Executive Remuneration

November boasted two articles related to executive remuneration that showed immense insight. Firstly, Chris Bones, stepping down as head of Henley Business School, delivered a speech in which he skewered the ‘Cult of the Leader’. He discussed the reward disparity of the leader

"There is a plethora of statistics to show the unequal rate of growth of CEO and leadership rewards versus that of the average wage-earner.

In 2006 the chief executives of America's 500 biggest companies got a collective 38% pay raise to $7.5 billion. That was an average $15.2 million apiece.

In the UK in 2007 chief executives earned on average 98 times more than the average for all UK full-time workers.  Ten years ago the pay differential was 39 times that of the average worker."

Then he addressed the weakness of the justification

"And, with some notable exceptions … performance doesn’t seem to come into it.  Sixty companies at the bottom of the Russell 3000 Index in the US lost $769bn in market value in the five years ending 2004 while their boards paid their top five executives at each firm more than $12bn.

Many of today’s leaders of enterprise are rewarded far more like the entrepreneurs than corporate stewards.The point of being an entrepreneur is that you are prepared to risk your own capital and if you fail there is no one to give you a handsome severance payment and a pension pot worth millions of pounds when they fail."

And then he homed in on the problem

"When you get this reinforcement of personal worth within a corporation displaying all the signs of being narcissistic you have the ingredients for a tragedy."

The problem we face is self-reinforcing. Because heroic leaders are the fount of all success they must be paid massive rewards, which they must justify by adopting high risk/high return short-term strategies. If these work, their market value boosted, they will tend to move on to another role. If they don’t work, they will move on, cushioned by a large severance payment. And, of course, they must be heroic…look how much they are paid!

Then Sir Paul Judge, an immensely successful business leader as well as a philanthropist, wrote an article in the Times, with the authority of first hand experience, that explained at least part of the origin of the problem. He lays a large part of the blame at the door of the Greenbury report into directors’ pay in 2003.

"...remuneration practice since has been fatally undermined by the innocent paragraph 4.16: “The (remuneration) committee should have access to reliable, up-to-date information about remuneration in other companies and should judge the implications carefully.” This was coupled with paragraph 5.2: “We attach the highest importance to full disclosure of directors’ remuneration as a means of ensuring accountability to shareholders and reassuring the public.

The law of unintended consequences often bites hardest those who believe most in their good intentions. Those two paragraphs were an invitation to consultants … to provide boards with reams of comparative information. The consultants then scour the annual reports and provide an analysis of pay practices for salary, bonus and long-term incentives. These typically show a spread of about plus or minus 30% around the average figure.

The remuneration committee then decides where its executive should fit. I have never known of a remuneration committee prepared to declare that its chief executive is below average (they would presumably then have to sack the person). Typically, a committee will pitch the salary at around the upper quartile of the comparator companies.

However, when the pay consultants go through the exercise the following year — using the latest information incorporating increases resulting from companies having placed their executives at the upper quartile — pure arithmetic means the average must have increased. Detailed maths shows that if there is a plus or minus 30% spread and all committees separately agree the upper quartile for their executives then the average will rise by about 15% — exactly what it has done since Greenbury was implemented."

Judge believes in restoring the link between top pay and bottom pay through an approach that uses multiples rather than comparability with other overpaid executives.