Monday, 1 September 2014

What is the problem with executives’ and directors’ pay?

During the last decade, executive directors and non-directors pay has attracted public and media interest mainly by reason of the overly generous pay offered by employers to this specific category of employees. According to research, in the period from 1998 to 2011 the median total remuneration of FTSE100 CEOs recorded an average growth from £1m to £4.2m. In 2011, nearly a quarter of FTSE 100 CEOs benefited from a 41 per cent total reward package value rise vis-à-vis the previous year; however, the average pay increase in the period has been calculated at 12 per cent. The findings of the investigation also revealed that pay increases mostly occurred in the form of deferred bonuses and long-term incentives, whereas base pay increased of just 2.5 per cent on average (Manifest and MM & K, 2012).
The worth of the reward packages earned by CEOs and the pace at which these have increased during the last years have both attracted public interest and bad press, insofar as political leaders too have turned their attention to this issue and laid specific laws down. In general, governments and regulators of many European countries have imposed restrictions on public sector and financial services organizations, mostly whether these are state-supported. None of the European countries has, however, adopted any particular measures in regard to the executive pay of the private sector organizations.

The main reasons why during the last decade executive pay has remarkably increased are usually associated with:
Ø  The extended level of responsibility taken by CEOs for organizations becoming increasingly larger and complex (Kaplan and Rauh, 2007);
Ø  The drawbacks produced by the need for more strict governance controls over executives’ pay, requiring many employers having to disclose executives’ pay details. Since employers benchmark their directors pay against the reward packages offered by their competitors, this has caused businesses to offer executives more generous reward packages in order to retain and attract quality professionals. For the same reasons, employers of countries where no regulations on executive pay transparency are in place have felt a fortiori encouraged to offer directors more generous reward packages (BIS, 2011);
Ø  The evolution of rewarding systems which tend to become the more and more sophisticated, accounting for employers paying larger amount of variable pay in a bid to more effectively link executives’ performance and results to pay;
Ø  The trend pushing reward specialists to develop more complex reward systems favouring deferred pay. Since according to these arrangements the higher the level of risk the higher the pay, the base for pay is usually inflated in that  objectives might not be attained and executives might in turn receive reduced bonus payments, if any (PwC, 2011);
Ø  The complexity of reward arrangements which may cause the link between performance and reward to be blurred, at best, and completely lost, at worst. Moreover, being these systems based on a larger number of reward options, it is very likely that in the end some of them will be paid despite not completely justified by the real executive performance.
According to the Croner’s “Directors’ Reward Survey” (Cree, 2010), however, the typical director’s fat cat image can be considered just as an executive representation of the past. Findings of the investigation revealed, but this should not come as a surprise, that many executive directors work more than 60 hours a week (21 per cent) and that some of them seldom take all of their contractual holidays. As regards the link between pay and performance, only half of the participants said that their pay is linked to performance; it also emerged that this occurrence is mostly typical of large organizations. Nearly 50 per cent of directors reported just a 2 per cent salary increase, 37 per cent said that their pay had been frozen and 9 per cent of the respondents to the investigation said that they had even undergone a pay reduction. Only 40 per cent of the directors reported having received a bonus during the previous twelve months. The investigation also revealed that the typical bonus amount was of £25,000 for executive directors and £15,000 for executive non-directors.
The findings of the survey actually depict a scenery overly different from that known to the general public. The investigation backdrop may possibly help to find out the reasons for such different depiction. The questionnaire was sent by Croner to 45,000 members of the UK Institute of Directors (IoD) whereas only 745 executive directors responded to the survey, namely less than 1.7 per cent. The final result of the overall investigation is hence the result of the opinion expressed by a minority of directors, possibly those less happy with their current experience and circumstances.

Notwithstanding, the real reason for executive pay having caught the public interest and having had bad press during the last decade is not that much associated with the generous sums of money paid in absolute terms by employers to this specific category of professionals, but rather with the lack of a clear cause-effect relationship between such generous payouts and performance. In many cases, executive directors have received very large amounts of money even for having failed to attain organizational objectives. This bad practice, known as “rewards for failure”, has also actually had a remarkable impact on executives’ and directors’ payment of severance packages. In some cases in fact executive directors have received extremely generous severance payouts upon leaving their companies also after having outrageously failed to attain their objectives.
Averting to reward executives for failure
In many countries the awareness of the negative impact provoked by such bad practice has prompted governments to take appropriate actions. However, also the shareholders of many organizations have expressed concern for the serious threat this undesired habit could pose to their companies, not least from the reputational viewpoint.
The identification of a series of measures aiming at preventing executives to be rewarded for failure has become hence necessary. Amongst these, requiring shareholders vote on executive directors pay and attributing to this a binding value is definitely considered of crucial importance. Giving firms’ shareholders “say on pay” is believed to prompt these to be more involved in the business management and to publicly provide evidence of the significance organizations associate with their executives’ pay decision-making process. Indeed, by reason of the relevance the phenomenon has lately acquired, shareholders’ vote should also be introduced for severance payments determination. In the UK, this requisite has been legally introduced by the Companies Act 2006.
Since the largest component of executives’ reward packages is represented by variable rewards, particular attention has to be paid to the development of schemes establishing a clear line of sight between pay and performance. Care needs indeed to be taken during the implementation phase too; also in this case a sensible difference could emerge between what has been designed on paper and implemented in practice.
The role of remuneration committees is clearly paramount and members composing these should never forget that their main objective is that to foster the long-term interest of the business.
Members of remuneration committees are habitually individuals who have the professional experience and expertise to identify challenging objectives, set appropriate reward packages and develop effective assessment methods of executive performance. On the other hand, however, these individuals, just by reason of their past experience, are also considerably influenced by the “generous pay” culture, insofar as what may be deemed as excessive for the general public could be simply considered as a norm for them (The High Pay Commission, 2011). Additionally, remuneration committee components usually tend to design and introduce pay arrangements based on traditional approaches, rather than coming up with new methods fitting the business circumstances (Main et al, 2008).
It is the more and more believed that diversifying the composition of these committees, avoiding these to be entirely formed by non-executive components of the board, may definitely help (BIS, 2011). To this extent it may turn to be particularly effectual asking independent members with, for instance, academic, consultancy and advisory background (Hay Group, 2011) to become part of the commission with no need for these to become full non-executive members of the board (BIS, 2011). The different background and expertise of these individuals could indeed enable organizations to gain new perspectives and develop new approaches to executive pay practices (TUC, 2011).
An additional feature, more directly associated with the full independence of the remuneration committee members and in turn with their impartiality of judgment in terms of executive pay decision-making, relates to the circumstance that many directors may cover at the same time different positions in different organizations. This may cause that, for instance, a person making pay decisions about the pay of another individual in a given organization is subject to the decision made by that same person in a different organization, still in terms of reward. This could clearly affect the pay decision process in both organizations and cause evident conflicts of interest which should be averted from the outset (BIS, 2011).
Some stakeholders in the UK have supported the idea that, in order to implement a radical and effective change in the executive pay decision-making process, employee representatives should be invited to be part of remuneration committees. This recommendation is based on the assumptions that employees would better dissect pay or severance pay proposals practically aiming at rewarding executives for failure and would better assess extremely generous executive pay offers and increases vis-à-vis those offered to the other employees, especially when the latter have benefitted of very modest pay increases or the business has made people redundant.
Where implemented this initiative has produced mixed results, as well as has produced mixed reactions the proposition to introduce this initiative as a rule in some other countries. According to research conducted by Buck and Sharhrim (2005), for instance, employee involvement has produced positive results in Germany; by contrast, several other investigations have underscored the difficulties emerging when trying to execute this approach in practice in other countries.
The effectual implementation of this initiative implies first and foremost that employees have or gain an in-depth knowledge of the business strategy. Additionally, it should be clearly defined what their responsibilities are and this aspect could be clarified only determining whose interest these are supposed to protect: that of the employer, that of the employees or both? Whether these should be representative of the employer interest, it should be assumed that it would be up to the employer nominating these, whereas in the case they should be representative of the overall workforce interest it should be most appropriate these to be elected by the employees.
The implementation of this approach should be also clearly based on the company law in force in each country. Europe, for instance, is characterized by a fair level of heterogeneity in term of employee representation at board-level insofar as three different grouping of countries can be identified with reference to this aspect (Worker Participation, 2013):
Ø  Countries without any specific legislation (Belgium, Bulgaria, Cyprus, Estonia, Italy, Latvia, Lithuania, Malta, Romania and the United Kingdom),
Ø  Countries where employee board-level representation is limited to state-owned companies (Greece, Ireland, Poland, Spain and Portugal),
Ø  Countries where employee board-level participation is extended to private sector employers (Austria, Croatia, the Czech Republic, Denmark, Finland, France, Germany, Hungary, Luxembourg, the Netherlands, Norway, Slovakia, Slovenia and Sweden).
Notwithstanding, board-level employee representation is differently regulated in each nation. In many countries, for instance, it is subject to the number of employees forming the overall workforce. The lowest threshold has currently been set in Sweden with 25 employees, whereas the highest in France with 5,000 individuals. Differences are also concerned with the rate of board seats occupied by employees and the title seats are occupied, namely whether these are taken on a supervisory board or single tier board title (Worker Participation, 2013).
The introduction of laws regulating board-level employee participation can also have an impact on, and may require hence a revision of, the company law accordingly. In the UK, for example, company law entails that individuals participating at board or committee meetings are companies’ directors. The introduction of a rule extending employee participation to remuneration committee would, by extension, require the amendment of the company law accordingly.
Irrespective of the legal constraints, however, it can be considered questionable assuming that employee involvement in remuneration committees could reveal to be beneficial for organizations. Once employees would be invited to participate to the committee meetings these should clearly have an active role and it is unlikely that these may have the technical knowledge and experience to actively participate on a decision-making process for which committees members, when needing advice, are used to have recourse to accredited national and international firms. As discussed earlier, executive pay arrangements tend to be the more and more complex and sophisticated; employees not having the required expertise and experience would clearly be in difficulty and would be essentially unable to have their say in such meetings.
As mentioned above, even though responsibility for executives’ pay will invariably rest with remuneration committees, it is possible for their members to seek external professional advice. Since consultancies could hold sway over the remuneration committees final decision, in 2009 was introduced in the UK a voluntary Code of Conduct in relation to the executive remuneration consulting activity. The Code, developed by the Remuneration Consultants Group (RCG) in representation of the major consultancies of the UK listed organizations, as stated by the same Remuneration Consultants Group, basically “sets out the role of executive remuneration consultants and the professional standards by which they advise their clients, whether their clients are Remuneration Committees or the executive management of the company.” It therefore aims at clearly explaining the scope and conduct of consultants when providing advice to the UK listed organizations as regards executives’ pay and defining the standards of the information that consultancies should provide to their clientele.
The conflict of interest which might potentially arise when remuneration committees have recourse to external consultancies has prompted many governments around the globe to take some actions. In 2011, for instance, the Australian government enforced stricter rules on the type of relationship which can be established between companies’ remuneration committees and consultants. Similar initiatives were also adopted in the United States were remuneration committees have the obligation to unveil how these have managed and sorted out the conflicts of interest eventually arisen (BIS, 2011).