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Discounting the future: The furore over long-term incentive plans

RISKY INVESTMENTS, mis-selling, tax avoidance – three big issues to emerge from the financial crisis guaranteed to excite the indignation of leader writers and general public alike. But if the list contained a fourth, it might be the continually rising executive pay and the perceived short-termism it produces.

So heightened is the concern over exorbitant rewards that the government conducted the Kay Review of executive pay, while others have called for pay to be more aligned to performance in a bid to bring the interests of company managers more in line with company shareholders. And yet, a pair of academics are challenging the idea that a blind charge for long-term incentive plans is the answer to the country’s executive pay conundrum. Indeed, for Dr Sandy Pepper, at the London School of Economics, and Julie Gore, at the University of Surrey, long-term incentives may in fact do their own damage.

Consultations and bellyaches
Pay rewards are on the national agenda. PIRC, the shareholder activist group, recently complained that long-term incentive plans used in the City were not really “long-term” at all and are poorly defined, while fund managers Fidelity carped that the use of long-term plans was not growing fast enough in the FTSE 350.

However, the concern about executive pay has been formalised through government legislation in October, which made it a legal requirement for companies to offer up their remuneration policies for approval at AGMs. Payments that fail to fall in line with the policy will be unlawful.

More recently, a consultation was launched by the Financial Reporting Council on elements in the UK’s corporate governance code that deal with remuneration. Indeed, it discusses whether a key section, Schedule A, should be reformed. Currently that section says: “The remuneration committee should consider whether the directors should be eligible for annual bonuses. If so, performance conditions should be relevant, stretching and designed to promote the long-term success of the company.”

But Dr Pepper and Gore have a different view of long-term incentives – they have concluded that they may be part of the problem. Why? Because after questioning 756 executives in 13 countries, Gore and Pepper found that company managers negotiating pay deals discount the value of long-term incentives by as much as 30% per year. The result of this is that executives can regard long-term pay components as worth less than 50% of their face value at the time of being agreed, if they run over three years.

Arguing for this variable element in pay to run even longer than three years makes the situation worse, according to Dr Pepper. “What the findings strongly showed is that senior executives are much more risk-averse than normal economic analysis suggests. They have an acute dislike of uncertainty and complexity. So, if they are paid in an instrument that is complex, they discount the value significantly. And most interestingly, they discount the future at a rate of around 30%,” he adds.

“I think there’s a huge amount of evidence now that says high-powered incentives can be very damaging to economies and organisations.

“That does not mean that incentives are a completely bad idea, and there’s quite a lot of evidence that weak incentives can be quite helpful. They can signal the kind of behaviours a company is trying to encourage without causing those behaviours to turn into undesirable behaviours we’ve been talking about.”

Alignment
In the UK, most long-term plans are based on shareholdings given to executives to “align” their interests with those of company owners – the shareholders. But a problem crops up in uncertain times, according to Nicki Demby, a consultant and partner at Deloitte. Executives negotiate harder on their long-term incentives because the future success of a business is much less certain. That said, Deloitte research shows that in the past three years, the typical FTSE 100 long-term plan has paid out 50% of maximum – or, in other words, done exactly what they were designed to do. However, Demby says individual executives may not be feeling the benefits, which creates the pressure to negotiate upwards.

Demby points out a significant difficulty is that owners – shareholders – may often hold shares for a wide variety of reasons, and “long” holdings can be as short as ten weeks. Individually or combined, these factors can be at odds with the interests of a company manager whose shares may not be paid out for three years or more.
Long-term plans, she advises, should therefore not be characterised as an “incentive” but as part of the process of building the executive’s personal wealth. “If you take that long-term wealth building point of view, rather than just looking at long-term incentives, you get a very different picture,” she says.

What’s my motivation?
Not everyone sees long-term incentives in the same light. At the heart of the pay conundrum lies a question about what executives really want. For many, the answer is “peer recognition”. The challenge, then, is how to achieve that goal, because many companies simply resort to wealth as the only measure.

According to Edward Beale, chief executive of The City Group and a non-executive director serving on remuneration committees, companies should be seeking to escape this “one-size-fits-all” approach to find alternative ways to incentivise their executives, giving examples such as making charitable donations or funds to pursue pet projects that could benefit an executive’s company as well as him or herself.

And yet, Beale insists that long-term incentives still have their place. One ideal advocated by Beale is companies paying out only after an executive has retired. Short of that, incentives should run longer than three years, even as long as five. “The challenge is to design something that not only motivates the person but doesn’t reward failure and incentivises them to do the right things, whatever the individual circumstances of the company. Usually, those right things are about growing long-term value and, in those circumstances, it makes sense for incentives to be weighted toward the achievement of long-term value. Which means having extended time periods,” he says.

Dr Pepper also sees room for change. His approach, however, is about balance in the pay deal. “A much healthier remuneration is a larger salary and lower incentives. My belief is that if people were paid in a more balanced way, they would be happier and the effects on the financial markets more positive. But getting from where we are today to that situation is fraught with complexity,” he says. ?

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