Noticing Notice Periods

Following a change to the UK Corporate Governance Code which limits executive notice periods to one year, Towers Watson reports that Old Mutual Global Investors is now leading a campaign to further reduce the standard notice period to substantially less than that. Support for this position has been seen from the Investment Association, National Association of Pension Funds and the Financial Reporting Council.

Outrage over termination payments and executive notice periods is not a new phenomenon. Most recently, outcry followed termination payments given to outgoing executives at Tesco following a major accounting scandal that hammered Tesco’s share price. Shareholders were angered that Tesco’s former CFO was paid a £970,800 termination payment, in addition to his salary during the notice period, despite the scandal in his department. It would take 35 years for someone making the current average UK salary of £27,200 to earn what Laurie McIlwee earned for resigning amidst scandal.

Situations such as Tesco’s have brought notice periods and termination provisions into a bad light. However, contractual notice periods play a very important role in enticing talented executives to leave secure positions at other companies. Boards must have the flexibility to ensure that they can recruit top talent even if that talent is entrenched in a secure position at a competitor. Skilled executives are unlikely to leave a sure-deal for a risky unknown without some downside protection.

While lengthy notice periods and bulky termination payments should not be standard features in every executive’s contract, a blanket proclamation limiting all notice periods to a period substantially shorter than 1 year would not be in a company’s best interests. Companies must have some flexibility in cases where a lengthier notice period is truly necessary for recruitment. Hopefully Old Mutual will allow for such flexibility in its campaign.

Guardians of the pay galaxy

Asset managers manage shareholders’ investments in company shares, acting as agents charged with ensuring that companies are compliant with principles of good corporate governance. Any time an agent acts on behalf of a beneficiary, there is the potential for a conflict of interest to arise. This occurs when the interests of the beneficiary and the interests of the agent are not aligned.

One particular corporate governance principle that asset managers are responsible for overseeing is the transparency and legitimacy of executive pay. Oversight of this principle gives rise to a potential conflict of interest between asset managers and the ultimate shareholder. Asset managers indirectly benefit when executives and managers of public companies receive higher salaries, as they are more likely to be able to demand higher wages themselves. In fact, the Financial Times reports that asset managers could be paid more on average than investment bankers within the next year, indicating that they are already firmly entrenched in what the High Pay Centre calls the “high pay culture.” The Institute of Directors argues that when asset managers are part of the high pay culture, they are less likely to protest against the culture of high pay at other companies.

In order to minimize this agency problem, shareholders should be armed with tools to ensure that asset managers act in their best interests. One such tool is information: asset managers should be required to disclose how they vote on resolutions raised at annual general meetings, including those on a company’s remuneration policy. Requiring the disclosure of this information would enable shareholders to demand both explanation and action from their fund managers on important issues.

The Financial Times has also reported that the Institute of Directors is calling for fund managers to disclose their pay levels and policies to clients. The disclosure of remuneration policies at asset management firms would provide useful information to shareholders on the incentives facing fund managers. It would allow clients to ensure that their asset managers are incentivized to act in their best interests.

However, disclosure of actual pay levels would be counterproductive. When public companies were required to disclose executive remuneration levels, we began to see companies using high pay at other companies to justify their own remuneration levels. As a result, we have seen huge pay packages become the market standard as companies benchmark themselves against one another. The requirement to disclose executive remuneration has resulted in a situation where it is very difficult to restrain pay. If fund managers are required to disclose this information, it is likely we would see the same result. A fund manager could use pay at a competitor to justify demands for a raise.

More transparency and information from asset managers is definitely needed; more justification for higher pay is not. Shareholders should be armed with greater information on how asset managers are incentivized and how they are voting at annual general meetings on remuneration resolutions. However, disclosure of salary figures would not arm shareholders with useful information; it would instead arm fund managers with the tools necessary to argue for even more.

Giving South African workers a say on pay

Debbie Collier (co-author of Executive salaries in South Africa: Who should have a say on pay?), has called for unions to push for worker representation on remuneration committees in order to address income inequality within companies. This suggestion was made during her recent presentation at the Federation of Unions’ collective bargaining conference in South Africa. A summary of her remarks can be seen on this SABC news segment.

The recommendation to involve workers on remuneration committees is not unique to South Africa. The UK’s Trades Unions Congress has made a similar proposition. TUC argues that remuneration committees lack diversity because most members have been directors for many years and often serve on the remuneration committee of more than one company. Members of remuneration committees make many multiples of the average worker’s wage every year and thus are out of touch with the average worker’s reality. This lack of diversity on remuneration committees impedes real change because the current members have an incentive to maintain or inflate remuneration. By having employees serve as remuneration committee members, the board would be encouraged to consider other viewpoints as well as rates of pay at all levels of the company.

The question is whether South African labour unions will heed the call to actively and productively engage with companies on wages being paid at all levels of a company. South Africa’s system of collective bargaining is unique, not in terms of the letter of the law, but in terms of the atmosphere in which it is conducted. Due to apartheid’s legacy, worker and company relations are strained at best, and violent and deadly at worst. Deep mistrust runs between those at the top and bottom of the corporate structure. South African labour law already provides workers with the right to create workplace forums to engage companies on various issues, but to date, these rights have been largely ignored in favour of traditional adversarial methods of collective bargaining.

Strikes and worker unrest, however, are crippling the South African economy. The violence exhibited by both workers and the police sway businesses away from investing in the country. More productive methods of engagement must be found if South Africa is to move forward. Worker representation on board remuneration committees could be just the place to start this dialogue. Not only would it provide workers with an opportunity to have a (hopefully) productive voice, but it would help companies meet their obligations to remediate historical income inequalities rooted in apartheid.

What do you think? Would giving workers representation on remuneration committees be productive? Or would it just result in one more forum for workers and companies to clash?

 

 

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.