The risks of failing to act effectively on executive remuneration

This month saw the publication of the High Pay Commission’s final report. Having run for a year, the Commission, which includes investor representatives Robert Talbut from Royal London Asset Management and Brian Bailey of the West Midlands Pension Fund, has published a well-evidenced report containing 12 headline recommendations. Given that the report has been well covered in the press already, it is worth considering a few of the Commission’s individual proposals, and their wider significance, in detail.

Radical simplification of executive pay is, in policy terms, the closest the Commission might get to a win-win. No-one, with the exception of remuneration consultants, really benefits from complexity. Investors regularly complain about having to read remuneration reports that go on for a dozen or more pages, and anecdotal feedback from directors suggests that complex schemes may not even be properly understood by those they are supposed to incentivise.

It is worth noting that the complexity we currently face is in no small part a result of companies seeking to put in place what investors supposedly want – carefully-designed performance linkage. As The Independent’s David Prosser put it: “[T]he pay structures in place at many companies today reflect previous attempts to hold executives to account… Executive pay is now set with reference to hugely complicated performance yardsticks because remuneration committees have sought to show they are sensitive to complaints about rewards for failure.”
This, in turn, leads to a deeper question about whether the performance linkage that investors have sought is actually desirable after all. For one, does it simply replicate the performance pressure that asset managers(who cast most of the votes on remuneration reports) are themselves under? Do we really want our largest public companies run with one eye on short-term trends that, in reality, may be nothing but noise?

Secondly, does performance linkage actually deliver performance? It’s notable that the Commission digs into this issue a little and comes up with a fair bit of evidence, academic and anecdotal, that complicated incentive schemes don’t really motivate directors. Again, scepticism about the ability of performance-related reward to actually improve motivation (which for investors is presumably at least part of the rationale for having it) seems to be growing and, in our opinion, with good reason.

The other headline proposal that has received most attention is remuneration committee reform, and in particular the idea that employees should have representation or some other feed in. It is notable that within a couple of years this idea has gone from being advocated by just a handful of organisations (mainly the trades unions) to a proposal seriously discussed in the mainstream market debates. As an indication of the direction of travel, the Institute of Directors has adopted the position that there should be “engagement of remuneration committees, on a voluntary basis, with employee representatives as part of the remuneration setting process.”

There are probably a number of reasons why the idea has caught hold. For one, the sense that remuneration committees are too clubby, that directors set each others’ pay and therefore have no incentive to be tough, is easily graspable. As such, and in contrast to much corporate governance policy, this reform may have a tiny sliver of populist resonance.

In addition, as PIRC has argued in its submission to the recent BIS consultation on executive pay, there’s some psychological evidence that shaking up group membership to include more diverse opinions can make decision-making less extreme. Finally broadening remuneration committee membership is a reform that seeks to address executive pay earlier in the process, at the decision-making stage. This is in contrast to much recent reform which has focused on a combination of better disclosure and shareholder empowerment, so that decisions that have already been taken can be challenged.

This last point is important, because it’s a tacit admission that shareholder oversight, as currently constituted, won’t crack the executive pay problem by itself. This may be because shareholders still don’t have the right tools make a difference, or the right information to take an informed view. However, we suspect that most informed comment on this topic would now concede that it’s actually a deeper problem relating to share ownership. Too much of the market still sees executive pay as an irrelevance, and as such many companies receive very little challenge. Yet in other walks of life there is an acknowledgment that something has gone wrong with top pay. A stronger focus on the stewardship aspects of share-ownership is part of the solution, no doubt. But the process of company decision-making on remuneration looks likely to be the site of much future reform.

In all of this the High Pay Commission has pushed the debate on executive pay onto new terrain (or shifted the Overton window if you prefer a more technical term!). Its recommendations will probably come to be seen as relatively ‘normal’ fairly quickly. There will likely still be a fight over whether or to what extent employees feed into company decision-making on pay, but some kind of remuneration committee reform looks increasingly likely.There has been some push back on the Commission’s recommendations, with some arguing for the larger focus to be on shareholder empowerment. Whilst PIRC would always seek to strengthen the hand of shareholders in governance where appropriate, we wonder whether this smacks a little of fighting the last war. Ideas put forward include a binding vote and/or a forward-looking vote. Both are ideas we would like to see explored further. But, given that in nine years of advisory votes on remuneration reports, shareholders collectively have defeated around 20, where is the evidence that simply improving shareholder powers is the best approach? Many institutional investors only rarely use the weak powers they have, so it’s not obvious that giving them stronger rights should form the larger part of the solution to escalating executive pay.
One final thought about the future. The High Pay Commission has done a good job because it has essentially aimed a couple of years into the future, plotting forward a little from where we are currently. So, unless you are the sort of person who thinks that employee involvement in remuneration committee decisions is a Cuban approach to policy, as one headhunter does apparently, none of the proposals are overly radical. However, if we don’t pursue something like the approach the Commission has set out, and continue to rely on market pressure alone, the pressure for more direct intervention may become irresistible. That may mean that far more illiberal ideas for dealing with pay come into play.
There is an unfortunate tendency in the investment industry to repeatedly present public policy intervention as running the risk of negative unintended consequences. However, in respect of executive remuneration we may be in a position where a failure to act effectively soon runs the greater risk. Sometimes inaction is the most dangerous course.

Tom Powdrill is Head of Communications at PIRC, the corporate governance advisor.