Are you paying attention to pay?

THE PUBLICITY surrounding allegedly excessive directors’ pay has contributed greatly to the prevalent distrust of big business in the UK. Perceived ‘payment for failure’ and pay increases seemingly out of proportion with those of companies’ employees more generally have created an impression that directors of public companies are more concerned with lining their own pockets than with creating value for shareholders, employees and, more broadly, UK plc.

The government has reacted to this with new regulations laid in parliament this week to curb excessive executive pay. These changes are due to come into force from 1 October 2013 and it now seems reasonable to ask if the impending changes are appropriate and will hit the targets they are intended for.

The regulations will apply to all companies listed on the London Stock Exchange, irrespective of size. The most recent reported earnings of executive directors of companies on the UK public markets shows that – for the most part – pay increases have been in the range of 3 to 3.5%. While this is not insignificant in the low inflation and wage increase economy we live in, it would not in itself seem to be extreme.

However, if one breaks down the market and looks at what directors actually do earn in different parts of the market, the answers are startling. Average FTSE 100 executive directors earn over £2m per annum. In the FTSE 250, this figure falls to under £850,000. By the time you get to the AIM market, it is under £200,000. While it will generally be right that there is significant variation between the pay of executive directors of the largest and most complex companies and those with much smaller market capitalisation, the sheer size of that variation is considerable.

It’s interesting to speculate as to why it is so great. Attributing it to the abusive behaviour of executives is facile; all these companies have remuneration committees formed of experienced business people who can reasonably be assumed to want the best for their company and who are there to act in the interests of shareholders. Blaming remuneration consultants, on the basis that constant benchmarking of one company against another is always going to push the base price up, would seem insufficient to account for this level of differential.

Research we have recently undertaken suggests that the root of the problem is the definition of performance. Ironically, the desire to link pay to performance has, in many cases, had the opposite effect. Poor performance measures can often be selected, largely relating to measurements that are internal to the company (and over which the executives can reasonably be expected to have some control), rather than those which relate to the value created by the business overall (which will be of greater interest to shareholders). In a further irony, the variability that is potentially available in performance-related reward is optically damaging; the largest possible awards will always be quoted, rather than a median or achieved level. That is just human nature, but it does have the effect of making the underlying problem seem greater than it actually is.

The new regulatory requirements propose that a single figure is given for each director’s pay. Considerable research has gone into determining how one can agree a single figure, given that there are significant variable elements. However, there remains the possibility that remuneration could look artificially high in any particular period. Companies are also to submit their policies to a binding shareholder vote on at least a tri-annual basis and to have considerable additional reporting requirements.

One must question whether a problem that seems largely restricted to the FTSE 100 should be remedied by regulation that produces considerable extra regulations for all of the 2,300 quoted companies in the UK. This is regulation that will exercise smaller company remuneration committees (and it is again ironic that non-executive remuneration hasn’t markedly increased). Excessive directors’ remuneration, however real the issue, is a problem because of its corrosive effect. The solutions, however, should be targeted at those with evidence of rust and not the broad swathe of quoted British businesses.

James Roberts is senior audit partner at BDO. Additional content provided by Andy Goodman and David Ogden in BDO’s Human Capital team