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TOP EXECUTIVE COMPENSATION.
PART TWO

THE COMPLEX AND OFTEN SURREAL WORLD OF CURRENT PRACTISE.

In this Chapter we will try to:

• Describe the make-up of contemporary top executive compensation packages
• Scope out what to-day's top managers actually receive in pay, bonuses and benefits.
• Comment on the drivers and likely impacts of current practise

We have divided it into two parts, Part One describing the design of compensation programmes, and Part Two describing what directors are actually paid.

In order to do these things, we have spent several days getting ourselves up to date by wading through company annual reports, compensation consultants' reviews and talking to contacts who are still practising in the field of executive compensation and benefits.

The effects of this immersion are multifold - wonder at the Byzantine complexity of some current practise, combined with a serious headache, magnified by vague feelings of guilt - the writer used to do this stuff!
We seriously wonder why a potentially simple matter like pay and perquisites should have been made so complex - perhaps a combination of justifying compensation consultants' fees, special pleading to investors and confusing the enemy?

Put crudely, the experience has been like striving to re-learn complex code in a foreign language whilst being immersed in a bath full of the waste products from well-fed bulls!

To explain what we mean, here are a few quotes from company annual reports:

It is vital for this group to employ people of the high calibre essential to the successful leadership of a global business at the leading edge of the telecommunications industry. The scale and complexity of the group continues to grow, with operations in 29 countries in 5 continents.

The executive talent needed to maximise returns for shareholders in this industry is very scarce and the future success of the group will depend upon its ability to provide remuneration packages which are competitive in actual and prospective value when measured against the best in the industry.
Vodafone annual report 2001 - a year in which the company reported a £13.5 billion loss).

In September 1999 share owners approved the introduction of LEAP (Leadership Equity Acquisition Plan) to reward superior performance relative to WPP's peer companies, so as to create strong shared interests with share owners through significant personal investment and ownership in stock by executives and to ensure competitive total rewards in the appropriate market place.
(WPP annual report.)

Recent market practise has seen the introduction of schemes with greater scope in terms of the value of shares which can be awarded per person. The remuneration committee now believes that the 1.5 times limit is no longer competitive and consequently the directors are seeking shareholders' approval to raise this limit to three times in order to retain and reward the best people to meet the current needs of the company in this crucial recovery period.(!!)
(M&S annual report 2000)

We could go on and on - often feeling our credulity stretched - as in the instance of the company that declared that its compensation advisers believed its share option allocations were no longer at the forefront of competitive practise. Rectification of this sorry state of affairs necessitated doubling the allocations to several key directors, who were doubtless surprised when shortly afterwards the company received a successful takeover bid - that caused the share price to rocket and their options to immediately vest!

Just in case readers haven't got the messages, they are:

• We need Top Guns - the best of the best - to survive in the white heat of the global market place. The best of the best don't come cheap
• We are unwavering in our dedication to satisfying the needs of our 'shareholders'.

PART ONE.

The Content of Compensation Packages.

1. Base Pay.

All top executives receive a salary, or base pay. This pay is usually reviewed annually and has the additional purpose of forming the basis for calculating many aspects of executives' variable compensation. The value of annual and long-term incentive bonuses and of share option grants is usually defined as a proportion or multiple of Base Pay

2. Annual Incentive Bonus Scheme

Nearly all FTSE 100 companies offer annual bonuses to their top executives. (The exception has been Supermarket group, William Morrison, which has been the only company to have a rigorously simple compensation programme. It has also resisted having outside directors).

The usual range of bonus opportunity offered is between 50% and 100% of base pay.
As an example, in 2001, the actual levels of annual bonus paid to FTSE 100 CEO's and Finance Directors were:

Deferred Annual bonus.

In 2001, 46 out of the FTSE 100 companies had a provision for deferring the payment of annual bonus. Deferral means that the payment of the bonus is withheld for a period, typically 2/3 years.
A common deferral practise is to use a proportion of the bonus, often half, to purchase company shares which are held in trust until the end of the deferral period.
Of the 46 companies practising deferral, 25 made the provision voluntary, 21 had an element of compulsion. 10 of this number then matched, i.e doubled, the bonus at the end of the deferral period.

All companies that practised deferral of annual bonus also had Long Term Incentive plans and granted Share options.

Long Term Incentive Plans.

It is at this point that we enter a world of surreal complexity that the compensation sections of company annual reports do little to clarify.

Here are the bare bones of what Long Term Incentive Plans (LTIPs) are about:

• In 2001, 76 out of the FTSE100 companies had an LTIP.
• Typically, Compensation Committees set performance targets, (usually proposed by the executive) for 3 year blocks of time. If the targets are partly or completely met, executives will be granted shares in the company to a value of a percentage of their salary.

Bonus targets are often defined as Total Shareholder Returns compared with a reference or comparator group of companies from the same industry. Total Shareholder Return is the increase in the company's share price over the (3 year) period of the plan + the value of dividends.

The currency that LTIP bonuses are paid in is typically shares to a value of a proportion of the executive's salary: this proportion depending on the performance achieved over the LTIP period.

In summary,

• Over 70% of FTSE companies have LTIPs.
• The currency in which LT bonus is paid is shares in 68 out of the 70 - the 2 other companies paid in cash.
• The amounts paid obviously depend on performance against the targets set, but it is not unusual for executives to receive LTIP bonuses to the value of between 50% and 100% of their base salary.

To give readers a flavour of the stuff that must be read by those who wish to understand what companies are up to, here is an excerpt from the Hanson plc annual report describing their directors' LTIP.

Under the terms of the Long Term Incentive Plan (the LTIP) conditional awards of shares were made in 2000 to executive directors of 75% of basic salary. The award is subject to performance criteria and the remuneration committee determined that for this award the appropriate measure of the underlying performance is total shareholder return (TSR). TSR is the aggregate of share price growth and dividends paid on the assumption that such dividends are reinvested in Hanson shares during the performance period.

The awards will vest only if Hanson achieves a TSR over the three year performance period from the date of the award in September 2000, which is greater than the TSR achieved by at least 50% of the members of a comparator group of international building materials companies at the date of the grant (the comparator group).
If so 30% of the award will vest.
All of the award will vest if the company achieves a TSR over the performance period which is greater than that achieved by 80% of the comparator group over the same period. Between these two points the award will vest in the proportion of 2.33% of the award for each 1% improvement in the company's ranking.

On reflection, its not that the plan is incomprehensible that causes our gripe - it's the sheer Byzantine complexity of it all.
What it all means is that an amount equal to 75% of base pay is set aside for 3-year periods, renewed annually, and if the company exceeds a performance greater than 50% of a group of industry peers, 30% of 75% of base pay will be paid. Thereafter, for each 1% improvement in ranking, 2.33% of base pay will be paid, until the full 75% is trousered when the company achieves a performance greater than 80% of the comparator group. Geddit!!

We have one question and an observation.
Question - what companies are in the comparator group?
Observation - compensation consultants come in for a lot of ignorant stick. They do not decide what executives shall be paid, Compensation Committees do this.
But they do add to the complexity of compensation packages - we can recognise from grim experience the hand of a compensation consultant behind this LTIP!

Now, onwards to a truly lucrative element of top executives' compensation packages:

Share Options.

One of the authors of this site has the dubious honour of having designed a very early executive share option scheme in 1982 - sorry!

The theory is simple. An executive is granted an option to buy shares to a certain value at a time in the future - called the vesting date. If the shares are worth more at the end of the vesting period than at the beginning, a gain is realised when the shares are sold.

Executives can avoid the risk of holding the shares by having the company's brokers buy the shares on his/her behalf and immediately sell them into the market.

Once upon a time, in the good old days, the limit on the grant of options was equivalent to 4 times annual compensation (or salary if the company was stingy) and options were granted over a period of three years.

Exercise of share options is usually subject to the achievement of a company performance condition - typically that Earnings Per Share growth should equal or exceed the growth in the Retail Price Index over a three year period.

In the good old days of roaring share markets, executive share options provided a huge bonanza.

The availability of such potential riches, apparently 'free' to the company - as cost could be wrapped up in the increase in the share price, made everybody, especially investors, happy.
(An ex-colleague has just pointed out that they did not make the junior staff responsible for administering them at all cheerful.)

As the potential rewards increased, so did the growth of quaint Byzantine practises. Here are some:

• If the value of share options already granted did not appear to be increasing - the options were 'under water' - then they could be cancelled and a new series of options begun. This practise was graced with the wondrous euphemism of 'rebasing'. Such practises are now frowned upon.
• Initially, companies were restricted to granting no more than 5% of their share capital in 10 years as options. As hunger for wealth increased, this limit became onerous. To quote compensation consultants, Monks Partnership under the heading of 'Evolving Practises', "Companies have found the overall limit on subscription shares available of 5% of share capital in 10 years to be too restricting, and.........granted options over(more) shares purchased in the market and placed in trust.
• Monks Partnership go on to say, ...."The overall limit on options over shares held of four times earnings has also been too limiting .... Some companies have therefore adopted plans with an annual limit rather than an overall four times limit".
  These relaxations have not been opposed by governance watchdogs like the ABI, possibly because share options 'align the interests of managers and shareholders' (Good words).

The grant of share options and restricted shares has upped the stakes for executives vastly. One hugely lucrative practise has been the common provision that share options vest if there is a change in control of the company. This means if the company is sold, acquired or merged as the junior partner, the value of the executives' share options can be immediately cashed in. This provision surely quells the pain of being acquired - for some!

As an example, Mr Stuart Rose, now CEO of Marks and Spencer, has benefited greatly from share grants and options.
When he left Iceland Foods, as was, after a period of months as CEO; Arcadia, his next company, rewarded him with over £500,000 to compensate him for losing the value of his Iceland shares. They further greeted his arrival by granting him options over 2,000,000 Arcadia shares. Mr Rose did well - shortly after joining Arcadia, the value of Iceland shares crashed, following a series of profit warnings, and after some 25 months in Arcadia, the company was bought, netting Mr Rose a reported £26 million in share value gain.

Executive Share Option Plans are understandably popular - over 90 of the FTSE 100 companies have a plan in place.

Benefits.

In addition to direct and variable compensation, all companies provide their directors with a wide range of benefits.

The most valuable benefit is usually Pension.

Pension Plans come in three forms:

• Defined Benefit Plans or Final Salary Plans.
  The plan-member will receive a pension based on his/her pensionable pay and length of service.
  Pension accrues as a fraction of pensionable pay credited for each year of service in the plan.
  The most rapid rate of accrual allowed by the Inland Revenue is a pension of 2/3 of final pensionable pay after 20 years service.
  It is thought that this is what is provided in about 80% of FTSE 100 defined benefit plans.
• Defined Contribution or 'money purchase' plans.
  The company builds a fund for each plan member (to which they may or may not contribute). At retirement date this fund is used to provide a pension. The amounts needed to provide pensions for some of the highest paid are vast - running to many £millions.
• Personal Pension Plans.
  The plan is personal to the executive. It may be provided by an external pension provider or may be self-administered. The employing company may make contributions to a director's plan.

The complexities of calculating how much funding is required to provide a pension are vast, as they depend on a large range of assumptions about life-spans and the amounts that need to be put aside at a point in time to provide a benefit in the future - complicated still further by assumptions about future rates of return on invested assets.

We will return to the topic of pensions in the future, because most people will know that there is a huge time-bomb under pensions that will mean that millions of ordinary employees will have their pension rights reduced or may lose them totally.

It hardly bears saying that directors are not sharing the grief of many ordinary employees - few have lost any benefit.

To complicate matters still further, the Inland Revenue has placed a limit on the amount of salary that can be counted for pension purposes. This limit increases each year and is currently just over £100,000.
Companies that have recruited new directors usually get round this problem by promising that the prospective pension will be based on the full salary. Some companies leave this as an unfunded promise, and others provide funding to back it. As there is not a FTSE 100 executive director earning anything like as little as £100,000, this is quite an expensive provision.

In 2001, FTSE companies provided the following,

• Defined Benefit Plan - 59
• Defined Contribution Plan - 8
• Contributions to a Personal Pension Plan - 4
• Mixture of all the above - 18
• Closed Defined Benefit plan - other provision offered - 10.

It is estimated that about 50% of large company defined benefit plans have been closed to ordinary employees.

The Normal Retirement Age is 60 for the majority of directors, who normally make some contribution towards their pension fund, normally in the range of 3% to 10% of their basic pay. This is a tiny proportion of the cost to the company of providing the pensions.

Other Benefits

We are nor going to stray too far into the sometimes murky field of perquisites.

Common 'other' benefits for directors include:

• Company funded vehicle, fuel, service and driver/chauffeur.
• Full private medical coverage for executive and family
• Insurance covering accident, disability or death.
• Perquisites: ranging from stays in extremely expensive hotels for special meetings, (See 'Hope you enjoyed your stay' on this website), conferences or normal business travel. Sometimes it may be necessary for a director to be accompanied by a spouse.

Some companies also provide the use of private aircraft and others have private accommodation in major cities available for the use of top managers.

Last, a word about Compensation Consultants and Compensation Committees.

All quoted companies are required to set up a compensation committee, which shall be advised by an independent external consultant.
The tasks of the compensation committee are typically to lay down policy and guiding principles governing board and often senior manager compensation and benefits practise.
Membership of compensation committees is usually the non-executive directors of the company. It may be chaired by the non-executive chair, the senior non-executive director or sometimes by a non-executive director judged to be particularly suited to the role.

The role of 'shareholders'

The remuneration packages of the directors have to be approved by the company's shareholders - usually at the Annual General Meeting, when the full details of their compensation packages and proposals have to be made available.
There has been much outrage about compensation practise from small shareholders, but generally they have not been supported by the big institutions. More recently, institutional investors have stirred a little and voted against some of the more outrageous proposals, like JP Garnier's $22 million severance package. Having made their point, the institutions did not oppose further slightly less lavish provisions - which were proposed after frantic lobbying by GSK's chairman.
One investor said privately, "We think the proposals are still ridiculous, but have been told that 'JP' may leave if they are not accepted - best to let it go".

Readers may conclude that using institutional investors as society's watchdog on executive pay abuses is a bit of a cop-out by politicians, who are supposed to play that role (Are they not?).

The committee is usually advised by one of the larger international Compensation and Benefits consultants.
Prime amongst these are Towers Perrin, Mercer, Watson-Wyatt and Monks Partnership, owned by PricewaterhouseCoopers.
These consultants provide comprehensive survey data, comparing a company's practise and levels of pay and benefits with those of peer organisations and the market in general.

As we have said before, the truly compelling aspect of these surveys is that it enables directors to compare their packages with those of their real or imagined peers, in the UK and elsewhere if desired.

This has given rise to the tyranny of the 'Median'- or often the 'Upper Quartile'.
It is hardly tenable to pay below the median of a comparator population - and companies have tended to develop the argument that 'Upper quartile performance (now or in the future) demands upper quartile executives, commanding upper quartile pay'.

Thus the whole herd pursues an upper quartile position, ratcheting up compensation levels in the fashion which we know all too well.

Summary of Practise.

The Table below summarises the makeup of top executive packages in FTSE 100 companies in 2002/3.

Base salary is not mentioned as it is common to all.

PART TWO

Pay Practise.

In this section, we aim to give a flavour of the actual pay and benefits of top managers.
We have chosen to focus mainly on the pay and benefits of the most publicly visible of top managers, the CEO. We have done this to avoid getting bogged down in a welter of detail - and also because CEO's compensation levels set a benchmark for other directors.

Our information comes from a variety of sources - in particular surveys by compensation consultants, the 'Guardian' pay surveys and conversations with ex-colleagues and contacts in the field of compensation and benefits

FTSE 100 CEO Median Pay. (£1000) (Sources, Guardian, Monks Partnership)

2003 Sample of Top CEOs (£1000) (Source, Guardian)

Top 10 Pension entitlements 2003

Pension Costs.

It is extraordinarily expensive to provide for pensions.

Rough rules of thumb are:

• To buy a pension at age 60 would cost at least 14 to 15 times its annual value. So Mr Garnier's pension would cost about £13,475,000 to purchase.
• The funding rate to provide for a senior executive pension is about 30% to 40% of pay annually over 20 years.

This explains the big numbers required to fund pensions.

For example, the pension 'pot' for Lord Browne of BP was nearly £15 million in 2003/4, that for Sir Chris Gent was over £15.5 million, and that for Niall Fitzgerald of Unilever is £13.8 million.

Comparisons with other employees

1. The compensation of FTSE 100 CEOs was over 70 times the average pay of employees in those companies.
2. The worst paying companies are in the leisure, brewing, retail and general services areas, which have been a growing part of the British economy.
   Rentokil, M&S, Tesco and Scottish and Newcastle; pay an average of about £10,000. Sir Terry Leahy of Tesco earned a total of over £4 million in 2003, whilst the average for all employees in Tesco was £12,945 - and this was quite good for retailing!
3. The best paying companies are in the high-knowledge services and high technology fields, which have seen a huge decline in British-owned companies.
   For example, Shire Pharma, Shell, Reuters, HSBC, Barclays, Carlton, and 3i Group all paid an average of over £50,000 to their employees.

Parting Observations

We hope that readers will find this review useful and enlightening.

Having waded through a wealth of detail, here are a few overriding impressions about top executive compensation:

1. There is a lack of transparency in how top managers are compensated. This is compounded by the complexity of many incentive plans, and the language used to describe them. But the biggest problems come in unravelling the often huge differences between cash paid on an annual basis (salary and annual bonus) and the total compensation amount. This difference can frequently amount to £millions and is made up of such factors as deferred bonus, the value of share options, and the taxable value of benefits.
2. Compensation packages are markedly skewed towards share price related reward. This makes the relationships between top managers and the financial markets the main determinant of executives' success - please the markets, get the share price up, and considerable wealth can accrue.
3. There is also a bias towards the short term in the make-up of packages. Some might argue that 3 years (the typical 'LT'IP time horizon) is long-term, but this is manifest rubbish when one considers how long it takes to create really high performing organisations, roll out complex strategies, see the benefits of R&D programmes, develop complex and innovative products, see through capital investment programmes and so on.
   
   So a combination of extreme sensitivity about the financial markets and a short-term orientation is highly likely to tempt managements to indulge in transactions and deals - which of course the markets like.
4. The language and tone of many of the statements of policy and practise in annual reports is interesting.
   It is possible to detect several threads. Firstly, the tone is rather self-justificatory and defensive. It is as though those behind such statements realise deep down that they are up to something slightly shady and are trying to head off criticism. The tone can rapidly change to aggressive blustering if opposition appears. Students of the field will have become familiar with statements along the lines of: "Well, if you can't recognise the value of the 'best of the best', we can always move to the US, where they understand such things and then see what a mess you'll be in........"
   
   It is also blatantly obvious that no opportunity is missed to declare undying commitment to pleasing 'the shareholders'.
   Other stakeholders do not get a mention.

A Little Homework.

Readers may have read extracts from the reports of some Compensation Committees in company annual reports. If not, sampling a few in your library can provide a little light relief. Most of these reports are clearly directed at investors and their representative bodies ('the shareholders').

Now please write the same kind of report, but this time to explain and justify the compensation of the directors to their colleagues, the company's employees.

Next Chapter

In the next section, to be published shortly, we will consider the scope for beneficial change in the compensation and benefits system.