Sarah Jane Leake | Bloomberg Law
The concept “pay for performance” has dominated corporate governance culture over recent years. However, while corporate governance reforms have tried to align directors’ and shareholders’ interests by linking pay to performance, the UK’s High Pay Commission’s (HPC) latest report1 reveals that there is in reality little link between a director’s incentives and the way in which a company performs.
Statistics show that, over the last decade, the average annual bonus for a FTSE 350 director increased by 197 percent while the average year-end share price fell by 71 percent. Is the link between pay and performance therefore merely illusory?
Corporate Governance Reforms
Some 20 years ago, Sir Adrian Cadbury was asked to develop the first corporate governance framework for the UK. The report2 was published in 1992, and the principles articulated therein have guided corporate governance developments ever since. One of his recommendations, which has had lasting effect, stated that boards “should appoint remuneration committees . . . to recommend to the board the remuneration of the executive directors in all its forms, drawing on outside advice as necessary.”3 While it was thought that this would help curb executive excess, such expectations were premature. Concerns over “fat cat” salaries resurfaced during the mid-1990s, sparked by some big pay rises for the executives of the country’s recently privatised utilities companies.
To help calm the public storm, Sir Richard Greenbury was commissioned to further develop a corporate code of best practice.4 Accepting and building on the principles set out in the Cadbury Code, the Greenbury Code emphasised two further themes that ended up shaping the future of executive remuneration – pay for performance, and the alignment of shareholder and director interests.
The Greenbury Code, however, failed to restrain pay at the top and dampen public disquiet. Further committees were subsequently set up by the Government in order to tackle the problem. As a last resort, in 2005, the Government amended the company law legislative framework, to put remuneration disclosure requirements on a statutory footing.5 Amongst other things, quoted companies were required to publish a directors’ remuneration report as part of their annual reporting cycle.
The Financial Sector
“Nowhere,” comments the HPC, “is there a clearer example of corporate failure than in finance.”6 In 2010, the average total earnings of executive directors in state-supported banks amounted to just under £4 million, compared to a significantly lesser sum of £1.7 million 10 years earlier – a difference of almost 130 percent. This figure is all the more shocking upon learning that earnings in state-supported and bailed-out banks outstrip those in the rest of the FTSE 350 and in non-state-supported banks.
Northern Rock was the first UK bank to suffer a bank run in 150 years. Ironically, just two years before it was taken into state ownership, its annual report stated that “the continuing improvement in the performance of the Company depends on individual contributions made by the Executive Directors. For this reason, the remuneration policy is designed to provide transparency, competitive packages to motivate, reward and retain Executive Directors.” Upon the company’s near-collapse, its five directors received salaries, bonuses and benefits to the tune of £6.2 million – a sum that, evidently, failed to ensure improvement in company performance.
The new rules inevitably did little to stem the tide of criticism levelled at the financial sector, particularly during and in the wake of the financial crisis when pay restraint and pay freezes prevail for many.
In line with the recommendations arising out the Walker Review,7 the Financial Services Authority developed a Code of Practice of Remuneration (Remuneration Code),8 which came into force on New Year’s Day 2010. Initially applicable to the 26 biggest FSA-regulated banks, building societies and broker-dealers, the Code provided that firms “must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management.” A revised version of the Remuneration Code came into force on 1 January 2011,9 and now over 2,500 firms fall within its scope.10 Amongst other things, the Remuneration Code makes performance-related remuneration subject to clawback and requires that it is assessed in a multi-year framework.
These rules, however, only apply to a small percentage of companies in the UK. Further, statistical evidence indicates that they are not working as effectively as anticipated. While a number of banks claim to have embraced the pay for performance culture, in the wake of their failures, serious doubt is cast on whether the generous incentives schemes that top directors participate in really do improve company performance.
Trends
Today, a typical executive compensation package includes a base salary, benefits (e.g., healthcare insurance), short-term incentives (e.g., annual bonus), long-term incentives (e.g., performance shares, share options, etc.), self/co-investment plan, and a pension.
There has been a shift away from fixed remuneration, in favour of variable compensation arrangements. This has not, however, come at the expense of absolute rises in salary – instead, an additional layer of incentive awards is given on top of base salary levels for executive directors which themselves have increased 63.9 percent over the decade.
Remuneration packages are also becoming increasingly more complex, comprising a myriad of schemes with overlapping aims and targets. While annual bonus schemes appear to be evolving into medium-term incentive plans, long-term incentive plans (LTIPs) are increasingly becoming the long-term incentive of choice.11 Further, the average value of LTIP awards has grown spectacularly over recent years – by 700 percent in just nine years. In the HPC’s view, this growth is completely out of proportion to any change in stock market measures; year-end share prices have fallen, market capitalisation has not improved, and there is a difference of some 640 index points between the growth in LTIP awards and EPS.
Over the last ten years:
- Total earnings of all FTSE 350 directors has increased by 108 percent;
- Salaries of all FTSE 350 directors have risen by 64 percent;
- Annual bonuses for all FTSE 350 directors went up by 187 percent;
- Year-end share prices dropped by 71 percent;
- Pre-tax profits increased by 51 percent;
- Earnings per share (EPS) rose by 73 percent; and
- Market capitalisation went up by 8 percent.
Therefore, almost all the elements of boardroom pay have increased at a faster rate than corresponding measures of corporate performance. This suggests that there is no real relationship between pay and performance.
Admittedly, there was a fall in bonuses during the financial crisis. Yet, the effects of this drought “were dampened by less drastic declines in the remaining variable elements of directors’ remuneration and by the continuing rise in basic salary levels.”12 Therefore, total earnings suffered “only marginally” during the crisis13 and, although recovery is still in its infancy, statistics suggest that incentive levels are already back on track.
Survival
If the purpose behind incentives is to promote good performance, it should therefore ensure the long-term success of the company. This, in particular, means continuation in the FTSE 350, often labelled the corporate badge of success.
Companies fall outside the FTSE 350 for a number of reasons, not all of which are indicative of failure. However, non-survival does suggest that paying higher incentives does not automatically ensure long-term success.
If survival in the FTSE 350 is interpreted as a sign that incentive schemes deliver long-term performance, statistics show that they have not delivered. For example, of the 757 companies that have featured in the FTSE 350 since 2000, only 124 remain. Comparing incentive schemes offered by both the survivors and the non-survivors, the HPC finds that over the decade, the average value of LTIPs in surviving companies increased by 488 percent compared to a much higher 1,476 percent in non-surviving companies.
The HPC therefore concludes that having a highly rewarding LTIP does not guarantee a good corporate performance over the long-term.
Conclusion
While, during the crisis, there was a dip in directors’ remuneration, it has not taken long for executive earnings to resume business as usual. Without further legislative restraint, the unhealthy trends outlined above are likely to continue, mounting excess upon excess. In the meantime, the HPC’s recommended course of action is quite simple – to cite Deborah Hargreaves, HPC Chair, “boards need to think again about how to structure their pay awards.” 14
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