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Section XVI
Executives and teams
Director and executive reward
Introduction
Inasmuch as compensation and reward in general represents one of the most delicate
aspects which have to be managed within an organization, setting directors and
executive pay in particular constitutes an even more difficult task employers have to deal
with. Indeed, decisions related to both aspects are normally affected by the endogenous
and exogenous environment and can potentially produce internal repercussions in terms
of both pay fairness and retention and attraction policies effectiveness. Notwithstanding,
executive pay is potentially more likely to gain public visibility, attract media interest and
eventually bad press; all undesirable events which would certainly blacken organizations
name and reputation.
Directors’ and executives’ pay decisions should be made by employers taking into
account the ideas expressed by a few relevant theories and the guidelines set by the
remuneration committees. Amidst the theories which can actually be considered
appropriate and significant for the executive pay decision-making process, the most
important are the agency and the tournament theories; even though this does not
necessarily entail that in modern times these theories are undoubtedly the most
conclusive and useful in practice.
The Agency Theory
The agency theory is underpinned by the assumption that since employers, or business
owners, have no direct grip on the way executives practically manage their business, in
order to avoid that these might be tempted to make personal profit or take personal
advantage by their position to the detriment of shareholders interest, employers should
pay them larger amount of money. In practice, companies’ shareholders should grant to
executives even greater sums of money in order to these produce better results and
boost business performance. This approach, called “incentive alignment”, is based on the
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idea that employers are willing to pay more to executives because they are expected
these to contribute more to organizational success.
As suggested by Perkins and Hendry (2005), this theory essentially aims at introducing
somewhat of a variable pay scheme based on the performance-related pay mechanism.
On the other hand, however, this approach to executive pay may also encourage risk-
taking as it has actually mostly been the case, for instance, of financial and banking
institutions (Bruce et al, 2005). Indeed, agency theory notwithstanding, it can hardly be
averred that nowadays employers’ decision on executive pay are made on the basis of
their concern for executives taking advantage of their position for personal benefit. Most
likely, employers are keen to pay executives more generous reward packages in order to
these enabling the firm to actually gain competitive edge.
The Tournament Theory
The tournament theory, to some extent, completes and reinforces the agency theory
adding to this an element of “relativity.” According to this theory, executives have to be
rewarded for the position they reach in the final rank, after having jousting in the market
league. Also in this case, hence, a direct cause-effect relationship between performance
and pay can clearly be identified. Executives, however, according to this theory, should
be rewarded in the light of the final place in the market competition they attain vis-à-vis
the other participants and not according to their level of performance considered in
absolute terms (Conyon et al, 2001).
Remuneration Committees
The role of remuneration committees is very much associated with governance.
Executives, as all of the other employees of any organization, are paid according to what
it has been agreed and showed in their contract of employment; its content and the
guidelines on the way this has to be prepared, notwithstanding, have to be clearly and
consistently set beforehand.
In the United Kingdom the need for all companies having a remuneration committee
emerged for the first time from the Cadbury Report (Cadbury, 1992). The main
recommendations made by the study, sponsored by the Stock Exchange, were that
committees should have been predominantly formed by non-executive directors and that
remuneration committees should have unveiled in the corporate annual reports details
about the executive directors’ pay.
Subsequently, findings of the investigation funded by the Confederation of British
Industry (CBI) and carried out by the Greenbury Committee (Greenbury, 1995),
suggested some other recommendations, in addition to those previously emerged from
the Cadbury Report.
More in particular, the Greenbury Committee recommended that:
Remuneration committees should have been exclusively formed by independent
directors,
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Guidelines on executive remunerations should have been included into the Stock
Exchange particulars,
In the companies’ annual report a specific section should have been devoted to
remuneration committees in order to these disclose details about executive
directors’ contract of employment, pay and benefits.
Three years later, an additional similar research was carried out by the Hampel
Committee under the sponsorship of the London Stock Exchange, the CBI, the Institute
of Directors (IoD), the Consultative Committee of Accountancy Bodies, the National
Association of Pension Funds (NAPF) and the Association of British Insurers (ABI). On the
subject of executive remuneration, the Hampel Committee recommended remunerations
committees not to refer to external surveys or inter-company benchmarking to make
executive pay decisions, but rather to come up with practices fitting the specific
company’s circumstances (Hampel, 1998).
As clearly emerged from all of the recommendations made in the above-mentioned
reports, the role of remuneration committees is hence that to design and develop the
most suitable reward practices for the company’s executive directors and non-directors
and identify for each of them the appropriate total reward package value (Hampel, 1998).
In the early 2000s, the Higgs Report, commissioned by the Chancellor of the Exchequer
and the Secretary of State for Trade and Industry, further stressed the need for
remuneration committee members to be independent and ensure that executive reward
packages were properly devised in order to avert rewarding executives for poor
performance (Higgs, 2003).
The task of the remuneration committee members is actually harder than it might
apparently seem to be. Executive and director reward packages in fact need to be
generous enough to attract and retain quality individuals, but not exceedingly generous
insofar as resulting unjustified and, even worse, to reward executives and directors for
failure. As maintained by Hewitt (2003), rewarding a few directors and executives for
failure can also seriously blacken the reputation of the national business. The need for
establishing a direct link between executive pay and performance, by extension, is
totally justified.
In order to execute their tasks remuneration committee members can have recourse to
external consultancies and advisors; however, this has to be eventually done with
caution. Consultants might be prone to suggest committee members to offer companies’
executives overly generous salaries in line with the external labour market pressures.
Indeed, albeit these forces cannot be totally overlooked, the primary objective that has
to be pursued when developing reward practices and packages is fitting the specific
circumstances. This aim has to be clearly explained to external advisors from the outset
in order to avert later disappointment and, even worse, to put in place policies
inappropriate and unsuitable for the specific circumstances.
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The problem with executives’ and directors’ pay
During the last decade, executive directors and non-directors pay has attracted public
and media interest mainly by reason of the overly generous pay offered by employers to
this specific category of employees. According to research, in the period from 1998 to
2011 the median total remuneration of FTSE100 CEOs recorded an average growth from
£1m to £4.2m. In 2011, nearly a quarter of FTSE 100 CEOs benefited from a 41 per cent
total reward package value rise vis-à-vis the previous year; however, the average pay
increase in the period has been calculated at 12 per cent. The findings of the
investigation also revealed that pay increases mostly occurred in the form of deferred
bonuses and long-term incentives, whereas base pay increased of just 2.5 per cent on
average (Manifest and MM & K, 2012).
The worth of the reward packages earned by CEOs and the pace at which these have
increased during the last years have both attracted public interest and bad press, insofar
as political leaders too have turned their attention to this issue and laid specific laws
down. In general, governments and regulators of many European countries have
imposed restrictions on public sector and financial services organizations, mostly
whether these are state-supported. None of the European countries has, however,
adopted any particular measures in regard to the executive pay of the private sector
organizations.
The main reasons why during the last decade executive pay has remarkably increased
are usually associated with:
The extended level of responsibility taken by CEOs for organizations becoming
increasingly larger and complex (Kaplan and Rauh, 2007);
The drawbacks produced by the need for more strict governance controls over
executives’ pay, requiring many employers having to disclose executives’ pay
details. Since employers benchmark their directors pay against the reward
packages offered by their competitors, this has caused businesses to offer
executives more generous reward packages in order to retain and attract quality
professionals. For the same reasons, employers of countries where no
regulations on executive pay transparency are in place have felt a fortiori
encouraged to offer directors more generous reward packages (BIS, 2011);
The evolution of rewarding systems which tend to become the more and more
sophisticated, accounting for employers paying larger amount of variable pay in
a bid to more effectively link executives’ performance and results to pay;
The trend pushing reward specialists to develop more complex reward systems
favouring deferred pay. Since according to these arrangements the higher the
level of risk the higher the pay, the base for pay is usually inflated in that
objectives might not be attained and executives might in turn receive reduced
bonus payments, if any (PwC, 2011);
The complexity of reward arrangements which may cause the link between
performance and reward to be blurred, at best, and completely lost, at worst.
Moreover, being these systems based on a larger number of reward options, it is
very likely that in the end some of them will be paid despite not completely
justified by the real executive performance.
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According to the Croner’s “Directors’ Reward Survey” (Cree, 2010), however, the typical
director’s fat cat image can be considered just as an executive representation of the past.
Findings of the investigation revealed, but this should not come as a surprise, that many
executive directors work more than 60 hours a week (21 per cent) and that some of
them seldom take all of their contractual holidays. As regards the link between pay and
performance, only half of the participants said that their pay is linked to performance; it
also emerged that this occurrence is mostly typical of large organizations. Nearly 50 per
cent of directors reported just a 2 per cent salary increase, 37 per cent said that their
pay had been frozen and 9 per cent of the respondents to the investigation said that
they had even undergone a pay reduction. Only 40 per cent of the directors reported
having received a bonus during the previous twelve months. The investigation also
revealed that the typical bonus amount was of £25,000 for executive directors and
£15,000 for executive non-directors.
The findings of the survey actually depict a scenery overly different from that known to
the general public. The investigation backdrop may possibly help to find out the reasons
for such different depiction. The questionnaire was sent by Croner to 45,000 members of
the UK Institute of Directors (IoD) whereas only 745 executive directors responded to
the survey, namely less than 1.7 per cent. The final result of the overall investigation is
hence the result of the opinion expressed by a minority of directors, possibly those less
happy with their current experience and circumstances.
Notwithstanding, the real reason for executive pay having caught the public interest and
having had bad press during the last decade is not that much associated with the
generous sums of money paid in absolute terms by employers to this specific category of
professionals, but rather with the lack of a clear cause-effect relationship between such
generous payouts and performance. In many cases, executive directors have received
very large amounts of money even for having failed to attain organizational objectives.
This bad practice, known as “rewards for failure”, has also actually had a remarkable
impact on executives’ and directors’ payment of severance packages. In some cases in
fact executive directors have received extremely generous severance payouts upon
leaving their companies also after having outrageously failed to attain their objectives.
Averting to reward executives for failure
In many countries the awareness of the negative impact provoked by such bad practice
has prompted governments to take appropriate actions. However, also the shareholders
of many organizations have expressed concern for the serious threat this undesired habit
could pose to their companies, not least from the reputational viewpoint.
The identification of a series of measures aiming at preventing executives to be
rewarded for failure has become hence necessary. Amongst these, requiring
shareholders vote on executive directors pay and attributing to this a binding value is
definitely considered of crucial importance. Giving firms’ shareholders “say on pay” is
believed to prompt these to be more involved in the business management and to
publicly provide evidence of the significance organizations associate with their executives’
pay decision-making process. Indeed, by reason of the relevance the phenomenon has
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lately acquired, shareholders’ vote should also be introduced for severance payments
determination. In the UK, this requisite has been legally introduced by the Companies
Act 2006.
Since the largest component of executives’ reward packages is represented by variable
rewards, particular attention has to be paid to the development of schemes establishing
a clear line of sight between pay and performance. Care needs indeed to be taken during
the implementation phase too; also in this case a sensible difference could emerge
between what has been designed on paper and implemented in practice.
The role of remuneration committees is clearly paramount and members composing
these should never forget that their main objective is that to foster the long-term
interest of the business.
Members of remuneration committees are habitually individuals who have the
professional experience and expertise to identify challenging objectives, set appropriate
reward packages and develop effective assessment methods of executive performance.
On the other hand, however, these individuals, just by reason of their past experience,
are also considerably influenced by the “generous pay” culture, insofar as what may be
deemed as excessive for the general public could be simply considered as a norm for
them (The High Pay Commission, 2011). Additionally, remuneration committee
components usually tend to design and introduce pay arrangements based on traditional
approaches, rather than coming up with new methods fitting the business circumstances
(Main et al, 2008).
It is the more and more believed that diversifying the composition of these committees,
avoiding these to be entirely formed by non-executive components of the board, may
definitely help (BIS, 2011). To this extent it may turn to be particularly effectual asking
independent members with, for instance, academic, consultancy and advisory
background (Hay Group, 2011) to become part of the commission with no need for these
to become full non-executive members of the board (BIS, 2011). The different
background and expertise of these individuals could indeed enable organizations to gain
new perspectives and develop new approaches to executive pay practices (TUC, 2011).
An additional feature, more directly associated with the full independence of the
remuneration committee members and in turn with their impartiality of judgment in
terms of executive pay decision-making, relates to the circumstance that many directors
may cover at the same time different positions in different organizations. This may cause
that, for instance, a person making pay decisions about the pay of another individual in a
given organization is subject to the decision made by that same person in a different
organization, still in terms of reward. This could clearly affect the pay decision process in
both organizations and cause evident conflicts of interest which should be averted from
the outset (BIS, 2011).
Some stakeholders in the UK have supported the idea that, in order to implement a
radical and effective change in the executive pay decision-making process, employee
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representatives should be invited to be part of remuneration committees. This
recommendation is based on the assumptions that employees would better dissect pay
or severance pay proposals practically aiming at rewarding executives for failure and
would better assess extremely generous executive pay offers and increases vis-à-vis
those offered to the other employees, especially when the latter have benefitted of very
modest pay increases or the business has made people redundant.
Where implemented this initiative has produced mixed results, as well as has produced
mixed reactions the proposition to introduce this initiative as a rule in some other
countries. According to research conducted by Buck and Sharhrim (2005), for instance,
employee involvement has produced positive results in Germany; by contrast, several
other investigations have underscored the difficulties emerging when trying to execute
this approach in practice in other countries.
The effectual implementation of this initiative implies first and foremost that employees
have or gain an in-depth knowledge of the business strategy. Additionally, it should be
clearly defined what their responsibilities are and this aspect could be clarified only
determining whose interest these are supposed to protect: that of the employer, that of
the employees or both? Whether these should be representative of the employer interest,
it should be assumed that it would be up to the employer nominating these, whereas in
the case they should be representative of the overall workforce interest it should be
most appropriate these to be elected by the employees.
The implementation of this approach should be also clearly based on the company law in
force in each country. Europe, for instance, is characterized by a fair level of
heterogeneity in term of employee representation at board-level insofar as three
different grouping of countries can be identified with reference to this aspect (Worker
Participation, 2013):
Countries without any specific legislation (Belgium, Bulgaria, Cyprus, Estonia,
Italy, Latvia, Lithuania, Malta, Romania and the United Kingdom),
Countries where employee board-level representation is limited to state-owned
companies (Greece, Ireland, Poland, Spain and Portugal),
Countries where employee board-level participation is extended to private sector
employers (Austria, Croatia, the Czech Republic, Denmark, Finland, France,
Germany, Hungary, Luxembourg, the Netherlands, Norway, Slovakia, Slovenia
and Sweden).
Notwithstanding, board-level employee representation is differently regulated in each
nation. In many countries, for instance, it is subject to the number of employees forming
the overall workforce. The lowest threshold has currently been set in Sweden with 25
employees, whereas the highest in France with 5,000 individuals. Differences are also
concerned with the rate of board seats occupied by employees and the title seats are
occupied, namely whether these are taken on a supervisory board or single tier board
title (Worker Participation, 2013).
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The introduction of laws regulating board-level employe