So the UK solution of paying more in shares and making material risk takers and the highest paid wait for them, even after they’ve left the company, has its attractions. That way, executives will build up significant stakes and if things go wrong, the share price falls and disasters hit them in the pocket.
Executives don’t like this, of course. Psychologically, most people’s time horizons only stretch out for about two years. Awarding someone shares that they won’t see for three years is bad enough; stretching it to five or longer pushes them beyond our emotional reach. Add in the uncertainty of getting the award in the first place, the threat of it being taken away even if it has been paid, unknowns like the future share price or changing personal circumstances and the awards lose meaning. People want certainty: which is why executives, like most people,tend to focus on their salary.
The EU’s solution of capping bank bonuses is another control. It’s supposed to reduce excessive risk taking and will apply in earnest in 2015. An adviser to the European Court of Justice recently sunk the UK’s legal challenge to it, on the grounds (or so it was reported) that it’s okay to limit a bonus to no more than once or twice the salary as long as salaries are uncapped.
Hidden pay increases: when a cap in hand is worth two in the bush
But actually, it’s not as simple as that. Take Antonio Horta-Osorio, Lloyds Banking Group’s Chief Executive, for instance. His old pay package would have exceeded the cap, so Lloyds’ answer was to cut his maximum bonus and introduce a new “fixed” share award for 2014. This works because the cap relates to fixed and variable pay, rather than just the salary and bonus. Together his total package was worth £7.3m, and adjusting the components to keep this total the same must have seemed fair.
| Pay of Lloyds Banking Group Chief Executive | 2012 and 2013 | 2014 |
| figures in £ thousands | ||
| Salary | 1,061 | 1,061 |
| Benefits (including pension) | 681 | 681 |
| Fixed share award | 900 | |
| Total fixed pay | 1,742 | 2,642 |
| Maximum bonus (% of salary) | 225% | 140% |
| Maximum bonus | 2,387 | 1,485 |
| LTIP award (maximum: 3 x salary) | 3,183 | 3,183 |
| Total maximum variable pay | 5,570 | 4,668 |
| Total potential pay | 7,312 | 7,310 |
| Bonus cap ratio: variable pay/fixed pay | 3.2 | 1.8 |
Source: Lloyds Banking Group 2013 Annual Report; ignores buy-out arrangements (actual total pay in 2012: £3.3m; actual total pay in 2013: £6.6m.)
It might not be obvious, but in fact, he’s been slipped a pay rise. How? It comes back to that question of certainty. Variable pay is subject to performance conditions and so might never be paid; fixed pay is guaranteed. So adding £1 to fixed pay is worth much more than cutting £1 from variable pay. How much more? Well, that depends on what you think his and Lloyds’ future performance will be, but a rule of thumb is that fixed pay is worth between two and three times as much as variable.
And maybe that margin should be even wider. If you believe that bonuses motivate, it follows that high bonuses bring about higher individual performance. Logically then, a bonus cap cuts potential performance for both the individual and the bank, so fixed pay ought also to be reduced in step with this.
Of course, you might instead doubt whether bonuses really do encourage greater risk taking or incentivise higher performance. But then, if you believe they don’t, there’d be no reason to have a bonus cap in the first place.
Shareholder concerns
There are several reasons for performance related pay. It gives more flexibility to management and it’s cheaper because you can get the pay back if someone leaves. It helps keep people focused on what they’re supposed to be doing and it enables pay to go up or down with company performance – for you can’t cut salaries, but you can cut bonuses.
The new bonus cap undermines this, which is why UK banks lobbied against it. From now on, if a bank hits hard times, a greater part of the pay of those mostly responsible will be guaranteed and can’t be cut or taken away. So they’ll continue to be paid high salaries and benefits and won’t be held as financially accountable for poor performance as they would have been without the cap. Meanwhile, there’ll be a greater relative impact on those lower down the organisation, who’ll be earning less, and will have their bonuses cut as before.
Senior bank executives objected to the bonus cap for good reasons. But in terms of their own pay, it’s turned out rather well for them. And that wasn’t the intention at all.
