Back to the bonus?

For the past thirty years, governments, boards and shareholders have taken steps to move companies towards a pay-for-performance model. This model is meant to align the interests of management and shareholders by rewarding executives when the company performs well, and scaling down remuneration when the company performs poorly. By linking pay to personal and company performance, executives have an incentive to maximize shareholder value.

In 2014, the High Pay Centre commissioned a report from Incomes Data Services to explore the link between executive pay and company performance at FTSE 350 companies. The report contains the following summary of conclusions:

  • “the statistical correlations between changes in two key annual bonus performance metrics, pre-tax profit and earnings per share (EPS), and subsequent bonus payments were insignificant;
  •  98.7 per cent of the change in annual bonuses could not be explained by changes in pre-tax profit;
  • 99 per cent of the change in annual bonuses could not be explained by changes in EPS;
  • there was no noticeable correlation between the relative ranking of long-term incentive plan (LTIP) share awards and the relative ranking of changes in total shareholder return over three years;
  • there was no noticeable correlation between the relative ranking of long-term incentive plan (LTIP) share awards and the relative ranking of changes in EPS over three years.”

(Source: New High Pay Centre report: Performance-related Pay is nothing of the sort | Publications | High Pay Centre pages 5-6)

Governments have spent countless hours legislating a link between pay and performance. Companies have invested countless dollars designing incentive plans to link pay and performance. Yet, the statistical evidence indicates that the link between what an executive earns and how a company performs is tenuous.

Governments have spent countless hours legislating a link between pay and performance. Companies have invested countless dollars designing incentive plans to link pay and performance. Yet, the statistical evidence indicates that the link between what an executive earns and how a company performs is tenuous.

In the name of linking pay to performance, executive compensation schemes have become more and more complicated. We have seen companies move away from the standard option grant to a more elaborate system of share instruments. These instruments tend to be subject to long-term vesting criteria, and each type has its own intricate set of rules and restrictions at each company. The result is that even when remuneration reports are read in minute detail, it is often difficult to understand exactly how an executive is paid, and how that pay is linked to performance.

Given the evidence, maybe we should rethink the pay-for-performance model. Executive remuneration is ballooning at a rate that cannot be explained in any way by performance. For schemes that are not actually achieving their goal, long-term incentive plans are needlessly technical and complex.

Instead of further complicating executive remuneration structures, perhaps it is time to go back to the basics: the bonus. A bonus is simple and straightforward. If the bonus is capped, there are no surprises when it comes to maximum pay-outs. Properly structured, bonus policies can create a coherent link between pay, and company or executive performance. If a company wants executives to also be shareholders, it can enact a minimum shareholding policy requiring executives to use a portion of their annual bonus to purchase shares on the market.

What do you think? Should we move away from long-term incentives back to the standard bonus? Or is there a way to simplify the pay-for-performance scheme while ensuring it actually achieves its goal?                                    

Pay ratios: Fact or fiction?

In July of 2010, the Dodd-Frank Reform Act was passed, requiring the US Securities and Exchange Commission (“SEC”) to promulgate a rule obligating companies to disclose the ratio of the CEO’s pay to the median salary of the company’s workers. Almost five years after Dodd-Frank’s enactment, we are still waiting for that rule.

Fierce debate has ensued since the enactment of Dodd-Frank. Proponents argue that pay ratio disclosure will force companies to rein in executive pay because shareholders will demand a smaller pay gap. Critics argue that it will be extremely costly for companies to calculate the pay ratio, especially those with worldwide operations and unintegrated pay systems.

It seems inevitable that pay ratio disclosure will soon be routine. Over the years, politicians and shareholders have pushed for more and better disclosure of executive pay schemes, and every year companies provide even greater detail than the year before. The European Union is considering requiring companies to both publish a pay ratio and put that ratio to a mandatory shareholder vote.

Instead of resisting the SEC’s rule, we should focus on shaping the rule’s substance to ensure that it results in the disclosure of meaningful, rather than misleading, information. The SEC has an opportunity to draft a rule that is clear and effective, and that can serve as a model for other countries.

In drafting the rule, some lessons can be learned from companies that voluntarily disclose pay ratios. Perhaps the best example is Whole Foods, which has a corporate policy that limits the cash compensation paid to any employee to 19 times the average annual wage and bonus of all full-time employees. As a result of this rule, Walter Robb (the co-CEO of Whole Foods) saw his salary and bonus capped at $757,200 in 2014, 19 times the $39,953 average annual wage of full-time employees. However, Whole Foods’ compensation story does not end with a 19:1 ratio. In fact, this ratio does not include the most lucrative portion of Walter Robb’s 2014 remuneration: a grant of options and share incentives that brought his total income up to $2,742,520, or almost 69 times the average salary and bonus of workers.

This example demonstrates how the omission of one portion of an executive’s remuneration package from the ratio’s calculation can obscure the actual levels of income inequality within a company. This result comes from a company that has a laudable goal of limiting executive remuneration levels. What fictional ratios will be seen from companies with no such intention, or with the intention of minimizing the ratio?

If pay ratios are to provide meaningful information to the market, the SEC must give clear direction on how to calculate them. The SEC should require companies to account for all elements of remuneration, including the fair value of any share incentives granted during the year. Share incentives can frequently amount to many multiples of an executive’s cash income. Consider the South African company, Naspers, which does not award its CEO any cash income. Instead, the CEO receives a periodic grant of share incentives, sometimes worth billions of rand. It would be completely nonsensical to ignore the value of those share incentives and instead compare the CEO’s non-existent cash income to the average worker’s pay.

Not only must the SEC be clear on what constitutes remuneration, it must also provide direction on which employees should be used in calculating a company’s average salary. Should the calculation include the pay of worldwide employees? Domestic employees? Contractors? A sample of employees? If a sample, how exactly must the sample be selected? What about part-time employees, who tend to be the lowest paid and often form the lion’s share of the workforce?

Given the myriad of employee categories, if companies are able to choose which categories to include in calculating an average wage, they will essentially be able to decide in advance what ratio is desirable and then pick and choose those employees with salaries leading to that ratio. For example, the Financial Times reports that British American Tobacco discloses a pay ratio of 8:1 when comparing the salary of the CEO to a comparator group of 80 senior managers. While there is nothing wrong with comparing the salary of the CEO to the salary of senior managers, this statistic does not actually address the true level of income inequality between the CEO and the company’s 50,000 odd employees. Similarly, it does not allow shareholders to compare the level of income inequality within British American Tobacco to any other company that uses a different comparator group to calculate its pay ratio. Standardization will ensure that companies cannot manipulate the numbers to produce a favourable ratio, and will also allow for a meaningful comparison across companies.

Given that the SEC has had five years to draft the pay ratio disclosure rule, one can hope that all of these concerns have been addressed. Unfortunately, it is more likely that the SEC is deliberately stalling, and will eventually release a watered-down rule giving companies significant flexibility in calculating an average wage. If this occurs, not only will the resulting statistics fail to accurately portray income inequality within an organization, they could actually lead investors to believe that pay ratios are reasonable even if they are completely out of control.

Misinformation is worse than no information. The SEC should either do it right or not at all.

What do you think? Should companies be required to publish pay ratios? If so, what must be included in the calculation?

Bonus caps are a perk for bankers

In January of 2014, European Union rules became effective that limit a banker’s variable income to 100% of fixed income. This ratio can be increased to 2:1 with shareholder approval, which is routinely given. The purpose of the cap was to reduce excessive risk-taking in the financial services industry by limiting rewards for successful recklessness. While this was intended to be bad news for those in the financial industry, in actuality, it has been a banker’s bounty. Overall pay levels have remained relatively constant as banks have resorted to shifting previously at-risk pay into guaranteed income.

As soon as the bonus cap was introduced in 2013, the Financial Times reported that four out of five European banks admitted in a survey that they were planning to raise base pay in order to counteract the effect of the bonus cap on overall income. Despite the banks’ stated intentions to minimize the impact of the cap, the EU passed the law as it was. As expected, banks responded by revising their 2014 remuneration policies to increase fixed income in the form of a new category of pay: the ‘role-based’ allowance. Annual reports describe this allowance as a payment of cash or shares that takes into account the role and responsibility of the employee (or, if you are cynical, the size of his or her last bonus).

The impact of role-based pay on the guaranteed income of executives is pronounced. In 2014, Barclay’s CEO was paid a salary of £1.1 million in addition to a role-based allowance of £950,000. While the CEO’s maximum potential earning opportunity for 2014 did decrease slightly from 2013, his guaranteed income has almost doubled. An even larger benefit was seen by the CEO of HSBC, whose guaranteed income has more than doubled with the introduction of the bonus cap. In previous years, HSBC’s CEO was entitled to a maximum award of variable pay that was 900% of his salary. In order to get around the bonus cap in 2014, HSBC’s CEO was given an allowance of £1.7 million, which is in addition to, and significantly more than, his £1.25 million salary.

Bank remuneration committees have gone to great lengths to use phrases such as “fixed” and “not related to performance” when describing role-based pay in order to ensure that it cannot be classified as variable pay.  However, in many cases, the amount can be adjusted upwards or downwards upon review (see Barclay’s 2013 Annual Report for example). This distinguishes role-based pay from an employee’s salary, which is non-revocable and subject only to increases over time.

The European Banking Authority (‘EBA’) released a report in October of 2014, stating that 39 financial institutions had introduced role-based pay. In the report, the EBA questions role-based pay’s compliance with EU law, pronouncing that in order for allowances to constitute fixed remuneration, the allowances must be permanent, non-discretionary and non-revocable. The majority of the role-based allowances paid out in 2014 were both discretionary and revocable in nature.

The next obvious step is for banks to remove the flimsy distinction between ‘role-based’ pay and salary by simply increasing salaries (which, incidentally, are also based on an employee’s role and responsibility). It is clear from reading the annual reports of financial institutions that they have absolutely no intention of significantly reducing the actual take-home pay of bankers unless faced with no alternative.

Given these consequences, the EU bonus cap seems deeply misguided as a policy designed to reduce excessive risk-taking. Bankers now have a large safety net in the form of a bigger guaranteed salary to fall back on if their risk-taking behaviour fails to produce results. They also have the potential to earn double that salary as a bonus if risk-taking behaviour pays off. It is possible that this structure actually incentivizes risk-taking (see the IMF’s Global Financial Stability Report which found no evidence that larger amounts of fixed pay decreases risk-taking and which indicates that a cap on variable pay can actually increase risky behaviour). Banks have no flexibility to reduce those large salaries during years of poor performance, adding to the cost of doing business. Due to these unintended consequences, the bonus cap should be scrapped as a perk that banks simply cannot afford.