Executives at the largest UK companies have seen their salaries rising at a rate that is hard to justify when compared with their company’s performance. When large numbers of employees and smaller company executives are facing pay freezes or cuts it is particularly galling to see senior executives in some sectors seemingly rewarded for their incompetence.
This is most markedly apparent in the banking sector where the architects of the biggest global recession in history not only seem to be unaffected by the economic constraints that they have created but still appear to be doing rather well.
It is clear that the problem of rapidly increasing executive pay is primarily an issue for the largest stock market-listed corporations. There is little evidence of similar pay inflation in small and medium-sized companies. In the current difficult economic environment, the company directors of most SMEs are struggling to keep their businesses afloat. Pay at such enterprises is inevitably tied to performance whether they like it on not.
So, whose fault is it that senior executives in large corporations are paid way beyond their level of competence and what can be done about it?
The executive pay process at larger companies is typically led by a sub-committee of the board of directors: the remuneration committee. According to the UK Corporate Governance Code, members of the remuneration committee should be independent non-executive directors. The intention of this code requirement is to ensure that executive pay is set by a group of individuals with an informed but objective (and unconflicted) perspective regarding the best interests of the company.
Despite their independent composition, remuneration committees have in recent years experienced significant challenges in ensuring a strong link between executive pay and company performance. Increased globalisation has given rise to a global market for executive talent with associated globally defined remuneration levels. An individual remuneration committee may be faced with the dilemma of losing the services of a key member of the management team if they do not respond to such market expectations. This could have major implications for the achievement of the company’s strategy.
Greater transparency and disclosure of executive remuneration has also – despite good intentions – exerted an upward ratcheting effect on top-manager pay. Senior executives understandably wish to be paid at levels equivalent to their peers in similar companies. With increased transparency, they are in a good position to know if this is the case and, if not, demand an increase in their remuneration levels.
Given these challenges, what is to be done? Three principles should be used to improve the legitimacy of executive pay: greater simplicity, greater accountability and greater diversity.
Greater simplicity is an essential prerequisite for the improved governance of executive pay. In an attempt to align the interests of executives with those of shareholders, executive remuneration packages have, over the last decade, become ever more complex and opaque. This trend has been encouraged by the growing role of remuneration consultants in advising remuneration committees. In the midst of such complexity, it has been increasingly difficult to keep track of the implications for total executive pay over time.
In response to this problem, remuneration committees and shareholders need to do a better job in demanding a simpler approach to executive remuneration. The variable component of executive pay should be clearly linked to a small number of longer-term performance indicators which are easy to justify and measure. Annual reports should demonstrate in a straightforward manner how the achievement of these performance criteria could feed into total remuneration levels.
Greater accountability should be introduced through the earlier involvement of shareholders in the approval of executive pay. At the current time, shareholders vote to approve executive pay – on an advisory basis – after it has been awarded. However, shareholders could offer their perspective on the structure of the remuneration policy – including the associated performance indicators – prior to its adoption. This would ensure that there were no nasty surprises after any pay award had been made.
Finally, a greater degree of diversity on boards would assist remuneration committees in making more socially grounded decisions on executive pay. This is not only about increasing gender diversity on boards. It is also about bringing exceptional individuals from different professional backgrounds on to the boards of large listed companies as independent non-executive directors.
Most non-executives tend to be serving or former senior executives from other companies. Although the business expertise of such individuals is invaluable, their perspectives may reflect their own personal expectations in respect of executive remuneration. Their contribution should therefore be balanced by the presence of a more diverse group of well-trained decision-makers.