Pay and Benefits

“Simply unacceptable.” That is how MPs described the decision by Network Rail to award Chief Executive Iain Coucher more than £1 million in bonuses while the organisation he led fell short of efficiency targets and performed 40 per cent worse than European counterparts.

It is a familiar story, and one that is rarely far from the headlines. There was furore in 2010 over the pay of local authority chief executive officers (CEOs). In recent weeks the BBC has been under fire as BBC Trust Chairman Lord Patten promised to tackle the “toxic” issue of pay at the Corporation.

Then there are the banking chiefs. According to data gathered for the Financial Times in July, the average pay for these executives has increased by 36 per cent in the past year. In the UK, those at the big four banks – Lloyds Banking Group, Barclays, Royal Bank of Scotland and HSBC – received rewards in the form of both cash and stock bonuses to the value of £16.1 million.

Indeed, in May, Lord Hutton’s High Pay Commission reported that if current trends continue, the top 0.1 per cent of UK earners will see their pay rise from five per cent to an estimated 14 per cent of national income by 2030. This is a level not previously seen in the UK since the start of the 20th century.

It is a significant and growing issue, and one that pay and benefits professionals need to consider. Increasingly, boards will come to them asking for the facts on this issue, seeking their opinion on whether or not it matters, and crucially demanding to know best practice in the area. Advising on the boss’s pay is a thorny issue, but one that the very best in the profession will be willing to grasp with both hands.

According to the High Pay Commission, in 2010 the average annual salary of FTSE 100 chief executives was roughly £3,747,000 – 145 times greater than the national median full-time wage of £25,800. The report predicts that by 2020 they will earn 214 times the average pay.

In just the month of July 2011 there were two startling examples of what many view as excessive pay. Firstly, Dixons Retail announced it was awarding its Chief Executive John Browett a cash bonus of £122,000, and total remuneration of £1.03 million for 2010–11. That was down from £1.57 million the year before.

Then David Yu, the outgoing boss of online betting firm Betfair, took home £824,676, a pay rise of 125 per cent. This was despite a 50 per cent collapse in the company’s share price since a disastrous flotation in October 2010.

They are by no means the worst offenders of recent months. According to a 2011 survey by pay specialist Inbucon, Thierry Falque-Pierrotin from Comet owner Kesa is the most overpaid FTSE 250 chief executive. He took home £2.1 million, while the group’s sales fell by 1.5 per cent on a like-for-like basis.

 

It is true that sometimes top pay falls. In 2010 Sainsburys boss Justin King took home £8 million, while this year he will have to get by on just £3.2 million – despite profits rising by nine per cent.

Whether you look at sales, profits or share price, there seems no clear link to chief executive pay. In general their salary increases regardless of how well the company performs.

In fact, the situation might be even worse. In February Raghavendra Rau, the Rothschild Professor of Finance at Cambridge Judge Business School, released a paper in conjunction with colleagues from the University of Utah and Purdue University. It looked at 1,500 of the largest companies in the world and found that the top 10 per cent, in terms of chief executive pay, saw profits fall by an average of nine per cent over three years.

Professor Rau comments: “Not all chief executives are overpaid, but some are. Our research found quite conclusively that the more share options a CEO is paid the worse a company performs.”

Professor Rau goes on to explain why he believes this happens. “The problem is that CEOs only compare their pay to that of other CEOs. They might be paid 145 times the average wage, but if their competitor gets 150 times that they believe they are poorly paid. That just ratchets up pay levels completely unrelated to performance.”

So, why might this have such a detrimental effect on company performance? After all, there is only one chief executive in a company. The actual amount has little bearing on a company’s bottom line. The experts believe it is a problem for two reasons.

Firstly it can demotivate workers. According to the Office for National Statistics, UK workers have lost £647 in take-home wages in the past year. The average salary increase over the past year was 2.3 per cent, but with inflation running at five per cent this is in real terms a pay cut.

Peter Reilly, Director of HR Research & Consultancy at the Institute for Employment Studies, says: “In tough times it is more important than ever that workers feel they have a shared destiny with those at the top of their organisations. If they see the chief executive receiving a huge pay rise while they are having to struggle to make ends meet, it does a great deal of damage to their commitment and motivation.”

 

The second issue with excessive pay is that it is a symptom and possibly a cause of poor CEO recruitment and selection. Ultimately, spiralling pay attracts those who are good at finding higher paying jobs and performing well in interviews.

Professor Rau says: “People who are overconfident risk-takers tend to look for options-based remuneration packages, while it is often long-term strategists who make the best CEOs.”

Not only does this mean those organisations bring in the wrong bosses, but that they do not even stay long enough to devise and implement effective strategies. According to Booz & Company’s 2011 CEO Succession Study, a staggering 14.3 per cent of CEOs at the UK’s top 300 companies changed jobs in the previous 12 months.

A combination of worker demotivation, poor executive selection, and a lack of long-term strategic thinking tend to prove damaging to a company’s prospects. In many cases these problems stem from excessive CEO pay. The crucial question is what can be done about it.

In his report on fair pay Lord Hutton proposed a salary cap of 20 times the average pay. It is an appealingly simple idea, but one that has significant flaws.

“For one thing it’s impossible to enforce,” says Peter. “There’s always a way to make indirect payments or non-cash compensation. Then there’s the issue of international competition. How could we lure the very best CEOs to the UK if competitors in the United States or elsewhere could pay more?”

For his part, Professor Rau believes the issue of excessive CEO pay is to some extent unavoidable.

“There is the issue of moral hazard,” he says. “You can’t force someone who has contracted to do something to actually do it.” That said, he does believe that companies can reduce their exposure to this risk, primarily by selecting the right people in the first place.

 

Andrew Menhennet, Director at AM Consulting, believes there is more that companies can do. He suggests a further four steps that should be followed to make it more likely that high CEO pay in their organisations will result in high sales, profits and dividends.

“The first step is to get accurate, high quality benchmarking data,” he says. “It’s never an entirely scientific process but you must bring in professionals who can access the right surveys, compare your organisation with genuine competitors, and provide insightful analysis.”

Andrew then recommends establishing a strong governance structure. In larger companies this is a remuneration committee; in smaller ones it is the board of directors. Whichever it is, they need to be people with the skills, knowledge and above all else, confidence to make what can be difficult decisions. They must be fully apprised of all the facts, and they must follow a proper procedure. Once you have the data and the people, you need to put in place the right policies.

He says: “The company needs to spend time thinking about what outcomes and behaviours it wants to reward, where it wants to peg itself against its competitors, and how to get the right balance between base pay, bonus, share options, and other benefits.”

Peter also notes that it is important to consider timescale. “Sir Alex Ferguson is the best example of this,” he says. “In January 1990 the Manchester United Manager had found no success in his first three years and his job was only saved by a last-minute winning goal in the FA Cup third round. He went on to win the trophy, the first of many. Maybe more companies should consider structuring CEO pay with this in mind.”

Andrew’s final step is transparency and disclosure. He says: “Companies need to avoid shocking customers, shareholders and employees with revelations about CEO pay. They should openly publicise how much they pay their bosses and explain how they have arrived at that amount.”

There are few examples of companies that do all this well. To a large extent this is due to a governance deficit. While it tends to be shareholders who suffer from poor CEO performance, they lack power to compel boards to rein it in. It is only directors on remuneration committees who can do that, and all too often the same people move between companies, simply signing off pay increases and failing to ask the difficult questions.

However, as more and more stakeholders become aware of the inverse relationship between CEO pay and company performance this will change. A growing number of those directors will look to their payroll and benefits teams to give them the advice they need.

It will take courage for those professionals to deliver that advice – proposing a cut to the boss’s salary has rarely been a route to career progression – but effective remuneration packages should see the best long-term performers better rewarded, and the short-term bluffers weeded out. The payroll and benefits professionals who can give advice enabling companies to do that will be the ones most in demand in the years ahead.

 

Alex Blyth is a Freelance Journalist