Reward Success Compensate Failure

Friday, 13 June: the day investors attacked Tesco for the ‘obscenity’ of two-year contracts for chief executive Sir Terry Leahy and seven board colleagues marked a turning point in the bitter debate over executive pay.

Long hailed a model of exemplary management, Tesco’s relentless customer focus has driven consistent growth in profits, which hit £1.3bn last year, and Sir Terry is one of Britain’s most admired businessmen. Amid shareholders’ mounting anger and intolerance of excessive pay and payoffs for failure, the £1m-plus packages of Tesco directors were deemed a fair reward for superb performance.

That all changed in June at one of the most hostile and angry AGMs of any large company this year. Forty percent of shareholders abstained or voted against Tesco’s remuneration policy, which is in clear contravention of corporate governance g0uidelines designed to reduce the level of compensation paid to departing directors. Other companies, such as Kingfisher, have headed off such protests by moving to one-year contracts.

“It is unusual for a company that has done so well to get such a big protest vote,” says a spokesperson from the National Association of Pension Funds. “The episode signalled a sea change among investors who are anxious to prevent problems rather than waiting for them to happen,” says Stuart Bell, research director at shareholder action group Pirc.

Executive pay in top companies is too high and has become a serious reputational issue. It has risen by 17% and 28% over the past two years against a backdrop of falling stockmarkets and profits and low inflation. This affects everyone, not just the biggest shareholders. We are all investors now, if not directly then indirectly, through pensions, endowments and equity-linked savings such as ISAs. The gap between executive pay and that of ordinary employees is widening and some of the biggest awards have been accompanied by wide-scale redundancies.

Recently we have seen a controversial new pay package for Sainsbury’s boss Sir Peter Davis which, despite the supermarket group’s lacklustre performance, could net him 1.5 million shares if he opens some new stores, updates IT systems, recruits a new chief executive and deputy chairman, and uses his “best endeavours” to ensure they settle in. At Burberry, chief Rose-Marie Bravo will earn a £13m bonus purely for staying in the job for three years. And new HSBC board member William Aldinger get free medical and dental treatment for himself and his wife for life, even after his contract is terminated.

The routine excuses trotted out by companies in defence of their pay policies are beginning to look spurious.

For example, there is no real international market in top executives. In any case, though, the US pays more than we do; pay levels are much lower in Europe. What’s more, the shorter tenure and increasing risk inherent in top jobs is reflected in higher remuneration and shouldn’t be doubly compensated for in lucrative payoffs, especially when these people, if they are as good as they say, could walk straight into another job.

A third justification – that executives need incentives to do their job – sounds absurd. “These people are performance-oriented and drive themselves harder than others. They don’t need incentivising: they aren’t sales people,” says Peter Kontes, co-chairman and co-founder of US management advisory firm Marakon Associates.

There are three main reasons for spiralling executive pay and payoffs.

One, remuneration consultants, whom Berkshire Hathaway boss Warren Buffett dubs “Ratchet, Ratchet and Ratchet”, are too ready to pitch all their clients in the upper quartile of their peer group. Furthermore, remuneration committees comprise a cosy cadre of well-paid executives who sit on each other’s boards and would no more question each other’s salaries than, in Buffett’s words, “belch at the dinner table”.

But the most critical problem is remuneration committees’ lack of expertise. “Most remuneration committee members are amateurs and lack the time to build their knowledge,” says Peter Brown, chairman of specialist consultancy Independent Remuneration Solutions (IRS). They seem unaware of best practice guidelines from the Association of British Insurers, National Association of Pension Funds and International Corporate Governance Network, among others, and are out of touch with public sentiment.

And while disclosure has improved since the Greenbury and Hampel Committee recommendations were incorporated into the Combined Code in 1998, this has been at the cost of clarity. Some remuneration reports run to many pages, yet it is still virtually impossible to divine how much the chief exec earns.

Whether for basic pay, short-term bonuses, long-term incentives or payoffs, the chief gripe of shareholders is the lack of meaningful performance criteria. Bell says too many companies still use off-the-shelf performance targets that are insufficiently stretching and bear little relation to their particular circumstances and objectives. Too many bonuses are either guaranteed – a contradiction in terms – or triggered by thresholds that are too low. And many performance criteria are arbitrary. For example, Telewest chief executive Charles Burdick got a one-off payment of £170,000 when he was FD, reportedly for securing a new bank loan. And Chris Gent earned a bonus worth £6.5m for taking over Mannesmann in 2000, though the deal subsequently reduced shareholder value.

Such practices point to the growing trend in what Erik Stern, co-MD of the European arm of consulting firm Stern Stewart, calls “goal-seeking” remuneration policies. “Companies are manipulating targets to ensure they pay their executives what they want to pay them,” he explains. And where boards do set higher hurdles, they often lower their budget expectations to ensure they clear them.

To remedy this, Paul Myners, former chairman of Gartmore fund management group and now chairman of Guardian Media, proposes the emphasis in remuneration policy should switch from “opaque and unpredictable” performance incentives to basic salary. The suggestion is endorsed by Kontes, who advises abolishing the word incentive in favour of reward. “Reward is payment for something you have done and you can specify the targets more clearly up-front,” he says.

Kontes advocates paying selective bonuses, with exceptional pay for exceptional performance. This would be closely linked to the growth of the company’s intrinsic value (the present value of the company’s expected future equity cash flows, discounted at the cost of equity capital) over time.

Two of the best measures of this growth, says Kontes, are economic profits (net income minus a charge for capital) and total shareholder returns (share price growth plus reinvested dividends) relative to peers.

This model would align management and owners in a way that share options – certainly in big companies – never do, he argues. “Share options play a role in smaller startups, where you can’t pay big salaries and there is a completely different risk profile,” he adds.

But Stern believes the desired alignment between managers and owners is achievable through more detailed scenario planning when determining corporate strategy and its effect on the value of the firm and its executive pay levels. Using the Mannesmann deal as an example, he says boards must look at the risk of their actions. “But few boards will countenance the possibility of failure,” he says.

Stern argues that compensation influences behaviour, and where incentives are not aligned with shareholder value executives may take actions that benefit them but damage the company, or vice versa. For example, although shareholders recently voted against GlaxoSmithKline boss Jean-Pierre Garnier’s proposed £22m parachute, he could potentially have netted far more by screwing up than succeeding.

But while many bonus thresholds are too low, Stern argues that some companies pitch performance hurdles too high, which encourages executives to go for broke and pursue risky strategies that could damage the long-term health of the business. “It’s OK to have stretch targets – like doubling the share price in three years – providing you also reward if the share price grows at the expected rate,” he says. “Shareholders are happy if their expectations are met, not just exceeded, and rewarding average performance motivates more people to pursue less risky strategies that are more likely to lead to steady growth.”

Brown favours a sliding scale of targets that trigger different bonus levels but believes it needs to be refined. IRS uses what it calls the ’70/30 system’, whereby 70% of the total bonus pool is apportioned among qualifying directors according to their salary, with the remaining 30% allocated at the discretion of the remuneration committee; for example, to reward a junior director who excelled while the chief executive was off ill. Not only is this fair, it also combines reward and incentive, both of which are important, claims Brown.

He says the NAPF and ABI guidelines overemphasise the link between corporate performance and share performance. “The dotcom debacle (proves) share price is not the whole story. Short-term profit targets that boost the share price encourage short-termism,” he says.

Best practice now is to use a basket of measures, such as profits/earnings per share/ total shareholder return, cash flow and a strategic target – although Stern sounds a note of warning on the latter. “Provided these targets are critical to the success of a business, act an incentive to employees, are easy to calculate and can be monitored over time, that’s OK,” he says. “But measures such as market share, sales or assets under management are pure size measures that encourage the wrong behaviour. The only size variable that matters is consistent value creation.”

Because of recent share price volatility, long-term cash bonuses that pay out after three years are becoming more popular. But Brown believes share options continue to play an important role in retention and supports moves to reissue underwater options.

There are other ways to retain executives, which better align their interests with those of shareholders. For example, executives could be encouraged to buy shares with the help of a low-interest company loan, which they pay off with their bonuses over a number of years. If they don’t meet their targets, they either forfeit their shares or dig into their capital.

There is clearly no shortage of tools to help companies link pay and performance, and to make those links more explicit to shareholders and the general public. In that sense, the government’s consultation exercise on how to prevent reward for failure and the CBI taskforce set up to address the issue are attempts to reinvent the wheel. But given that most companies are ignoring these tools, some way of enforcing better practice is needed.

Legislation may exacerbate the situation, given companies’ tendency to comply with the letter rather than the spirit of the law. But the Private Member’s Bill drawn up by Tory MP and former Asda boss Archie Norman, which called for a minor amendment to company law to allow boards to limit payoffs to failed executives regardless of their contracts, could have proved highly effective.

It will be interesting to see if shareholder protest votes exert a downward pressure on executive pay. But in a climate of declining public trust in business, companies need to treat their remuneration policy as a risk management issue.

Tesco is riding high, but success is a friable commodity, as Sir Terry Leahy acknowledges. “We are never complacent,” he says. But the threat to Tesco’s supremacy might come from an unexpected source. As concerns about the growing dominance of supermarkets continue to bubble, Tesco could find that misjudging the public mood on executive pay blows the lid off the pot.