PAY AND PERFORMANCE: A GLASS HALF FULL OR HALF EMPTY?

1. SUCCESSES

Governance

There is no doubt that the Combined Code and in particular the Cadbury and Greenbury provisions on remuneration matters have made a significant impact on remuneration policy and procedure. The Combined Code and Greenbury provisions are now scrupulously observed by almost every large quoted company - especially those in the FTSE 100.

The Combined Code stipulates that companies should have "Formal and transparent procedures for developing policy on executive remuneration", and requires the establishment of Remuneration Committees and full reporting of executive directors' remuneration and benefits, including a full statement in the annual report detailing policy, packages and individual compensation. Schedule A of the Code gives specific guidance on the design of Performance-related remuneration, and Schedule B details the content of the Remuneration Report.

So the procedural requirements to ensure compliance with the governance codes are very clear and almost universally followed to the letter.
The Code also gives some general guidance on such matters as differentials, levels of competitive pay and performance pay:

"The Remuneration Committee should be sensitive to the wider scene, including pay and employment conditions elsewhere in the group, especially when determining annual salary increases"

"The Remuneration Committee should provide packages needed to attract, retain and motivate executive directors of the quality required but should avoid paying more than necessary for this purpose"

"The performance-related element of remuneration should form a significant proportion of the total remuneration package of executive directors and should be designed to align their interests with those of shareholders and give these directors keen incentives to perform at the highest levels".

On several dimensions, the period of 'pay for performance' from the mid-1980's has seen some marked successes. Since Greenbury, concerns to demonstrate that there are credible links between the fruits of managerial skill as represented by corporate performance and rewards has resulted in the fact that nearly every large company has a suite of performance-based variable pay plans. Alongside this, the domain of pay and performance has become more public, with UK companies being forced to disclose the bases and design of their top executive compensation programmes.

In addition, the strictures of the Code, that companies should be aware of competitive practice, have been more than fulsomely observed. There is now a veritable industry around the domain of compensation, incentive pay and benchmarking. Interest in the topic of remuneration, benefits and incentives has never been so high. Pfeffer and Sutton in their book, "Hard Facts, Dangerous Half-Truths and Total Nonsense" report that typing the words compensation and incentives into Amazon.com will realise 47,000 and 43,000 book entries respectively.

The introduction of investors into the pay-for-performance discussion has also borne some fruits - for example, GSK were forced to retract for a time on proposals for generous termination provisions for CEO JP Garnier by investor pressures. Since that time, several other examples have occurred of executives sacrificing bonuses when investors felt that they were not merited.
The position of the Remuneration Committee as an integral part of the governance arrangements for large companies has added an element of independence to decision-making about compensation. In most companies, the Remco stands alongside the Audit Committee as an integral part of boards' governance structures. The position of the HR function as an important influence on remuneration policy and practice has also in many cases been substantially enhanced. Finally, the Stock Exchange adopted the Cadbury Code of Best practice in 2001.

But, there is another dimension to 'pay for performance'......

2. WHAT HAS ACTUALLY HAPPENED : OUTCOMES DATA

Pay and Corporate Performance

So, against a background of successful adoption of the various Codes, and over 15 years of developing corporate governance practices, it is important to examine what has actually happened as a result.

The data presented have come from a number of sources, in particular research by the Manchester University-based Centre for Research on Socio-Cultural Change. CRESC is funded by the widely respected Economic and Social Research Council.

TOTAL REAL CHANGE IN HIGHEST PAID DIRECTORS' (CEO) PAY.
25 year trends = 1983-2007

IMPORTANT NOTES.

1. The measure of pay is basically cash or nearly cash (ie "total emoluments" base + bonus + cashed options + benefits in kind)
2. The data below therefore exclude the growing impact on total pay of LTIPs and also pension contributions. Thus the amounts by which pay exceeds performance are considerably greater than shown - in recent years by probably 25 - 40%.

Tables 1- 3 contrast relatively modest 24-year annual percentage increases in sales and pre-tax profit with much larger enhancements in dividends and directors' pay.

Table 1.

Note:

• FTSE constituents are every company that has passed through the FTSE 100 since 1983. Their data has been analysed for the time that they were included in the Index.
• FTSE survivors are the company that have been continuously in the FTSE 100 from 1983 to 2007. This number is very small; some 20 companies. Thus the attrition rate in the FTSE is very high, with 80% of companies disappearing from the Index. The reasons are usually mergers, failures, break-ups and foreign acquisitions.

Table 2

The same data as in Table 1, expressed in the form of indices, 1983 = 100.

FTSE 100 annual constituents: Performance indices [click to enlarge]

NB The line representing the impact of Long Term Incentive Plans (LTIPS) only runs from 2002 to 2007, as data were not available before that date. The figure in the graph represents the MEDIAN LTIP payment for all FTSE 100 companies. But what it does demonstrate is an even greater disparity between pay and performance than the original data indicated.

Table 3

Indices of Turnover, pre-tax profit, market value, dividends and directors' pay (1983 = 100)

FTSE 100 annual constituents: Selected measures
Indexes based on 2007 prices

Table 4

The levels of real net profits, dividends and retained earnings over the period 1983 - 2002. It contrasts increases in dividends as a percentage of net profits and decreases in retained earnings also as a percentage of net profits

Pay differentials, FTSE 100

Ratio of pay, directors to average pay

IF NOT PERFORMANCE, WHAT DRIVES PAY?

Company size

There is a convincing body of research from many sources on both sides of the Atlantic indicating very little correlation between levels of executive pay and corporate performance 7. A study of all the research into the relationships between performance and pay by Tosi and others 7 indicated that company size was the most important variable, with performance only influencing pay levels to about 5%. This is also borne out by UK research.

Readers might like to read a very interesting paper on the matter of performance and pay prepared by ESRC and KPMG, which suggests that there is a case for paying top managers on the same basis as institutional investors by the size of the assets that they manage. 8 In the US, researchers discovered a strong relationship between company ethics and CEO pay - those companies which have been investigated for accounting irregularities and other undesirable behaviours seeming to pay their CEOs significantly more than the average. Another study established strong links between the size of staff layoffs and CEO reward! 9

The pay-size relationships are very interesting. It appears that the FTSE 100 is a sort of 'club' that almost guarantees its CEOs very significantly higher levels of compensation than those of smaller quoted companies.

Evidence

Table 1

The table below contrast total pay of the CEOs of quoted companies of various sizes. It highlights the massive differences that size makes to pay, particularly between companies outside the FTSE 100 and those within. It also examines the relationships between base and total pay, highlighting the increases in variable pay percentages with increases in company size.

CEO pay, UK listed companies, 2002

Table 2.

This table illustrates vividly how the FTSE 100 acts as a kind of 'club', virtually guaranteeing high rewards to members. There is little difference in the ratios of pay to company size within the FTSE 100 - as opposed to previously demonstrated massive differences between FTSE 100 and smaller quoted companies.

FTSE 100 - breakdown of pay by size of company in Quintiles

This evidence must be qualified by the possibility that some individual companies have very successfully linked pay and performance, but this should still be seen in the context of very strong rises in overall pay levels driven by factors such as size and pay comparisons

SUMMARY

FTSE 100 Performance:

• Sales growth trails behind growth in profits
• Dividends increase much more than profit and retained earnings have declined. Dividends are therefore probably increasing at the expense of investment, which is very low by international standards. R&D and Capex amongst large companies is declining
• The rate of attrition and failure of FTSE 100 companies is very high, mainly due to M&A, failure and foreign acquisition
• There is strong evidence that British-owned companies are less productive and invest less than most foreign counterparts, even in the UK. The most productive companies in Britain and the highest investors are foreign-owned multi-nationals, followed by UK multi-nationals in Britain. Last come UK indigenous companies.

FTSE 100 Pay

• At the aggregate level, there is little evidence of any linkages between directors' pay and corporate performance, although there is a tiny number of individual examples - Glaxo from 1983 to 2002 did show a positive linkage, (although its performance/reward relationship has deteriorated since then).
• The differentials between the pay of the average employee and directors have widened dramatically over the period, and if anything accelerated since the adoption of the Greenbury provisions.
• A significant large part of the 'performance-related' element of directors' pay has come, not from underlying company performance improvement, but from non-profit related increases in dividend distributions to investors and general increases in share prices. Other main drivers seem to be company size and "the market for executive talent".

Analysis

There is a marked paradox between the adoption of the provisions of the Combined Code related to pay and the actual 'on-the-ground' trends. It would appear that companies have adopted the letter of the Code almost in its entirety and have then ignored the spirit. At the very least, it appears that procedural observance has had little traction so far when it comes to actual results.