Executive pay: Avoid paying more than is necessary

A supporting principle of the UK Corporate Governance Code with regard to executive pay stipulates that boards (through remuneration committees) should avoid paying more than is necessary. While on the face of it, this principle seems relatively straightforward, it appears that some organisations in practice find it challenging judging by the increasing public concern over the recent months. Although the principle is simply stated, it raises a number of challenging questions.

One of those questions is what is meant by necessary pay for executives which raises a number of supplementary questions as follows:

  • Is necessary pay to ensure that executives are appropriately motivated;
  • Is necessary pay to ensure motivation for the short-term or long-term or a proper balance of both?
  • Is necessary pay to ensure that executives are appropriately rewarded for outstanding performance?
  • Is necessary pay to attract and retain talented executives?

Issues of Concern

Some of the commonly cited key issues of concern with regard to executive pay are as follows:

  • Executive pay is poorly linked to organisational performance;
  • Executive pay is excessive and unfair particularly relative to average workers;
  • Executive pay exaggerates the contribution of executives as favourable external factors are downplayed;
  • Executive pay is not sufficiently aligned to promoting the best interests of all key stakeholders.

Special Treatment

It is interesting that the current debate on executive pay does not involve a similar debate on pay for average workers which suggests that there is a key underlying assumption that the basis of paying executives and other workers is fundamentally different. The question is whether such an assumption is valid. Presumably all employees should be paid relative to their perceived contribution to the success of their organisations. If executive pay is intended to drive and reward desired behaviours, why are the behaviours of executives more deserving of greater focus than other employees. Whether the contribution of executives deserves special treatment appears to be a key issue of contention and the corresponding debate on the appropriate degree of separation.

It seems to me that a key difference is that executives have significant control on the destiny of their organisations and ensuring that their contribution is appropriately aligned with the best interests of the shareholders is a key risk which arguably requires appropriate mitigation. The exercise of control of their respective organisations and the consequential wide ranging implications if such control is abused arguably appears to be sufficient justification for differential treatment.

If executive pay is largely informed by the market rate as argued by some why does the same argument not result in an upward pressure in pay for the employees lower than the organisational hierarchy. It may suggest that an inefficient market is in operation for executives as the expected downward pressure on price in a competitive market may be lacking.

External benchmarking of executive pay can be useful to gauge relevant market comparators but it should be used alongside internal benchmarking. Internal benchmarking should seek to sense check whether the relative gap between the lowest paid employees and executives is justifiable particularly as an organisation’s financial results should reflect the outcome of the collective effort of all employees.

Performance Unrelated Pay

The upward trend of executive pay appears to be correlated to the greater focus on ensuring that executive pay is more closely aligned to organisational performance particularly as evidenced by the increased weighting on variable pay in the overall pay package. As stated earlier, paying for performance is not the exclusive reserve of executives but a notable difference is the implied assumption that there is a high risk that the interests of executives and shareholders might be misaligned which is why an increasing proportion of variable pay is perceived to be necessary to mitigate that risk.

While in theory such an approach appears reasonable it creates the unintended consequence of ever increasing executive pay against a backdrop of suppressed pay for average workers which is bizarre if executive pay is to foster better corporate performance for the benefit of all key stakeholders. It appears broadly similar to the captain of the English football premier league champions taking home the championship trophy as a lasting souvenir and the rest of the team left with no medals or souvenirs of their collective victory.

Even if the assumption that executives require special motivation to advance the interests of shareholders is accepted as valid, the question still remains why their motivation is any different from average workers. Perhaps Maslow’s hierarchy of needs might explain some difference in motivation but surely the variance cannot be so significant to tilt the balance of variable pay in favour of executive pay relative to average workers. What could go wrong if executives were paid a reasonable base rate for doing the ‘job’ with the variable element carefully calibrated to incentivise exceptional performance if that could be fairly assessed? I suspect the so called ‘talent’ would not leave the planet.

Although benchmarking of executive pay in the marketplace is a common and important element of determining appropriate pay arrangements for executives.  The associated risks of that approach should be recognised and mitigated particularly when the signals in the marketplace suggest the market for talent is perhaps not operating effectively.

It appears perverse that individual performance targets for executives can be perceived to have been achieved but organisational performance either remains unchanged or deteriotatres.

A key challenge with linking the variable pay of executives with performance targets that aim to further the interests of shareholders is that such performance targets at best provide a partial picture of organisational performance which is further compounded looking through the lens of long-term success. In addition, the achievement of those targets in the short-term might be a trade off with the long-term success of the organisation. Furthermore, the targets which are set to align the interests of executives with those of shareholders perversely could lead to more misalignment of interests.

In order words what looks great today may appear disastrous in five years’ time. Furthermore, combining different performance targets in an attempt to address the partial perspective that each target offers perversely leads to a complex but incomplete picture of organisational performance.

The complexity of a comprehensive assessment of organisational performance which appropriately balances short-term and long-term success provides the conditions to enable executives to selectively control the levers of performance which appear to optimise shareholder value and correspondingly their pay.

Some performance targets utilised inadvertently foster a conflict between leading and lagging indicators that might paint a rosier picture of organisational performance which may benefit executives at present but may be storing up problems for the organisation in the future.

Some performance targets while intended to align the contribution of executives with interests of shareholders because of their inherent limitations could give underserved credit to executives for positive performance that was not of their own making such as favourable external factors out of their control.

Shaky Foundation

Determining the building blocks to achieve the desired outcome of only paying executives what is necessary requires a solid and robust foundation for appropriate executive pay relative to average workers.

The concept of seeking alignment between the interests of shareholders and executives is a noble one but is inherently challenging particularly as the short-term interests and long-term interests of all shareholders are not always aligned. So a system designed to align the interests of executives with the conflicted interests of shareholders is unsurprisingly fraught with difficulties and likely to lead to unsatisfactory outcomes.

It seems to me that the current unease about excessive executive pay arises from a set of arrangements commonly adopted by organisations in order to achieve the primary objectives widely accepted as the key drivers of executive pay which are broadly as follows:

  • To incentivise executives to focus on increasing shareholder value
  • To attract and retain key executive talent

If pursuing these objectives have led to the current governance arrangements and the corresponding perceived public dissatisfaction with the levels of executive pay. It seems appropriate to question whether those objectives are partly to blame.

It seems to me that paying what is necessary is that which incentivises senior executives to protect and advance the best interests of all key stakeholders in the right order.

 

 

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