Do executive incentives actually work?

Executive remuneration is not just a problem for banks. Headlines from other industries show there is a broader pay problem. Rewards in companies such as Tesco and Serco seem to have been a part of a weakness in strategy and governance. Boards assume that complex pay structures and incentives will drive useful management behaviour, but lack the research to support this belief.

One year on from UK legislation on say-on-pay, there is little sign of realism in incentives; many rewards remain detached from sustainable value creation. Some recent high profile problem companies have shown just how well paid strategic failure can be. In many companies, rewards remain focused on the short term, with opaque metrics and too much focus on boosting the share price. Change is slow; shareholders and boards need to raise their game.

This year’s binding vote on pay lets shareholders register dissent. Bad targets can be questioned, and even blocked. But it still does not let shareholders impact the remuneration setting process itself. The problem may even be the composition of boards; it seems too many non-executive directors come themselves from a culture of high pay. Boards offer shareholders the reassurance that remuneration consultants are involved in setting and benchmarking pat schemes. But a recent US study has found that involvement of consultants raises rewards on average by 7.5%. Compared with employing a single consultant to advise the board, pay is typically even higher when a second consultant is also engaged for the CEO.

The Department for Business Innovation and Skills (DBIS) consultation in September 2011 aimed to establish a “clear line of sight” between the levels and structure of remuneration and directors’ performance in meeting strategic objectives. But often companies claim commercial confidentiality on whether targets have been met, leaving the pay and performance relationship opaque. Goalposts shift, as companies redefine earnings per share or return on invested capital.

Analysis of the new DBIS regulation on pay shows limited impact. Base salary is now moving more in line with average incomes, but bonuses and share arrangements are rising strongly. Certainly, there is increased institutional shareholder disquiet, with proxy advisers recommending “vote against” more often. These rebellions may have picked off some of the individual worst offenders on a company-by-company basis, but the excesses remain. For FTSE 100 companies, three year vesting periods remain the most common and there is little sign of real long-term alignment with the timescale on which strategy might succeed or fail.

Why is progress so slow? It seems that the response to each new wave of pressure on boards and management is to employ external consultants. This facilitates engagement with the biggest shareholders and ensures a process. But the end result is lengthy remuneration reports, often fudging what has been paid and whether targets have actually been hit. Much still looks like an option on stockmarket progress, or even just an incentive to talk up the shares. Many of the bonus metrics are changed so often, it is unsurprising that pay has uncoupled from longer term corporate performance. The use of proxy advisers is also blamed for guiding boards to undue conformity.

Chief executives can collect generous bonuses for behaviour that might be assumed to be in base pay, such as “engagement with colleagues”. Others collect bonuses on targets such as reducing CO2 emissions – surprisingly easy in a shrinking business – or raising internet sales without any real cost offsets. Many of the incentives that feature in remuneration reports look like they should be simply part of what an effective CEO should do to keep his or her job.

The CEO bonus culture contrasts with lower pay grades; many mid-managers and other employees are expected to perform primarily for base pay, and progress in that. Indeed, academic research points to the limits of motivation by extrinsic financial reward. It can even be counter-productive in areas where quality or ethics really matter. Some incentive arrangements appear so complex that the consultants and executives involved must have diverted a great deal of time and effort in design and negotiation. It seems the more that shareholders want specifics, the more convoluted schemes become. The key issue now is less one of excess total pay, than that strategy is damaged by the wrong targets reviewed over too short a timescale.

Surprisingly, despite the importance of effective pay design, remarkably little independent research has been conducted. Measures are simply plucked out of the air with little hard evidence that they work over the longer term. Some bonuses are based on sector rankings, which are hard to check independently but nevertheless guarantee some winners every year. What data does exist suggests that measures such as free cash flow and return on invested capital are more effective than pay based on earnings per share and total shareholder return. Despite this, EPS and TSR still remain common, and the measurement and retention periods are relatively short. Companies still hide behind their consultants and claims of commercial confidentiality. Boards should be required to say exactly what they expect an incentive to deliver.

Many large company boards seem unable to challenge these trends, fearful they will lose a star CEO. Would UK business really be hampered in global competition by making a change in setting pay? Strategic failure in some of Britain’s biggest companies seems related more to the structure of pay and the wrong metrics, rather than the total sums. Surely the best executives would still be attracted by a package that paid for what they could really influence. Being rewarded for what they genuinely contributed should encourage executives to want to hold the shares long after departure. Instead, arrangements do not foster a faith in the long term intrinsic value of the share ownership.

The Kay Review is now being implemented, but focuses primarily on corporate strategy and the role of shareholders in stewardship. What is missing is an evidence-based understanding of the role of executive bonuses in long term corporate success. The focus on banks and on total executive pay should now turn to the structure of rewards at the top in commercial businesses. UK plc needs to move more decisively away from stockmarket-related measures towards long term business performance. Say-on-pay has started the debate, but a more radical review of incentive arrangements is now needed.

Summary of UK remuneration disclosure requirements.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice. At the time of writing neither I nor my employer’s clients had interests in any stock mentioned and had no plans to initiate any positions.

Image credit; $100 bill collection by Revisorweb, Creative Commons some rights reserved. http://commons.m.wikimedia.org/wiki/File:Hundred_dollar_bill_03.jpg

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