TOP EXECUTIVE COMPENSATION

PART THREE - IDEAS FOR REFORM

Before diving into concrete suggestions for change, we need to consider two preliminary questions:

1. Is the current 'system' broke - does it need to be changed?

2. What would reformers want to achieve by changing compensation systems?

Does the System need to be changed?

Charles Handy once observed that top executives were not like pop artists or individual sports heroes. The game in which they are involved is different. There is much research to indicate that the idea of all-powerful superhero CEOs is, except in very unusual circumstances, complete nonsense. Top managers are far more dependent on the organisations that they lead - and on the environment around them - than all the hype and propaganda lets on.

If they are to be positive in their impact, they have to be patient, bond with and be a part of their organisations. Those who stand apart and act as representatives of the 'shareholders' or some such are the ones who tend to cause long-term damage.
But, the drift of policy over the last ten years or so has been towards paying managers as though they were celebrity superstars.

So we believe that the current trends in top people's pay are unjustifiable - they are not supported by the objective reality of what makes for good corporate performance - and they are based on a sort of childish heroic fantasy about a global market for the top guns of industry. The propaganda supporting these fantasies is actually driven by the self interest of a really rather small group of people.

However, our 'take' on the matter is that it is not possible to go back 20 years to the days of much lower differentials between the average employee and their director colleagues. The real issues are what might be done to beneficially modify policy and practise for the future.

Objectives of Reform

It is tempting at this point to construct a list of all the ills of industry and relate them to inappropriate compensation strategies. This would be wrong. We should consider first whether compensation is really instrumental in influencing the behaviour and actions of top managers.
We believe that 'good' managers will tend to do what they believe is right for their organisations, regardless of the effects on their bank balances. But maybe it is expecting too much to expect all of them to be like this, and the reality is that money does influence the behaviour of many top managers.
This argument is heavily reinforced by the fact that relative pay has a huge effect on egos and self-esteem - as we demonstrated in Section Two, managers can compare their positions in the peer pecking order with great accuracy through pay comparisons.
So we would support the proposition that pay is influential in incentivising certain behaviours - but equally important in reinforcing them. To exemplify this: large slugs of wealth bound up with the company's share price are likely to cause many managers to think what they can do to elevate that price to the highest level possible - but will also reinforce a belief that investors are powerful and must be pleased.

So, we believe that pay reform can have an effect on top executive behaviour, but it has to be constantly borne in mind that executives are part of a system, and therefore not free agents. In fact, it is almost certainly true that contemporary managers as a class are far less powerful than investors - and there are comprehensive data to demonstrate that they too believe this. Therefore, really significant reform of the behaviours, skills and strategies of managers will require changes in the workings of the whole system that affects the performance and priorities of industry and commerce.

Remembering all these caveats, what Objectives for Change might we select?

First, some change objectives from Having Their Cake, the book:

Aims of Reform

1. To create a more balanced economy, with equal attention being paid to the development of enterprises requiring consistently high investment in advanced knowledge and technology, innovation and creativity; as well as to service and leisure based industries.
   
2. To encourage higher performance and productivity on the part of indigenously owned enterprises, and higher investment in the processes, systems, capital and IT equipment required to support the development of superior value creation.
   
3. To develop over time management and investment cultures that interact and collaborate to nurture and sustain high performing and innovative enterprises.
   
4. To foster the development of an ample supply of top managers with deep business and organisation building skills, and a high knowledge/ high skill, highly rewarded workforce, up to the standards of the most advanced economies.
   

We wrote this two years ago, and the Aims seem just as relevant and unfulfilled today as they did then.

But these objectives are too broad and sweeping to be capable of delivery by altering the design of compensation systems. It will require a concerted process of change to re-balance our industrial system. However, bear these wider objectives in mind as we consider more limited goals. At least, these wider perspectives should inform more modest changes and enable us to judge whether they are directionally appropriate.

More Realistic Objectives:

• To disentangle reward from volatile and fluctuating share prices.

  One of the greatest fallacies of our time is that managers and investors ought to think and act in the same way, and that tying managers' wealth and success to the share price of their companies is the best way of doing this.

  First, it is managers' role to run and develop their enterprises in order to fulfil a range of goals, the most important of which ought to be to secure the long-term vitality, health and survival of the company. All the research shows that this goal strongly motivates managers in the best companies. Economic performance (profit) is a necessary condition for long-term survival, not a goal. In the light of this, making managers accountable for this one dimension of performance and to only one external stakeholder - investors - will distort their priorities and judgment.

  Second, which 'shareholders' should managers try to satisfy? Satisfying the current range of investors and speculators that comprise the financial markets is akin to trying to please a riotous assembly united by one aim only - to make as much money as possible. Should managers try to please long-term investors (a minority), gamblers on short-term share prices (a majority), hedge funds, passive investors in indices, or what?
  There is little evidence that trying to satisfy the transient needs and whims of the markets ever did serious companies any good and a lot to show that it has caused great harm.

  Last, but not least, the ability of a few top managers to have a lasting and positive impact on their companies' share prices is quite small alongside factors such as industry trends, economic cycles, the overall capabilities of their organisations, stock market whims and fancies and many others. Much of the wealth accumulated in the last few years as a result of share price movements has had little to do with managers' actions. Note that we said a positive and lasting impact - top managers supported by a few corporate staff and external advisers can rapidly have a gross and negative impact on performance. It simply takes one really bad acquisition.

• To encourage managers to pay balanced attention to the full range of long-term business-building actions, not just short-term profit.

  There is very strong evidence that UK managers, driven by a majority of investors, are over-influenced by considerations of short-term profit and as a consequence invest far too little in innovation and business building.

• To encourage longer tenure on the part of top managers and to cause managers to be strongly bonded with the organisations that they lead.

  There are strong correlations between sustained long-term corporate performance and the knowledge, understanding, length of service and commitment of top managers to their companies. Also, the best companies lean markedly towards growing their own talent and do not rely on the dubious attractions of the external market for mobile executives.

• To make managers more widely accountable for their levels of compensation, and to make the whole compensation system more transparent.

  It should be plain to all that the current practise of leaving it to the investment markets to regulate top pay hasn't worked - why should it: the rewards of top players in the financial markets can make managers' pay seem like peanuts - and the markets are more interested in high returns than in how they are delivered. Pay continues to burgeon at rates greatly in excess of increases for the bulk of employees - governments protest weakly from time to time - and abdicate their responsibilities.

The attempts by various enquiries and committees to find ways of requiring managers to publicly justify their compensation have resulted in Compensation and Benefits sections in annual reports that plead special cases with passionate eloquence and serpentine complexity rather than anything smacking of accountability.

Last, but not least, many real perquisites of top executives' worlds are inadequately costed. The most obvious example is share options, which should be fully costed and regarded as an item in companies' accounts. Pension contributions are another large cost - which need to be compared with average employees' entitlements. But the cost to companies of supporting top managers' perquisites is normally hidden. So, the costs of property made available for executive use, travel for executives and families, vehicles, drivers and other help for executives' benefit should be fully declared and costed. This is surely right in the cause of transparency and trust.

Proposals for Changes in the Design of Compensation Packages.

1. Base Pay should form a large part of the total package.

This would mean reducing the amount available through the current ranges of annual and Long Term (LTIP) bonuses, paid in either cash or shares; and share options. We would propose that about two thirds of total remuneration should be in the form of annual base pay. This would obviously mean very large increases in base pay for many top managers, and a sharp reduction in the opportunities to earn bonus, especially short-term bonuses.

We are strong supporters of Gideon Haigh, who wrote in Bad Company - The Strange Cult of the CEO "(Performance bonuses) are a curious concept: one receives a salary for doing one's job, a bonus for doing it well, as though excellence and endeavour were not factored into the preliminary estimates".

It is our personal experience that much bonus pay is awarded as a result of factors that have little to do with the actions of the recipients. (And we know all too well that the biggest effect of providing bonus opportunities can be to cause the potential recipients to think about how to earn maximum bonus, which is often different to doing the right things for the long term.)

Making these changes will serve several causes. It will simplify pay systems, it will make the pay package more transparent, it will have the effect of reducing the amount of time and energy spent on thinking how to earn bonuses - and hopefully more time spent on doing the job well. If this means that some top executives will have base pay of many £millions, so be it - at least everybody will know without having to disentangle the Byzantine complexities of short-term, long-term and deferred bonuses.

2. Share-related compensation should become a much smaller part of the total package, and share option grants should be 'uncoupled' from base pay.

The so-called alignment of the interests of 'shareholders' and managers has done little to enhance the underlying performance of quoted companies. The interests of different shareholders are multifarious and very few shareholders have much interest in the long-term performance of individual companies. In the main, therefore, trying to serve the interests of investment institutions will have little to do with securing the long-term health of companies. All the research on sustainably successful companies shows that their managers are financially conservative and try as best they can to distance themselves from the influences of the financial markets.

Practically, we would propose that share-related benefits should be valued and granted, not as a multiple of pay, but as a total amount allocated to each eligible top executive.

This way, the value of shares and options would be transparent. We would also make the accumulation of shares dependent on substantial service with companies.

Managing a transition from excessive share-based rewards to cash should not be too difficult. Current allocations of shares and options could be valued at their present value and made available to recipients as a deferred cash amount, vesting over a number of years. The value of new options could be replaced by a combination of higher base salary and long-term cash bonus.

We would strongly advocate the end of such practises as the award of shares or cash as 'Golden Hellos' and the vesting of share options on a change of control of the company, if they had not already vested as a result of service.

3. Employment and Compensation packages should be designed to encourage continuity and long service.

There is little evidence to support the popular notion that top executives become stale after about five years in post and quite a lot to show that the demands of rapidly changing competitive environments provide sufficient challenge and variety to keep most normal people occupied for whole careers. Research shows that the best companies grow their own talent and that by the time individuals reach the top jobs they usually spend at least ten years in post. It is also the case that the best executives are strongly bonded with their companies, understand their organisations, businesses and industries deeply and are concerned to pass on a better company to their successors. This also ties in with evidence that innovation in companies is more the result of cumulative experience than of sudden, breakthrough inventions. Such innovation is nurtured by a degree of continuity.

Compensation packages should therefore be designed to encourage long term commitments. This means that executives should be able to accumulate wealth as a result of consistent performance over long time periods. Mechanisms for doing this will be pension, share grants and cash bonuses that are performance and service related.

4. Terminal Payments should be standardised and paid in cash.

The rigours of a complex, competitive and turbulent environment will mean that some top executives will fail, no matter how hard they may try.

We suffer currently from two kinds of excess - too much reward if things go well and often summary punishment if things go badly. We have strongly suggested removing the peaks and troughs of executive reward. Payments for success should be moderated, on the basis that performance is more likely to be the result of team effort and a favourable environment than fantastic acts of virtuosity by superheroes. Those who fail should be dealt with fairly and with dignity. This is more easily done if the rewards for good performance are not exaggerated. Terminal payments for top executives dismissed for inadequate performance should be equivalent to one year's base pay, with no frills.

5. Top Executives' Compensation and Benefits should be reported to employees, together with the reasoning behind policy and practise.

Top executives are employees of companies, just like everybody else. This is the nature of their employment contracts. They are mostly directors as well and this brings certain legal obligations, but it does not alter their basic contracts.

In this regard, they are the colleagues of all other employees - a fact that often seems to be forgotten. As colleagues and employees they are, or should be part of the same 'plot' as all other employees. They and everybody else need to pull together if the enterprise is to succeed. Having one part of the employee body whose terms and conditions are fixed by distant external agencies with no regard to their levels of remuneration relative to their colleagues is objectively silly and damaging to internal relationships.

Some realism and sanity might be restored over time by the simple mechanism of causing top managers to report how much they are paid, and why, to the wider body of their co-employees and colleagues.

Performance Criteria for Bonuses.

Most bonuses should be paid in cash, not shares. We would strongly advocate the removal of short-term, annual bonuses. Greatly higher base pay would compensate for this.

Bonuses should be based on long term performance - this is what top executives' roles should be primarily about. Bonus payments should also encourage longer tenure on the part of top managers.

Financial Criteria.

We very strongly favour a long term measure of Value Creation. Readers will remember that a minimum criterion for financial viability is that cash generated from operations should exceed the cost of capital tied up in a business. Companies that cannot meet this threshold will not, in the medium to long term, be able to invest enough to sustain performance and competitiveness.

So, we would select long-term Cash Value Added as the main measure of financial performance - and by long term, we ideally mean over a business cycle. Our favoured design of bonus plan would have three to five year targets, with a portion of the bonus earned on each three year period withheld for a further period and 'matched' if long-term performance exceeded the cost of capital by a stipulated amount.

Non-financial measures.

It would be nice if the relationships between companies and their investors were close enough to enable a comprehensive dialogue to take place about the range of strategies companies were employing to build the business for the future. If relationships could be like this, and if more investors understood and were interested in the internal workings of companies, there would be a strong case for advocating that responsible investors should be regarded in the same light as a good corporate parent to a subsidiary business.

Corporate parents wish to understand the competitive dynamics of their businesses and the full range of strategies and projects that management are proposing to take their businesses forward. Then, they want to set up mutually agreed means of tracking progress and identifying problems early.

Many companies seek to use a 'Balanced Scorecard'* of financial and non-financial criteria to set the agenda for corporate-business unit dialogue.

One day, the relationships between responsible, long-term investors and like-minded companies might evolve to a sufficient state of openness and maturity. But, we are nowhere near this state of maturity yet in the UK, and the current laws regarding insider information militates against it happening.

So, the time is not really ripe to use non-financial criteria as a basis for judging reward.

To Sum Up

A very senior Compensation and Benefits consultant confided recently that he believed the time had come for a 'return to basics' for top executive compensation. He believed that the purposes and design of compensation strategies had become obscure and over-complex. He also opined that some in management and consulting were using complexity as a smokescreen to cover a range of rather dubious practises. He then hastened to confirm that his comments were unattributable, as such talk was likely to be career limiting!

The current practise of top executive pay has become unnecessarily complex. This is done partly to create the impression that very high compensation is tied to elaborate and watertight performance targets (and partly to confuse the enemy?). But, a hell of a lot of the results that companies deliver are a consequence of events and factors that have less than to do with the actions of top executives than they might like us to think. Also, there has been much massaging of accounts in recent years, some of which is not unconnected to the skins and wealth of top managers.

So, like our consultant friend, we also believe that the time has come to simplify the whole system, and to pay good managers what they are worth in the simplest manner possible. And if the revelation of the full worth and cost of top executive compensation and benefits causes another outcry - at least we will know the full story and be able to have an adult discussion about it.

Our strongly held position is that competent top managers who stick to their lasts and help to build successful companies that can innovate, create and compete over the long term are worth a lot of money. We badly need more of them.

A last thought. The process of building strong, innovative and durable companies is one that is continuous and needs long time perspectives. Business and organisation building need steady consistent attention. Innovation is a progressive activity, in which existing stores of knowledge are built on and extended. These processes in large companies need the dedication and skills of a cast of thousands. Top managers may be more important in their impact than the average employee - but they cannot perform their leadership roles unless they are deeply and intimately involved with their colleague employees.

Destroying and weakening companies can be achieved by a relatively small number of powerful people - a few top managers, supported by corporate staff and some consultants or banking advisers can plot large acquisitions, dramatic cost reduction blitzes or radical new strategies devised miles away from the real business.

So, building strong companies needs a cast of thousands, whilst destroying them can be done by a few dozen.

We intend to take our views out to a range of knowledgeable people in consulting and management to solicit their perspectives on where top executive compensation policy and practise should be going. We will report back in due course. Meanwhile, we would welcome any views or reactions from readers.

PS. **The average compensation packages of the UK's 10 highest earning CEO's in 2003 were as follows (£):

Following our suggestion of making base salary 60% of total compensation would result in an average salary of £3,336,000.
We can already hear the cries of horror, but, hey, this is what they get already, so why not make it quite transparent - and some of them are almost certainly worth it!

PPS. The amounts above do not include the value/cost of perquisites and pension payments, which believe us, will be quite considerable.

* See 'The Balanced Scorecard', by Robert Kaplan and David Norton.
** Source, 'The Guardian'.
***The value of share option gains + long-term incentive plans