Pay and Performance

Current media interest makes it clear that the issue of director remuneration remains firmly in the public eye. Headlines, not surprisingly, tend to stress the number of share options or similar long term incentives awarded to senior executives, with particular emphasis on the levels received by those CEOs associated with company failure. Recent examples include Kenneth Lay at Enron and Bernie Ebbers at Worldcom who have both recently appeared in the news in connection with the significant pay that they received even as their companies were falling in value.

Shareholders and incentive schemes
A UK company that wishes to award directors a long term incentive arrangement must first seek shareholder approval. Given that executive compensation is primarily used as a mechanism to align the interests of shareholders and managers, this approval is usually given. It is worth noting that shareholders do not automatically oppose a scheme just because the potential rewards may be significant. Further, shareholders will have the opportunity to vote on the remuneration report, thus providing a channel for shareholders to communicate with management.

Some companies do, however, run into difficulties with their shareholders. The Prudential recently decided to shelve a proposed scheme, in response to shareholder pressure. Shareholders were apparently concerned about the complexity of the scheme and that, in particular, the linkage between pay and performance was not transparent. Some shareholders were further concerned that the board was given too much discretion in the setting and measurement of performance targets.

Robert Booker of Mercers' executive compensation practice says that: "Shareholders must be satisfied that performance measures are applied in such a way as to ensure that the alignment of shareholder and manager interests is correctly established and maintained. However, it is difficult to design a performance measurement scheme that can, from the outset, deal with all eventualities. For this reason, Mercer advises its clients to ensure that an element of discretion is retained by the remuneration committee to be applied after the event, in their assessment of the actual results achieved in any given year."

So what goes wrong?
Given that executive compensation schemes are in shareholders' interests, and given that they have to be approved by shareholders, there is clearly no simple answer to the question of how they can go wrong. In some cases, over-reliance on a formulaic calculation can lead to situations where the company has performed well against the specific targets but has not created value for shareholders. In other cases, directors may not have been as diligent as they could have been, or information may have been deliberately withheld from them. In each case, though, it is the non-executive directors who are held accountable.

The role of the non-executive directors is certainly not straightforward. They have to balance upward pressures against downward constraints. Upward pressures include increasing globalisation, growing demands on CEOs, shortage of proven executive talent and the influence of US style reward packages. The downward constraints include institutional investor pressure and media focus.

Remuneration committees have to design packages that will attract, retain and motivate. If they fail in their duties, the risks include losing their best people, with the obvious associated risks to company performance and reputation.

What can be done?

Derek Higgs has recently been appointed by the Department of Trade & Industry to lead an independent review into the role and effectiveness of non-executive directors. This review will assess: