Executive pay is an emotive issue. You need to keep both your directors and your shareholders happy. This may mean questioning traditional packages, warns Peter Brown.

Executive pay is an emotive issue. You need to keep both your directors and your shareholders happy. This may mean questioning traditional packages, warns Peter Brown.

Recent incidents have focused attention on executive pay. Not least was last summer's Tompkins affair, when Greg Hutchins was asked to resign by the independent chairman following revelations about the perks he'd enjoyed in the previous decade.

"Fat cat" allegations can damage your corporate reputation and, in some cases, the goodwill of your brand. Your remuneration committee must be on top of your pay system for directors.

Committees that have pronounced on good corporate governance in relation to executive pay in the last decade include the Cadbury Committee, the Greenbury Committee and the Hample Committee. The latter's report in 1999 was turned into the combined code which sets the governance standard for pies. Virtually every company of any size, whether it is fully quoted or on the AIM or OFEX markets, has established a remuneration committee of the main board, staffed entirely by independent directors (IDs).

Effectiveness of IDs
Do IDs have sufficient power to affect governance issues? The findings of the Independent Chairman and NonExecutive Director Survey 2001, carried out by the Top Pay Research Group and 3i pie, show that the collective power of increasingly knowledgeable IDs to influence the board over key decisions, having increased steadily up to 2000, has now gone backwards.

The most worrying statistics relate to the companies with an independent chairman, where IDs feel that they collectively have less power than they did in 2000. This supports the increasing concern of investors and others that IDs may not be kept fully in the picture in areas such as directors' compensation. Here the percentage who are satisfied with their power has dropped from 93% to 85%.

The number of companies in our 2001 sample with a combined chairman/CEO is slightly more than for 2000.

Generally speaking, their IDs' confidence in their collective powers has increased. However, the number who feel they can influence strategic decisions, a vital ID role in this predominantly smaller company group, has reduced by 10% to 60%. The solution is obvious. If shareholders wish non-executives to have more influence on appointments, dismissals and directors' compensation, they should insist on the company appointing an independent chairman.

We also asked IDs in companies with an independent chairman if they felt they had sufficient power to implement governance recommendations.

Here again, percentages are beginning to plateau with only small increases on previous figures. The difference between quoted pie groups and private companies are in line with our expectations, but figures for AIM and other groups with pie status look low, as they did in 1999. Directors in such groups do not have to follow the combined code in full, although many choose to do so. It seems that it is in the remuneration area that IDs often have the most difficulty in persuading executives to accept transparency on following governance guidelines.

Don't get sidelined
The lead non-executive director often chairs the remuneration committee. It is one of the most onerous independent jobs available. The chairman will often have to question internal views on what would be a suitable uplift in salaries, a sweetening of bonus schemes or possibly an over-generous allocation of options. He won't earn his colleagues' love but he does need their respect.

The remuneration committee only needs to deal with the total remuneration of the main board directors . However, in practice, its remit probably runs to the chief executives of major operating divisions who do not sit on the main board, the allocation of options and possibly cash bonus policies.

The committee should not to get involved in items such as the value and allocation of executive cars, how far down a company medical insurance scheme should go, sales commission rates and similar issues. These are the responsibility of the chief executive or department heads. If a committee does get involved in such areas, it will become overloaded with trivia.

Establishing policy
In most companies, the head of human resources or the CEO will prepare a paper recommending review levels to the committee. It may be necessary to submit this to an independent consultant for evaluation if committee members don't feel they have the skills to do this themselves.

Such papers often suggest fairly generous up-lifts in remuneration, based upon comparisons with five or six companies generally seen as similar to the business itself. In fact, such companies normally tend to be larger and possibly more profitable - so any pay comparison with the executive cadre in those companies will reveal that your company is paying below the median level.

Inevitably, the CEO will imply: "We need to be a generous company to attract and retain key staff. You (the IDs) would obviously like us to be a generous company. Therefore, we should pay above market rates, ie the upper quartile". Five or six companies comparing salaries and bonuses in a kind of "remuneration club" produces a hopelessly inflationary situation. They all want to be upper-quartile payers. Inevitably, this leads to very rapid remuneration escalation.

Questions may be asked, either by shareholders at the annual general meeting or, possibly, by organisations like PIRC. The latter, set up by local authority pension schemes, monitors all fully quoted company accounts, checking and

ticking them off against a template to see if they are obeying best corporate governance practice. PIRC will always pick up excessive remuneration policies or excessively generous contracts of employment, including notice periods of over a year. It brings these to the attention of local authority pension scheme investors. These in turn may alert other major shareholders before the annual general meeting.

It is in your interest to avoid conflicts of this sort. Although a remuneration policy needs to be creative, the committee must avoid the trap of simply getting into a comparative type annual assessment. The following can help

  • taking advice
  • using an outside consultant
  • introducing consistent policies that relate to the group's business needs and long term plans

    If your remuneration committee hires a consultant, it should choose a firm that is used to dealing with companies of your type. As this is likely to be a long-term relationship, good chemistry between the individual consultant and the remuneration committee members is important. Any committee member should be able to call the consultant at any time, for example to check whether any new remuneration systems, such as the MFI initiative announced in the recent budget, could be relevant to the company's directors.

    Evaluating performance
    Your company needs known and quantifiable criteria against which to measure salary increases. These will probably be a combination of retail price inflation, how the company has performed and what is happening in similar companies. Then your committee can decide whether to raise salaries, bearing in mind its individual policy, ie paying slightly below median salaries with a high bonus, paying median rates, or paying above median salaries (most common in sectors where there is strong competition for qualified staff).

    Bonuses are more complex. At this level, they will almost certainly be based on the company's achievement in the last year against its internal budgets or market expectations. It can be difficult to explain to shareholders why you have paid bonuses to an executive team when profits are below the previous year. However, in some industries, exchange rate fluctuations, specific market situations or Y2K type booms make it virtually impossible to outdo the previous year's profits. If you suffer a drop of only a 3% or 4% compared with a 10-20% profit reduction by most of your competitors, bonuses are justified. Many remuneration committees don't see it this way. But only paying bonuses for increased profit regardless of market conditions can mean risking losing some very good executives.

    Allocating options
    The committee also has the duty to recommend option allocations to the board. Most companies now allocate executive share-options on a trickle basis. They issue a certain number of options to the beneficiary group each year rather than the whole amount eligible.

    A recent trend is to put internal hurdles into the option scheme. This prevents option owners cashing them, even if the shares have doubled in value, unless the company has achieved certain internal bench-marks. The latter could include an increase in earnings per share of, say, 40% over three years, the return on shareholders' funds increasing from, say, 12% to 17%, or total shareholder return which is the increase in share-price plus the added back dividends averaging, say, 20%.

    In some cases, companies impose an external share price hurdle. Although the shares have risen and internal hurdles been met, executives cannot cash their options unless the market price of the shares has actually risen by certain predetermined steps, for example, an average of 7% per year over three years, ie 21% from the day when the option was granted. This type of external price hurdle is particularly useful for companies that might be involved in a take-over or merger. In that situation, options tend to be encashable on a change of control. But an external price hurdle can ensure that executives can only cash in if the shareholders receive a premium price.

    Adequate reporting
    The chairman of the remuneration committee's report is included in the published accounts of every fully quoted company and many AIM and some OFEX groups, though it is not mandatory in their case. It specifies how the committee has gone about its work in the past year, how it has met the various corporate governance requirements on directors' remuneration and generally is a tour d'horizon of what is happening to main board remuneration. It may also cover some of the broader corporate issues, such as the method of allocating options, how bonuses are awarded and remuneration philosophy.

    The committee's chairman should not use this opportunity to give his personal views on general pay policies across the nation, such as the minimum wage. These are largely irrelevant to the shareholders of the company concerned. At the same time a couple of paragraphs just saying "We obey governance guidelines and here is a list of directors' bonuses and salaries" will not really do. Committee chairmen should give a flavour of how the independent directors have looked after shareholder and other interests and how they have assessed risk when considering the pay of the executive team over the previous year.
    Peter Brown is chairman, Top Pay Research Group Ltd, Tel: 020 7836 5831, e-mail: pbrown@toppay.co.uk

    Rising salaries
    Stock exchange company directors' pay rose by over a fifth on average in 1998, according to the latest annual Labour Research survey, published in September 2000. The highest-paid directors of quoted companies saw average pay rises of 212%, compared to 10.7% in 1998.

    Labour Research Department said that senior executive pay rises were far outstripping inflation, which ran at around 3% or less over the period. Typically, they ran at four times the pay increase of workers generally; earnings in the economy as a whole increased by around 5%. Many of the largest pay increases came mainly through big bonus payments.

    Issues Yes No Maybe Yes No Maybe Yes No Maybe Yes No Maybe
    % % % % % % % % % % % %
    Change underperforming directors? 92 0 8 82 6 12 35 17 48 42 23 35
    Influence the media/City perceptions of the company? 50 28 22 46 25 29 21 48 31 37 26 37
    Control directors' renumerations? 93 1 6 85 3 12 66 7 27 66 9 25
    Force a change of professional advisors? 90 2 8 85 4 11 40 34 26 68 11 21
    Address shareholders direct? 50 28 22 50 20 30 39 34 27 34 30 36
    Influence strategic decisions? 95 0 5 86 4 10 70 2 28 60 8 32
    Independent Directors' influence on implementing governance recommendations
    Boards with an independent chairman.
    Company Status 2000 2001
    Yes No Maybe Yes No Maybe
    Fully quoted 99 5 1 95 1 4
    AIM or plc groups 84 5 11 86 1 13
    Private companies 55 24 21 60 18 22