So to summarise: the initial award was worth £2.3m, but the currency used is actually shares. If at the end, your performance has reduced the number of shares, this pay element will be reduced by the same proportion. But we know that something else will happen too: the value of those shares will go up or down. What you’ve been awarded is a typical LTIP – the so-called Long Term Incentive Plan that ought really to be re-named a Long Term Investment Plan.
Flesh on the bone
In November 2014, Compass (CPG) paid its chief executive, Richard Cousins, a potential share award worth £2,348,000. That was the maximum he’d get – it depended on how Compass fared over the next three years. In fact, three years later, he ended up receiving about two-thirds of these shares. Valued at the November 2014 share price, they would have been worth £1,473,000 – that’s what he had earned through pay. But in the meantime, Compass’s share price had of course changed. Its increase over these three years added £1,192,000 to his wealth (before tax) – in other words, this was the gain due to the investment that had been forced upon him. He’d had no choice but to take on this risk – a risk of how much would be added to his personal finances. The share price could have fallen but, fortunately for him, the risk paid off.
But wait a moment. Add those two figures together and, according to the annual report, Mr Cousins received a total of £2,665,000 at the end of 2017. Yet at the time of the award in 2014, hadn’t Compass assured its shareholders that he would receive no more than £2,348,000? Critics of high pay grow angry at this sort of thing. Companies promise one thing, they say, and then blithely renege on their promises and pay more, hoping that nobody will notice.
There are more drastic examples. Last September, in 'Improvident', this column drew attention to Provident Financial (PFG) where, for several years before its demise, its chief executive received (on average) a total of £6m a year, compared with a pay package that suggested his maximum would be £4.5m. This proves that pay is out of control, critics say; the directors must be complicit in executive excess; shareholders ought to be made to be more effective.
So what’s going on? The problem lies with the measure of pay that companies have been required to publish every year since 2013. The 'Single Figure of Total Remuneration' has a major flaw: it treats all this as pay. It fails to distinguish between what has been earned and what is in reality a forced investment.
UK goes it alone – and gets in a mess
This issue came into stark contrast in last year’s annual report of the Anglo-Dutch RELX Group (REL). The British claim that the pay received by Erik Engstrom, its chief executive, in 2016 was £10.6m. The Dutch say it was £6.7m. That’s a massive difference - £4m – all due to his share-based awards. The UK treats the gain on the forced investment as pay; the Dutch don’t.
But why is this? The UK Single Figure of Total Remuneration is based on the premise that what is published is what the senior executive actually received. That’s what he or she is taxed on. There can be no argument with that. The initial award was part of the pay package so, the argument goes, the whole of what is eventually paid out must be defined as pay as well.
And ah, there’s the rub. It not only treats the forced investment as if it’s pay, it bundles together awards from different years that just happen to mature at the same time. That makes it too easy for critics to assume that the Single Figure relates to a single year’s pay. Last month’s column ('Home Run') looked at a share award at Persimmon (PSN), whose chief executive, Jeff Fairburn, had become entitled to shares then worth a staggering £126m. But this was a one-off award, made in 2012 and spread over 10 years – and absent from the Single Figure published by Persimmon so far. His Single Figure reported by Persimmon in each of the last three years? £2m. There’s nothing devious about this – it’s what the company is required to do. The share award will be reported in the year when the shares are actually transferred to Mr Fairburn – they are in the form of options, which must be exercised by 2022.
In contrast, the Dutch definition of pay is more consistent with what it actually costs the company – and with international accounting standards. Prudent companies hedge share awards – they effectively buy or otherwise secure shares at the time of the award to cover however many they expect to transfer to the executive. That way, all it costs them or their shareholders is the pay element – in a rising market, many of the massive pay figures that hit the headlines don’t cost the company anything like the amount that the executive receives. Once the award has been made, any subsequent gain due to the increase in the share price comes for free. (Just as with any other investment in shares, the gain is effectively funded by current buyers of the shares in the market.)
More inconsistencies
The distortions don’t end there. For, despite what was published in Compass’s 2017 annual report, Mr Cousins never actually received a gain of £1,192,000. This was based on an indicative share price of £16.15, averaged over three months. Had he sold the shares as soon as he could, on my calculations, the actual price he would have received would have been about £60,000 less.
Except he couldn’t do this. When a share award matures, executives normally pay tax and national insurance on its value, so Compass allows them to sell enough shares to cover their bills. But they have to hold the residual shares for a further two years. So the forced investment must continue – except that now, perversely, the UK definition no longer counts it as part of pay.
Skin-in-the-game
There’s another paradox. Compass, like many companies, requires its senior executives to own a minimum number of company shares in their own right. For its chief executive, that’s now three times the annual salary. This too is a forced investment – it’s a requirement of the job but, unlike the forced investment integral to the company’s share plans, the Single Figure does not count it as part of pay. This might seem like an inconsistency – logic suggests that either both are pay or both are not.
In fact, at the end of last year, Mr Cousins owned almost a million Compass shares – far more than the minimum required – accrued during his 11 years as chief executive. In theory, he has been free to sell most of these whenever he wishes. In practice, he can’t. The possession of price-sensitive information limits to just a few days each year the opportunities for senior executives to sell shares in their own companies. Often they are then discouraged by wariness about the negative message that director sales can send to the market – and the public scrutiny that might follow. The role itself inhibits sales – so are such large holdings quasi-pay? That’s a moot point.
Time for change
What senior executives earn depends on their future performance. This involves risk – nobody knows what the outcome will be – so pay packages are normally expressed as a range. The Single Figure of Total Remuneration gets around this by waiting until the performance is known and then pulling together every amount that executive directors have actually received.
These two definitions of pay involve a time shift – pay for the future versus pay from the past, and this gives rise to confusion. Some critics assume that the two are the same. Too often, changes in the Single Figure are quoted as evidence that current pay is going up or down, ignoring that they are the result of decisions taken years ago.
Nor does the Single Figure represent what directors have earned – because it fails to separate forced investment from pay. It might seem extravagant to claim that a substantial part of what everyone assumes is pay... is not really pay at all. But accept that and a number of other misconceptions fall away. Fail to recognise the forced investment element and the stage is set for distorted perceptions and worse, misguided regulations.
Just as surprising is how little companies appear to have done to help their case. In those well-thumbed Directors’ Remuneration Reports, they could be much more forthright in distinguishing between stock market gains (or losses) and pay. They could spell out how much cash the share-based payments have actually cost them (and if they’d failed to hedge them, why?). And while they’re at it, they might wish to lobby for the official definition of Total Remuneration to be updated.
Paul Jackson
