Super salaries – getting executive compensation right

July 2014  |  FEATURE  |  BOARDROOM INTELIGENCE

Financier Worldwide Magazine

The financial crisis has had a profound impact on many areas of business. One of the key consequences of the crisis and the subsequent global economic downturn was that it brought the subject of executive compensation under the microscope. Seemingly, everyone from the general public to the media and financial regulators have expressed an opinion on executive compensation and bonus packages, particularly for those operating in the financial sector. The appropriateness of executive compensation packages became a major talking point as the global markets endured the greatest economic crisis of a generation.

Since the onset of the crisis, analysts and critics of executive compensation packages have noted the increasing disparity between levels of pay in the c-suite and regular employees. Arguably, there is a case to be made about the escalation of executive remuneration, particularly when compared with the compensation package offered to the average worker. In the US, in the mid-1960s, chief executives at major corporations earned roughly 20 times more than the average employee – today they are more likely to earn 227 times more. Some analysts have suggested the excessive compensation paid to executives in recent years has been in direct conflict with the wider recessionary business climate of the last five or six years. Furthermore, there is some evidence to suggest that, to a large extent, the increase in American income inequality over the last four decades can be attributed to a steep rise in wages among the highest earners in society.

In light of this, executive compensation has become something of a political football in recent years. Politicians have claimed, particularly in the US, that those chief executives who are considered to be excessively compensated are the root cause of the competitiveness problem experienced by US firms on a global scale. To that end, and as a result of the financial crisis, a number of steps have been taken in the US to attempt to control executive pay. The Securities and Exchange Commission (SEC), via the Dodd-Frank financial reform law, now requires companies to publish data comparing the chief executive’s pay to the median pay of the company’s employees.

However, to suggest that executive compensation packages are the crux of the problem in the US and elsewhere grossly oversimplifies the issue. In a business climate where it is increasingly difficult for businesses to attract and retain the right individuals, it is imperative that firms make every effort to hang on to their top talent. In recent years these redemption efforts have become more diverse. Accordingly, given the microscope of social disapproval through which executive compensation is currently viewed, as well as the new regulatory pressures applied, it is important that companies explore new and more inventive means of compensating executives, rather than simply adding more zeroes to the end of their salary.

Stock options

Increasingly, executives are being offered large signing-on bonuses and dramatically increased stock options as part of their compensation schemes. These stock options are intended to reward executives in the long term, while helping to constrain pay levels as much as possible. Furthermore, rewarding executives with shares options rather than exorbitant salaries can serve as a motivational exercise – executives who are invested in the firm, literally, will be driven to raise the company’s share price higher through hard work. Clearly, any improvement in the company’s share price would be wholly beneficial for the firm and those executives who hold the firm’s stock. Pay in stock, as a percentage of overall pay, has risen of late, most notably in the years since the onset of the financial crisis. In 2006, payment in stock options accounted for 60.2 percent of total pay; by 2013 that figure had climbed to 63 percent.

Furthermore, according to a study on executive compensation before, during and after the financial crisis, carried out by the University of Twente in The Netherlands, the only substantial increase in packages offered to executives was found in the stock awards component of their total compensation packages. According to the University’s research, stock awards accounted for 23.39 percent of total compensation packages during the pre-crisis period, 28 percent during the crisis itself and 33.02 percent post-crisis.

However, critics of remuneration schemes involving high levels of stock have noted that although stock as executive compensation can have a positive effect, should the company perform well executives with large amounts of stock can still receive disproportionately large paydays when the company’s stock price is high.

Say-on-pay

One of the key questions related to stock options in compensation packages relates to how clearly a company’s investors can see the achievements and performance of members of the c-suite. To that end, it is important that companies put in place systems of transparency on executive compensation, regardless of the form that compensation takes.

In April, the EU unveiled a fresh round of measures designed to strengthen corporate governance and give investors more influence by enhancing transparency around executive pay. Michel Barnier, the EU commissioner responsible for the banker bonus cap, proposed new legislation which would see Europe’s top corporate executives having to seek shareholder approval for their salaries and justify the pay gap between a company’s management and its workers. The introduction of these measures by the EU, a move which can be seen as being a direct consequence of the shareholder spring of 2012, will see shareholders in listed companies given the right to vote down board’s remuneration policies, which include disclosure of maximum board pay, bonus levels and the gap with the average paid worker. The aim of these new measures, according to Mr Barnier, is to address the issue of ‘short termism’ which has damaged the European economy in recent years. The EU also hopes that the new legislation will encourage investment across the continent by promoting transparency.

Providing shareholders with a greater say over executive compensation is growing in popularity. Europe, the UK and the US are all following a similar path regarding shareholder interaction. The proposed rules governing executive compensation in Europe seem to share a great deal of DNA with the final rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which require public companies to hold a say-on-pay vote at least once every three years.

However, the European legislation appears to be more extreme than other policies. Under the European Commission’s proposals, shareholders will be required to participate in a binding vote on a wider range of remuneration benchmarks. Ten nations, thus far, have announced their intention to introduce the EU’s binding vote on compensation. Under the terms of the EU’s proposals, companies’ executive compensation packages would have to be approved by their shareholders every three years, however an annual report on executive’s pay schemes covering the previous year would also require a majority shareholder vote each year. The report would be required to include the envisaged discrepancy between remuneration at the executive level and the average pay of the company’s full-time workers. Furthermore, the annual report must also provide shareholders with a full “explanation of why this ratio is considered appropriate”.

If companies are to effectively justify the level of executive compensation they offer, to financial regulators and their own shareholders, it is also important they put in place mechanisms by which they can demonstrate their executive’s achievements. Transparency must become a watchword. Firms should make it clear to executives and shareholders alike how their compensation packages are calculated. If remuneration schemes are related to performance targets, for example, it should be made abundantly clear to all parties concerned how those targets are to be measured and how the executive will be compensated for meeting those targets. In order for this system to work, firms must prioritise communication as a key feature, and executives must be made aware of how their performance levels correspond to targets throughout the year.

Talent retention

With regulatory and shareholder interest in executive compensation increasing exponentially, there can be little doubt that there is a genuine debate to be had around the wider implications of remuneration at the executive level.

While there is a valid case for controlling and monitoring compensation schemes, we must also consider the need for firms to hang on to their most successful and influential executives. Indeed, advocates for higher executive compensation packages often cite the need for companies to retain top talent as one of the core reasons behind their high remuneration schemes. Undoubtedly, the recent recovery of certain sectors of the global economy has led to executive compensation packages assuming a heightened sense of importance. Some analysts believe that the high levels of compensation on offer are a response to the perceived lack of available and capable talent at the executive level. A Deloitte study released in April 2014 noted that the shortage of available talent, along with the retention of already captured talent, are two of the biggest challenges facing employers in the current business climate. As a result of these challenges, firms are being forced to beef up their executive compensation schemes in order to provide staff with an incentive to stay. According to Payscale’s 2014 Compensation Best Practices Report, nearly 60 percent of companies surveyed listed executive retention as a top concern for the year ahead. In light of these concerns, 88 percent of respondents noted that they intend to offer raises to help maintain existing personnel.

The argument surrounding executive compensation will likely continue for years. Although regulators are set to devise new disclosure requirements and legislative controls, firms will inevitably find creative methods to attract, motivate and retain executives outside of these controls. Executive compensation can often seem disproportionately high, especially when considered within the context of the average employee’s remuneration. However, this comparison is also something of an oversimplification of the argument. Staff at the executive level, much like average employees, are rewarded by the firm for the value that they generate for both the company and its shareholders. Although these figures can be difficult to calculate once an individual begins to scale the corporate ladder, it would be foolish to suggest that executives do not generate great sums of money for their firms.

Regardless of a debate that has raged for decades, it is clear that in the current market there is a need for companies to appropriately reward their executives. If the financial compensation on offer at the executive level is not competitive, firms may find members of their c-suite seeking greener pastures. The reputational risk associated with losing key executives as a result of a pay dispute would be considerable.

Arguably, the biggest challenge for firms in the current business climate is not the competitive nature of their compensation packages for executives; it is the justification of those schemes to the company’s shareholders and regulators. Ultimately, the compensation on offer to executives has one of the greatest impacts on the firm’s balance sheet and its shareholder value.

© Financier Worldwide

BY

Richard Summerfield