation! There is no real proof that paying a bonus makes people work harder for longer. It can even be a disincentive because when people find out that someone else has been paid a bigger bonus than they have they tend to become disillusioned and make less effort. Bonuses can also lead to inappropriate behaviour as we have seen in the financial services industry.

Dr Alexander Pepper, Professor of Management Practice at the London School of Economics, argues that executives ‘perceive the value of long-term incentives to be less than the cost to the company. This means that they are not motivated by the plans and this affects their performance.’
If complicated performance targets destroy value, how about scrapping bonuses entirely? Most executives are driven because they like to achieve things rather than for financial gain and with the basic salaries that most executives are now paid, they may still do a good job without share options or large cash bonuses.

America’s General Electric thinks it is such an honour to work for them that they do not offer bonuses to the chief executive. Perhaps this is the way forward. According to the big accounting firms, executives get 70% of their bonus whatever happens, so maybe it is time to go back to basics. After all, Jeroen van der Veer, former chief executive of Royal Dutch Shell told the audience at a conference in 2009: ‘You have to realise that if I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse.’

Simon Osborne is Chief Executive of ICSA

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