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Netting red herrings

The Investment Association's ideas for simplifying executive pay could be tilting at the wrong target

Netting red herrings

"You have to realise: if I had been paid 50 per cent more, I would not have done it better. If I had been paid 50 per cent less, then I would not have done it worse." In 2009, Jeroen van der Veer raised eyebrows when he said this as he stepped down as chief executive of Royal Dutch Shell (RDSB). The idea that pay failed to motivate flew against received wisdom. After all, if being underpaid can demotivate; surely it works the other way around? Soon afterwards, Daniel Pink stirred more doubts in his book Drive. Academic studies suggest that outperformers are internally driven, he argued. What matters is job satisfaction and self-fulfillment. Trying to increase performance through incentives just wastes money.

Even so, executives often seem to think that the sole purpose of performance-related pay is to motivate them towards higher levels of performance. A recent study by PwC found that those asked were evenly split. Half thought that their company's Long Term Incentive Plan (LTIP) was an effective incentive; half did not. Two-thirds, though, valued it as a form of pay.

But ask a quick question and you get a fast answer. Ask people instead to rank what motivates them in order of importance, and pay comes way down the list. Daniel Pink concluded that what really drives executives is purpose, autonomy and mastery: in other words, believing in what you do, having the freedom to do things your way, and being set tough challenges that you push yourself to overcome.

In April, the Working Group of the Investment Association, which represents UK investment managers, published their thoughts on executive pay - and, oh dear, here we go again: "LTIPs are intended to motivate executives to achieve certain goals…" they say. Perhaps that's what senior executives told them.

The problem, the Working Group goes on to say, is that performance targets are typically set for three to five years ahead, but the world does not stand still, so targets can lose their relevance. "This can lead executives to feel that they have little or no control over the outcomes of the awards… This loss of "line of sight" between an executive's contribution and the outcome of the LTIP limits the effectiveness of the remuneration model." Perfectly logical if that's the main purpose of paying for performance, but it is not. And it's not for a very good reason: to be effective, people running companies have to be self-driven. If executives need motivating, they shouldn't be running the companies in the first place.


Scrapping LTIPs

There's an easy way to simplify pay: don't pay for performance. But that would reward failure as if it was success, and nobody wants that. The main purpose of performance-related pay is not motivation, but focus and alignment. A company that knows where it is going can define the milestones it needs to pass to achieve its strategy. When these milestones are built into executives' individual performance targets, they keep them focused on that strategy. Make the company successful and the share price will benefit. Pay geared to company success will be in step with the returns experienced by shareholders.

The normal criticism of executive pay is that it's too high, it keeps ratcheting up and it's too complex. The Investment Association is hunting for ways to simplify it but complexity, like beauty, lies in the eye of the beholder. The concept, though, is simple: pay a going rate for the role (salary and benefits) plus a variable amount based on performance. Performance can look backwards or face forwards, and so consists of two parts:

■ A bonus for past performance, normally based on just the past year, and originally paid all in cash.

■ An LTIP for future performance, based on targets set typically over the next three or five years, and paid in company shares.

Over the years, bells and whistles have been added to safeguard shareholders. Bonuses partly deferred as shares, holding periods, clawback and share ownership requirements have all added to complexity and, for the executives, uncertainty.

It is this uncertainty that troubles the Working Group. Its consultation paper asserts that the main area of dispute lies in assessing long-term performance, so why do it? Easily achieved targets translate into excessive payouts. It recognises that different companies have different characteristics, so it accepts that some companies wish to keep LTIPs. They work for those who can identify the long-term milestones needed to deliver their company strategy and don't expect to change them over time.

For companies without such a clear vision, the Group suggests three alternatives:

■ Simply award a higher bonus, but with a greater proportion paid in company shares.

■ Vary this bonus concept by assessing performance over the past three years instead of one.

■ Forget performance and simply award company shares.

For the first two alternatives, directors will still need to decide in advance what criteria they will use to judge executive performance. The advantage is that the resulting pay will be less geared than current LTIPs have become - that steps around another reason for excessive pay: the way pay has been amplified by perceived good performance. By only looking at past performance, the argument goes, the uncertainties that lie in the future can safely be ignored for pay purposes. A recipe for short-termism, then? Not if shares still have to be held over a number of years and if you can convince yourself that share prices are a fair proxy for measuring long-term success.


Off the hook

So which model is best for which company? That's for Remuneration Committees to decide. And shareholders too, if they are to have any influence over pay. The proposals could be a boon for directors without a clear vision of where their company is going. Directors pushed into working out future performance conditions have been known to spot flaws in the practical application of their company strategy. Conditions entwined with strategy forces directors to define what success will look like. Shorter-term, backward-looking performance reviews would get them off the hook.

Scrapping LTIPs is likely to be popular with some executives because it reduces their pay-at-risk - a great way to crank up pay if it is simply replaced by guaranteed pay. Wise to this, the Working Group suggests a discount should apply, but how much? That's for consultation too, as is the period for which executives need to hold company shares. An important question this because being forced to hang on to shares adds to their uncertainty. The recent PwC study found, not unsurprisingly, that the longer executives have to wait before they can sell them, the less they think their pay is worth. So, the longer the holding period, the higher pay needs to become to have the same perceived value. This could result in executives eventually receiving greater amounts.

I think you'll find it's not as easy as that

The Working Group thinks that the main area of dispute is in assessing long-term performance but Deloitte says short-term performance is also an issue. "What is good performance as opposed to just doing the job?" it asks in a recent paper. "How do you measure performance and how do you ensure that the targets set are appropriate and stretching?" Just look at the annual bonus. Only about 5 per cent of large UK companies pay no bonus in any year.

This begs another issue: is the bonus supposed only to reward outperformance? In practice, it has become an integral part of pay, so you might expect 50 per cent of the potential bonus to be paid when executives perform as expected, with those receiving more for outperformance matched by those receiving less for falling short of the mark.

The Deloitte paper says that the median payout for large UK companies is 70 per cent of the potential bonus. Good news, then: just as in Lake Wobegon, where all the children are above average, most executives are outperforming. Or maybe not. Deloitte questions how well all executive performance is currently assessed. Performance measures are supposed to support the business strategy, encourage the right executive behaviour and avoid short-termism, but whether or not they do is contentious. PwC say that people get anchored on their current level of earnings, making it tougher to cut pay if performance flags. So it only goes one way and, as Deloitte point out, potential bonuses have tripled over the last 15 years.

Deloitte suggests that Remuneration Committees need to be tougher on performance and be more assertive when external factors distort performance measures. That means using more discretion, and having the courage to adjust pay if needs be. The Working Group made similar recommendations but you can see why directors are cautious about this. Discretion can lead to inconsistencies and inadvertent bias, more uncertainty for executives and to external misunderstandings and criticism. Greater communication and trust is called for, everyone says. Always a warning sign.

There's a telling conclusion in the Deloitte paper: pay might be complex but aren't we missing the obvious? That pay structures simply reflect the complexity of businesses these days. Simplify pay and you risk greater unfairness. You also risk throwing out shareholder safeguards that have been hard won over the years by the investment community. And the title of the paper? It's rather apt, considering the potential unintended consequences: "Be careful what you wish for".