Getting it right – the challenges of executive compensation

January 2020  |  COVER STORY  |  BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

January 2020 Issue

Executive compensation is a complex and deeply emotive subject. In the current regulatory climate, the salaries, bonuses and incentive packages offered to the C-suites of publicly traded companies are subject to heavy scrutiny and can be difficult to understand, particularly for the public, which can often lead to anger and mistrust.

Sensitivities around executive compensation have changed since the financial crisis. Public and media perceptions of inequality and the disparity between employees and senior executives have hardened over the last decade. Today there is wide reporting on the disconnect between top executives and the workforce at large, and between executive pay and individual performance. “A good example is Jeff Fairburn, chief executive of Permission, who in 2018 was reported as earning per minute what it would take the average worker three days to earn,” says Polly Rodway, a partner at Brahams Dutt Badrick French LLP. “The added scandal was that these earnings were related to profits of the company, which were impacted by the government’s ‘Help to Buy’ scheme, as opposed to because of his own personal contribution. Other recent salacious press coverage on the issue of executive pay includes that of Phillip Green, the chairman of Arcadia Group.”

Executive pay has risen exponentially in recent decades. Average pay of CEOs at the top 350 firms in 2018 was $17.2m, according to the Economic Policy Institute. CEO compensation is very high relative to typical worker compensation – a ratio of 278 to 1. Furthermore, from 1978 to 2018, CEO compensation grew by 1007.5 percent, while typical worker wages grew by just 11.9 percent.

Disparity of this kind can be difficult to accept. According to a 2016 Public Perception Survey on chief executive compensation from Stanford University, 74 percent of Americans believe that CEOs are paid the incorrect amount, relative to the average worker. Just 16 percent of respondents believe that CEOs are paid the right amount. While responses vary across demographic groups, overall sentiment regarding CEO pay remains largely negative.

‘Inflated’ executive pay has fuelled the conversation on income inequality and its implications for pay structures throughout the economy. “With the US facing a presidential election in 2020, further scrutiny will enter the debate based on recent campaign proposals for increased taxation of corporations paying executives beyond certain thresholds as compared to the mean for their employees, or requirements that employees elect a percentage of board members,” explains Michelle Capezza, a partner at Epstein Becker Green. “It will be important to analyse these issues more broadly, however, as the nature of work and expectations for workers is changing and the appropriate way to compensate individuals will need to be redesigned on all levels.”

Yet, in an increasingly competitive global marketplace, corporations cannot afford to neglect their executive compensation packages. For some, ‘excessive’ packages are an industry standard, despite increasing media and public attention. According to Ms Rodway, this scrutiny may result in a shaving down of packages at the top. “Doing so looks like an issue for retaining top talent, but most companies promote their top executives from within and no matter if they are being paid exorbitantly excessive remuneration or a justifiable and equitable package; there is no shortfall of talented individuals looking to take up these roles,” she adds.

Attracting and retaining talent

An effective compensation strategy is vital to attracting and retaining top talent, and motivating them to perform. Accordingly, compensation packages should be tailored to market demand, aligned with organisational goals and designed with the employee in mind. Companies must know exactly what type of executive they hope to attract. Factors such as salary, bonuses, reimbursements, pension contribution, car allowance, healthcare and private medical support, as well as support for personal development and other options, must be considered. Beyond financial remuneration, when investment in leadership and skills development may be more desirable, for example.

Another challenge in the current marketplace is that new types of jobs and career paths are emerging in many fields as the workplace transforms. Changing industries and job roles can further complicate negotiations. “There is a need for more individuals with new levels of technological and soft skills than can meet the demand for the ‘future of work’ and those that have the requisite combination of skills will be aggressively sought after,” says Ms Capezza. “Yet, many organisations are constrained by how they may compensate and incentivise their executives due to applicable laws and regulations, shareholders, as well as public opinion. Trying to design the right mix of compensation and benefits that is competitive for the future workplace, and compliant with applicable requirements, will become more challenging, but it will be imperative.”

Today, many compensation schemes link a higher percentage of executive pay to performance, based on measures such as income, profit and cash flow. According to PayScale, performance-based pay increases, bonuses and incentives are the most common way employers are linking pay and performance. The company’s 2017 Compensation Best Practices Report found that 74 percent of all employers offer some type of variable pay. Pay incentives are also more focused on long-term results. However, there are doubts that linking executive pay to performance is a successful strategy. A 2016 study by Lancaster University Management School, for example, found that the link between executive pay and company performance is negligible.

Companies should also evaluate their competition. Benchmark analysis can reveal what is considered a competitive mix of compensation, including base pay, incentives and additional employer-provided benefit programmes for a role in a specific industry. “For newer types of positions created in the future workplace, employers may find themselves setting the precedent as to what will be regarded as the benchmark compensation package,” says Ms Capezza. “It will also be necessary to determine new types of metrics to analyse pay for performance with evolving types of jobs, as well as to ensure that pay equity is addressed as is currently also being mandated under state and local laws. Once a competitive threshold is defined, companies must then analyse how to design the components in compliance with applicable laws and requirements, including any required caps on pay, clawback policies, confirmation that incentive programmes do not encourage inappropriate risk taking, other securities and tax law considerations, accounting, governance and approval procedures. It becomes an exercise in identifying the ideal, most competitive package for a designated role and then designing it to comply with applicable requirements and demands for review and approval,” she adds.

Companies should consider keeping their executive remuneration structures simple. “Transparent schemes enable shareholders to scrutinise executive pay decisions, likely to be ever-more important,” says Ms Rodway. “Profit-sharing schemes across the workforce, such as the model employed by British retailer John Lewis, are well known to be effective and worth consideration. When determining reward structures, consider what performance you are trying to encourage in the context of the long-term strategic goals of the company. Think beyond financial measures, and benchmarking, to people management, diversity and inclusion, and client satisfaction. Consider caps on remuneration for executives in any year, as is being encouraged by the Department for Business, Energy and Industrial Strategy (BEIS),” she adds.

Role of the remuneration committee

The remuneration committee also has a vital role to play. It must conduct research, including identifying studies, evaluating alternatives and designing the most appropriate components for executive compensation plans. These plans must meet the specifics of industry rules and regulations. The remuneration committee also takes on the primary responsibility for making sure that compensation plans produce intended results, link pay with performance, attract and retain executives, align executives’ goals with the company’s long-term strategy, and deter unnecessary risk-taking. This is no easy task, however. Quantifying executive performance is incredibly difficult, and it is almost certainly not done adequately by most companies. To be successful, compensation committees must develop and promote a philosophy which associates compensation with the company’s values and goals. They must take many issues into consideration, including business size, performance record, company prospects, financial condition, culture and values, the wider industry, key performance indicators and stakeholder interests.

In the UK, the Corporate Governance Code 2018 enhances the duties of the remuneration committee, setting a framework for how executive pay should be determined, for example by alignment to long-term objectives, company values and workforce pay. “It also provides for greater use of judgment and discretion when approving remuneration outcomes, such as avoiding formulaic determinations,” says Ms Rodway. “On the other hand, stakeholder engagement is also being actively encouraged to reign in the discretion of the remuneration committee, with the ability to alter policies without shareholder approval being narrowed. We are likely to see further encouragement of this type of stakeholder activism.”

Shareholders want transparency, accountability and compliance. Regulatory developments, public and media perceptions and the rise of shareholder activism, where say-on-pay votes are increasingly common, are moving things in this direction.

Regulatory developments

With these evolving roles and changing markets, firms must be conscious of shifting regulatory standards governing executive compensation. In early 2019, new laws requiring large UK public companies to be more open about their remuneration of boardroom executives came into force. These rules, among other things, set out how the pay awarded to CEOs compares to that of representative UK employees, with related explanations and disclosures. Specifically, the pay ratio regulations require companies to disclose and explain the ratio of their CEO’s total pay over a financial year to the median and 25 percent and 75 percent interquartile threshold total pay of the company’s UK employees for the same financial year.

There have also been important legal developments in the US since the early 2000s. The Sarbanes-Oxley Act, tax rules under Section 409A of the Internal Revenue Code for the deferral of compensation in nonqualified programmes, the Dodd-Frank Act, and, more recently, the Tax Cuts and Jobs Act of 2017 which, among other things, prohibits public companies from taking a tax deduction for executive compensation of covered executives in excess of $1m and removes the performance-based compensation exception to the deduction limit that existed under Section 162(m) of the tax code, have all had an impact. According to Ms Capezza, “these developments, along with shareholder demands, greatly impact the scrutiny over the fairness and design of executive compensation packages as well as the flexibility historically enjoyed. The debate continues, however, regarding how to appropriately compensate executives who must lead complex organisations, drive innovation and deliver profitability and value to shareholders while being subject to increased compensation oversight and limitations. This challenge will only increase as the nature of work evolves and those holding the highest positions will command robust compensation to the fullest extent permitted by the laws.”

Though important progress has been made, more must be done. Indeed, executive compensation is primed for further regulation in the US and beyond. A new body with powers to act on executive pay and reporting, the Audit Reporting and Governance Authority, is intended to be introduced imminently. “Other key developments include the 2018 Corporate Governance Code, which requires longer term vesting of a long-term incentive plan – five years not three – to promote alignment between pay and long-term objectives, and the statutory requirement of larger listed companies to publish their CEO pay gap, as well as reporting on the impact of share price growth on executive pay,” says Ms Rodway. “How impactful this will be remains to be seen.”

In the EU, regulations on governance, known as the Shareholder Rights Directive (SRD), were approved by the European Parliament in 2017. Each Member State was due to implement them into their local legislation by 10 June 2019, with the first annual reports under the regulations to be published in early 2020. The SRD is likely to be less impactful in Member States which already have detailed reporting and stringent voting regimes in place, however in other jurisdictions it could change the nature of engagement with shareholders on executive pay issues and the required level of disclosure.

Regulators are also increasingly willing to investigate potential malfeasance. In October, Argo Group International Holdings Ltd was subpoenaed by US securities regulators over perks offered to its executives and has launched an internal review. The Securities and Exchange Commission (SEC) has sought documentation focused on Argo’s disclosures about executive compensation. The company was accused by activist investor Voce Capital Management of misusing corporate assets, including company-owned aircraft and housing. Investigations of this nature may become more common in the future as regulators and activist investors continue to demand compliance and transparency.

Executive pay is now one of the most intensely scrutinised and debated elements of management, particularly given the disparity between the C-suite and ordinary workers. Ensuring that compensation packages are appropriate and transparent is a difficult challenge, but vital given the prevalent legal, social and political environment.

© Financier Worldwide

BY

Richard Summerfield