Kay Review & Executive Incentives

The flurry of consultations on executive pay now looks like a damp squib. The topic featured in the Kay Review and also Vince Cable’s Department for Business Innovation and Skills consultation – but both have missed the opportunity for real reform. Remuneration consultants, in particular, have escaped much criticism. Yet, reform of the way they work is surely crucial to making effective changes on executive pay. Investors need real accountability from all involved with company value creation, and its reporting. The onus is now on shareholders and fund managers who use company reporting information to push for change.

Kay has left much of the remuneration agenda to DBIS, focusing instead on metrics. Yet, good long term performance can only be built on the right short term incentives. Two-thirds of respondents to the DBIS consultation recommended moving away from total shareholder return and earnings per share based incentives. Neither report deals with that.

Executive rewards of big multiples of salary can be linked to goals that are hard to evidence externally. Sometimes earnings per share can be adjusted year by year from the statutory figures, effectively allowing the goal post to be moved by negotiation, depending on what is seen as exceptional. For total shareholder return comparisons, company accounts often give graphs, but not a table of the numbers themselves. And, the biggest area of concern is in peer group comparisons where a chief executive merely has beat the median of a selected group of competitors. Within a sector, boards might pick different peer groups, opening up the opportunity for every company in a sector to be the winner. And, there may be no clear rules for how this changes from time to time.

Numbers are rarely given for the calculations to be checked. If established sector indices were used, calculations would be effectively external and objectivity would be clearer. Instead, we have an important aspect of a company’s accounts that shareholders must simply take on trust. This contrasts with the way in which other company numbers are audited and reported.

Cable has focused initially on a say on pay, but not yet delivered on encapsulating total pay in a single number, or directing more change in how pay packages are constructed. Certainly, he has promised in Parliament to require a single number as well as a distribution statement, but nothing has yet been done. Everyone seems to agree – perhaps apart from company executives themselves – that many packages give too much reward on success, encourage short term risk taking, and can be asymmetric on outcomes. However, votes merely approve or reject; they cannot easily shape practice. Transparency is viewed as a good thing, but neither report has suggested how this might be achieved. Cable is proposing a shareholder vote, without really changing what is being voted on.

The Financial Reporting Council governs the professional standards of key professions involved in company reporting. Accountants and actuaries must take their lead from the FRC, with the aim of addressing conflicts more directly than self-regulation might. Yet remuneration consultants operate outside this strict regime, despite their key role in advising boards and the implications for shareholder value. Auditors are appointed by shareholders at AGMs, but remuneration consultants are simply appointed by boards. Actuaries can no longer advise both pension fund trustees and company pension sponsors in respect of the same fund. Yet, there is little transparency on the potential for remuneration conflicts. Again, Cable has promised that the Government will address fundamental conflicts of interest in the pay-setting process, with greater transparency around the role of consultants. Why this has not been prioritised is not clear.

Until Cable acts, we must rely on a little known self-regulating trade body, formed after the 2009 Walker Report. The Remuneration Consultants Group represents those that advise remuneration committees of FTSE 350 companies. It has a code of conduct, recently revised, which is not supervised by the FRC. The code is admirable, but is largely based on principles rather than rules. And, surprisingly membership of this group is not compulsory. The Walker Review envisaged the Group as a professional body, but instead it is a club of firms and sole traders. In its aim of standard setting, it encourages good practice, but has yet to demonstrate it can bite. And, surely it should be answerable to a body representing the public interest.

Remuneration consultants acting for companies need not disclose whether they are members of this group, and it is not clear what sanctions might be applied to any breaches of the code. The fact that pay has featured in so many consultations, shows there is a public interest in the topic – it is too important an issue to be handled privately. It would be natural to fit remuneration consulting into the FRC framework, which already covers other key professionals as well as being responsible for the Corporate Governance and Stewardship Codes.

Remuneration consultants answer that they do not themselves make substantive decisions on pay packages. Yet, they are the missing piece in the jigsaw, having a contribution to make to long term company performance, the effectiveness of the UK Corporate Governance Code and transparency on all this to shareholders and the public. It is anomalous that they should sit outside the FRC, thereby avoiding its external review and direction.

It is not too late to address the gaps in company pay and reporting. Votes on pay are less important than how remuneration policy is developed and whether the professionals involved are answerable externally. The Kay Review and DBIS could yet deliver meaningful change, but need to tackle all the parties involved in the reward process. Shareholders have a lot to gain from getting incentives right.