Executive Remuneration in need of a major makeover

15 July 2009 PricewaterhouseCoopers

Executive pay has changed beyond recognition during the last decade or so of economic growth, as previously modest infrequent bonuses have transformed into incentives that now form the majority of the total pay package of a senior executive. The current downturn, together with the turmoil in financial services, has brought the subject firmly into the spotlight. It has provoked widespread public anger about pay practices with regulators already issuing codes of practice that require appropriate reward structures that avoid incentives for excessive risk-taking. There is also a greater willingness among shareholders to vote against the remuneration reports of companies adopting practices that they do not approve of.

Gerald Seegers, PricewaterhouseCoopers SA partner and human resources tax specialist, says that executive pay models have largely failed to meet either of their key objectives - motivating executives, and aligning their reward with shareholder outcomes - and some serious changes are required.

PwC highlights in its May 2009 report “Preparing for the challenge ahead - The future of executive reward” that one of the key factors in this imminent transformation is that new executive reward models are required. Seegers says we need to challenge the use of the more traditional Total Shareholder Return and Earnings Per Share performance measures in long-term incentive plans, as these standard models do not produce the desired results. “Incentive designs should rather be tailored to the needs of that specific business and also kept relevant and simple, both in the number of elements and in their design. Executives should effectively be made significant shareholders in the business through shareholding requirements and increased use of restricted share options without performance conditions, with long-term holding periods to generate closer alignment of interests.”

Companies must also tackle the contentious question of ‘pay-for-performance’. Seegers says there is cynicism among shareholders that companies pay executives regardless of performance, exercising their discretion to pay out even when the formula does not yield the desired result. “There is a clear need to ensure that the relationship between pay and performance is robust. Key to this is that companies must demonstrate when the financial success of a business is as a result of the skills of the senior executive team - and conversely, where luck played a role. A pay-for-performance approach requires differentiation of these two and caution should be taken that such a remuneration policy does not encourage excessive risk- taking to boost performance.”

The unending upward momentum of executive remuneration also needs to come to an end. “The business responsibilities of executives have increased dramatically, prompting greater rewards; stronger corporate profits have made these higher levels of pay more affordable; and a talent war has supported this trend” notes Seegers. “However companies must stop trying to be at the median of the corporate remuneration scale and rather pay relative to the market, based on their own circumstances. Not everyone can be at the median. They should also first look inwards for talent as a more cost effective approach.”

Reward packages must also be considered in their totality. Executive reward is multifaceted, typically including fixed short-term pay in the form of salary and benefits; fixed long-term pay in the form of pension; variable short-term pay in the form of annual bonus; and variable long-term pay in the form of deferred bonus and long-term incentive awards. With the exception of salary and benefits, all of the other components of reward introduce uncertainty. However the remuneration committee must place a value on these different elements, which can move significantly in value over time, when making decisions on incentive awards. They must give thought not just to the value of reward today, but to the potential payouts and the impact on future retention value. Robust valuation methodologies involving specialist advice may be required to do this effectively.

Seegers says the remuneration committee will need to become more challenging and should not be afraid of exercising its discretion. “Committee members may have to increase their reliance on appropriate and truly independent advisers and specialists, improve their own knowledge, and cease being overly dependent on historic data which has limited relevance. Pegging of pay to market levels has introduced a systematic upward shift in the market itself, with pay for performance decisions being lost in the general upward movement of the market as a whole. The primary driver of reward decisions must always be the specific circumstances of the business and its stakeholders - and data can never provide the answers in isolation.”

In the clampdown and changes that will occur to executive remuneration, Seegers says it is important not to lose sight of the value that skilled executives performing at the top of their game do create for shareholders. “There is the danger that poorly-designed reward programmes lead to disengagement and discouragement. However, there is the legitimate requirement for companies to be able to justify executive pay decisions and demonstrate that they have made such decisions robustly and objectively. While there will always be a school of thought believing executive pay is excessive, many of the challenges over pay levels can be mitigated through greater transparency of the decision-making process and demonstrating the link between pay and performance. The remuneration report has to move beyond being a mere compliance document to an effective communication tool, explaining and justifying policies, rather than merely presenting facts.”

This had led Regulators around the world, and others concerned with financial stability issuing codes of practice requiring appropriate reward structures that will transform the governance and design of executive pay.

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