There has been a flood of recent executive pay revisionary thinking: from Nobel Prize-winning economists to major trade associations, fund managers and asset owners; notably in the UK: the Executive Remuneration Working Group (ERWG), The Investment Association (The UK’s fund management lobby group), and Legal and General Investment Management (LGIM). The latter were precursors to the release this week of the UK government’s new Green Paper on Corporate Governance, which majors on potential revisions to shareholder power to set pay, stakeholder involvement on boards, and the governance of private companies, with a view to regulation in 2017.
Today (Dec 1), The UK Pensions and Lifetime Savings Association (PLSA), which represents £1 trillion in assets for 1300 pension funds, published its AGM Season Report 2016. It says that 87% of funds responding to a survey say executive pay is too high, and that 60% believe high levels of asset management pay are preventing them from properly holding companies to account over pay practices! The PLSA is tightening its advice to members on re-electing directors with oversight of pay, after having written a letter recently to the Chair of every FTSE350 company raising awareness about the pay issue. Link to RI story
If I were a corporate remuneration committee chairman in the FTSE350, though, I’d be a bit confused. Let’s try and unpack some of this.
First, the Nobel Prize winner: MIT economist Bengt Holmström responded to questions about CEO pay at a press conference held to announce his 2016 Nobel Prize in economics, shared with Oliver Hart on ‘contract theory’, particularly reward and result. Holmström, a specialist in principal/agent issues, said: “I wish they would listen to what we know and understand about executive pay.” It’s gone from bad to worse, was his basic message: “It wasn’t in good shape during the Enron period,” he said, referring to the governance disaster, “and the problem there was that executives could cash out very quickly. But the problem was not stock options themselves. There’s no point going from ‘options are awful’ to ‘shares are good’; they are all in the same family. They did not diagnose the problem correctly and went in a direction that is an even sorrier state.” Holmström was a board member at Nokia from 1999 to 2012, where, he said, “pay went from reasonable to completely dreadful, largely because of all the pay consultants. There are so many pieces and it’s such a mess.”
Both the UK Executive Remuneration Working Groupand the Investment Association also warn against an over-reliance on pay consultants; possibly as the source of the all-too-common, off-the-shelf, three-year performance share plan that is ubiquitous in the UK. But there also appears to be a growing consensus that executive pay is too complicated. Who knew? It certainly didn’t need a Nobel Prize winning economist to tell us.
The Executive Remuneration Working Group (ERWG), which was set up as an independent panel by The Investment Association in 2015, issued its final recommendations in July this year. Its main recommendation was: “More flexibility for remuneration committees to choose the most appropriate pay structure.” In general, as in the interim report, the final report focuses on flexibility, on trying to move companies away from the one-size-fits-all, three-year performance measurement long-term incentive plan (LTIP) that has become the plan of choice for most UK companies. Unfortunately the group’s call for more diverse remuneration structures fails from a lack of imagination.
The forms proposed in the recommendations are: the standard LTIP, deferred shares and restricted shares. But these are all already in existence and heavily used so nothing new is proposed. The group did consider one new idea: a form known as “performance shares on grant”, where shares are awarded retrospectively based on prior performance. But this was dropped eventually. The group dismissed stock options from the start.
But the group also undermines its own calls for flexibility by being prescriptive about a number of other elements of pay. It recommends a discount rate of 50 per cent for restricted shares, a three-year performance period followed by two-year holding period for LTIPs, and a 500 per cent of salary shareholding guideline (though smaller for smaller companies), with the requirement that executives retain up to 50 per cent of the post-tax vesting amount until the guideline has been met.
But it could be claimed that all of these are also dependent on “how a business works” and should not be prescribed.
Next, LGIM weighed in with its principles, commenting on the restricted share awards ‘recommended’ by the ERWG, saying: “We do not believe that this structure is right for all companies. Therefore, companies will have to justify why this type of arrangement is appropriate and why the existing arrangement is no longer suitable.” It then provided prescriptive guidance as to when and how a restricted share plan could be adopted. It also recommended a reduced reliance on annual bonuses and increasing the portion of pay based on long-term performance.
Then, the Investment Association itself announced that it was rewriting its remuneration principles, at the same time as sending an open letter to FTSE 350 remuneration committee chairs and publishing the new principles. These say that the remuneration committee should “select a remuneration structure which is appropriate for the specific business, and efficient and cost-effective in delivering its longer-term strategy.” Adding that: “These Principles do not seek to prescribe or recommend any particular remuneration structure,” and that “complexity is discouraged. Shareholders prefer simple and understandable remuneration structures.”
While there are some good points in all these issuances of advice, there are no real answers to anyone seeking to implement more flexible pay structures. Simply saying that it would be a good thing and that investors would like it is not enough. Nor are the ‘recommendations’ on changes to LTIP structures particularly helpful. First of all, any rethink of pay structures should be much more far-reaching and should involve a rigorous examination of all elements of the pay package, not just LTIPs, since it is problematic to tinker with one element and leave all the others alone.
Moving away from the norm requires imagination based on the principle – and here all the advice correctly concurs – of ‘what is most appropriate for this business, this industry, this company and this management at this time’. That is a tough question to answer, and one that many pay consultants are ill-equipped to answer. In addition, fear of proxy advisors is a powerful dampening force on change.
Frankly, one of the most imaginative solutions to the LTIP problem was put together by WPP, the advertising group; a plan that required side-by-side investment from executives: investment that was at risk if performance targets were not met. But this plan was eventually rejected by shareholders because of the excessive awards it generated. That excess did not mean that the plan was wrong, it just meant that any cap on rewards was improperly set.
To find a real solution to this problem it might be time for investors to sit down with management and advisors and figure out the answer, company by company, to the question posed by the principle above. And maybe ask Mr Holmström, too?