The challenge of assessing executive pay
The High Pay Centre think tank has dubbed today ‘Fat Cat Wednesday’, having calculated that by lunchtime leading executives will already have earned the average UK salary of £28,200.
High levels of executive pay inevitably generate a great deal of comment about greed and unfairness, but is this justified? Matt Crossman, our group corporate governance manager, explains how we approach executive pay and protect our clients’ interests as shareholders.
At Rathbones, we seek to be a responsible shareholder of the companies we invest in on behalf of our clients, most notably in our voting at AGMs. The most contentious votes involve the issue of executive pay. The 2016 AGM season was no different, with high-profile defeats for some of the UK’s biggest companies.
At such times, everyone — politicians, newspapers, City ‘experts’ — has an opinion, with many calling high pay ‘unfair’. But which factors drive executive pay and who defines what’s ‘fair’? We have developed an approach that takes account of these concerns and questions.
First, we need to set the context. We’re not necessarily concerned with the overall size of the pay deal: a major factor in our responsible voting policy is the alignment of pay packages with the best interests of shareholders.
A key issue is basic versus variable pay. A salary remunerates an employee for services rendered — the day-to-day business of running a company and making strategic decisions. For most people, salary is what defines their value to the organisation. In 2014, basic salaries for a FTSE 100 chief executive (CEO) came in at £700,000 per annum.
While high levels of basic pay are controversial to some, the real issues come with ‘variable pay’. This is the catch-all term for the suite of bonuses, pension payments, share plans and the like that crystallise at various levels, dependent on the attainment of targets. Research from the High Pay Centre suggests the total remuneration of the average CEO is around £5.5 million per year. From our point of view, variable pay is the most controversial element as it has the potential to diverge from the expectations of shareholders.
An additional issue for investors is that of incentives. With regard to the targets set for senior staff, what kind of behaviour is being encouraged? If large bonuses can be attained by pushing short- over long-term performance, this is clearly working against the interests of committed, long-term shareholders. If there are to be variable rewards for performance, the criteria for determining those awards should be made clear and disclosed publicly, so all stakeholders can assess their validity. Even bearing this in mind, the evidence does not suggest that optimal variable pay arrangements are the only factor in driving outperformance.
Last year, BP provided a fascinating example of the challenges surrounding variable pay. The company’s CEO Bob Dudley stood to receive a total remuneration in excess of £13 million — in a year in which the company suffered huge losses and made job cuts. BP’s board argued that its senior team had done well in managing the company in a low oil price environment — to which concerned investors responded that this was its job, to be expected of the CEO and management team. Exceptional variable pay is deserved if there was exceptional performance. In this case, it really wasn’t clear that it was, so we voted against management on that resolution.
There are several red flags that we take account of in looking at pay packages. The first is benchmarking: reviewing pay against peers only tends to lead to inflation of pay levels. We prefer remuneration committees to review the strategic direction of the company and decide on the remuneration levels required to attract and retain the talent that will deliver on these targets.
The issues with executive pay have resisted attempts at reform. Under the coalition government, the business secretary Vince Cable introduced both a forward- and backward-looking vote on executive pay at all AGMs, giving investors the chance to vote on both future remuneration and the actual awards made in the previous year. The votes are only advisory in nature, however: the BP pay deal saw a 58% vote against, but the company was under no legal obligation to change the arrangement.
In her speech announcing her candidacy for the leadership of the Conservative Party, Theresa May indicated a willingness to take things further, making such votes on pay binding. But beware the law of unintended consequences — aware of their increased power, some investors may shy away from being overly critical, resulting in more, not fewer, egregious deals.
Industry working groups see further reforms coming in the area of complexity to encourage a greater simplicity in the award of variable pay structures. There also needs to be a greater flexibility. Many companies rely on the industry standard of a ‘long-term incentive plan’ (LTIP) under which shares vest to management on the achievement of various three-year financial targets — but these do not always suit the business model of the particular company.
At Rathbones, our guiding principle is clear: variable pay arrangements must incentivise management to act in the best long-term interests of all shareholders. Where those interests diverge, we will vote against.
This article first appeared in Rathbones Review Winter 2016.