Featherstone The growing REM headache

  • Date:01 May 2010
  • Type:CompanyDirectorMagazine
Tony Featherstone reports on how problematic executive remuneration is becoming for directors.

The growing REM headache

The executive pay debate has focused mostly on the link between CEO pay and performance and board effectiveness in setting appropriate remuneration. One study after another has examined the pay/performance nexus, the role of greater board independence in improving it and compared CEO rewards with that of ordinary workers. Less considered is the effect this debate is having on boards, remuneration committees and individual directors, and whether it is damaging companies.

I am surprised by just how problematic this issue has become for boards in the past year. I recently interviewed directors and remuneration experts for a feature. One director told me his remuneration committee spends almost as much time together as the board itself and that he finds it hard to justify allocating so much time to leading the board’s “Rem” effort, given director fees.

Another said being asked to run the remuneration committee felt like “getting the short straw” and that the intense focus of proxy advisers, investors and shareholder activists on executive pay made it a “job from hell”. Even worse, a consultant who advises a remuneration committee of a top 100 listed company said executive pay easily dominated each meeting. Other vital issues such as talent retention, succession and the alignment of people and strategy were barely considered.

“Remuneration committees are caught in calibration hell, trying to design incentives that are durable and balance the expectations of executives and shareholders,” said PricewaterhouseCoopers (PWC) in its 2010 report on executive remuneration. It is no surprise the debate is shifting towards whether boards have enough remuneration skills to assess CEO pay and consultant recommendations.

It is not just directors under pressure. Chairmen are spending more time explaining executive pay settings to investors, super funds and proxy advisers. Boards are spending more on remuneration and investor relations consultants to explain how and why they set pay. And, some annual general meetings have resembled circuses recently as investors increasingly set their sights on directors who led remuneration committees that erred on pay. This is a terrible development. Boards as one should be held accountable on executive pay, not individual directors.

The point is: getting executive pay right is vital to attract, retain and incentivise top talent and rightly a board priority. But it is one of many issues boards deal with. There is a danger some boards may become so preoccupied with this issue that they take their eye off bigger challenges such as overseeing strategy, governance, choosing CEOs and monitoring performance. They could be swayed too much by public sentiment and populist stories on this issue, and lose perspective.

As I see it, there are two key problems with executive pay. One is growing complexity, a point reinforced in PWC’s report. “The combination of higher remuneration outcomes and increased complexity has left almost everyone dissatisfied,” the report says. “Generally, management feels incentives have become too complex and prescriptive and are not aligned to business strategy or within their control.”

The other problem is that boards have not done enough to challenge traditional pay models. Most companies follow the standard approach of fixed salary, short-term incentives such as annual bonuses and long-term incentives such as restricted share issues or equity options. More companies are using relative total shareholder returns to gauge performance, even though some Australian companies have small local competitive sets or cannot be easily compared with similar companies overseas.

More telling is that companies have different business models, strategies and stakeholders, yet adopt a “one-size-fits-all” remuneration model that, as Debra Eckersley, head of PWC’s Australian People and Change practice notes, has had more “layers added to it in the past decade”. “The time has come to simplify executive pay and think about it more in terms of corporate strategies and goals,” she says.

In its report, PWC suggests a much simpler pay model where executives are paid a higher fixed salary, but must buy shares in their company each month with a significant proportion of this fixed pay. For example, an executive receives a guaranteed $1 million to $3 million in cash and $2 million in shares bought on a monthly basis and held for at least five years. There are no short or long-term incentives.

I doubt this model would work for all companies and suspect some executives would miss the leverage and potential upside that comes through long-term incentives such as options. Some observers may also argue that PWC’s proposal does not put enough executive pay “at risk” – the model generally leads to more remuneration certainty through higher fixed pay, but less upside.

Still, the model has several attractions: its sheer simplicity, the strong alignment between executive and shareholder interests, and the elimination of problematic short and long-term incentives. Most of all, it presents an alternative in the debate on the structure of executive pay.

The Australian Institute of Company Directors has published the Executive Remuneration: Guidelines for Listed Company Boards. To purchase a copy, visit our website at: www.companydirectors.com.au

Tony Featherstone is a former managing editor of BRW and Shares magazines