Remuneration: between a rock and a hard place

14 February 2007 by Virginia Bottomley, Ian Odgers, Aine Hurley

Nothing is more difficult for a Non-Executive Director than being on a collision course with the Chief Executive Officer. That is what the Chair of the Remuneration Committee strives to avoid, while at the same time upholding shareholders' interests.

To do so, he or she must undertake what is increasingly the most delicate balancing act required of any member of the board.

It is a demanding role, requiring sensitivity, toughness and sound judgment. The Remco Chair must balance the sometimes conflicting demands of executives and shareholders. He or she must steer a middle way between what seems fair and proportionate and the risk that good executives will leave if not paid market rates. Remuneration must be sufficient to recruit, retain and motivate exceptional performers.

In the UK, the Remco must strike a cultural balance between the increasingly prevalent US ethic that success deserves the highest reward and the envy of reward that still burdens parts of British society.

The best Remco Chairs can stand back, look beyond the social hang-ups and the tangled technical detail of directors' remuneration packages, judge what is necessary and reasonable, control pay policy and communicate that clearly and with authority to shareholders and other stakeholders.

Market driven

The two key components, amounts and structures, interact but are subject to slightly different forces, requiring different judgments. Amounts tend to be market driven, while the structure can be used to tailor rewards in line with the business objectives.

On amounts, markets continue to exert upward pressure. A curious logic tends to push executive pay rises well above the general inflation rate, even after a recent sharp easing in the rate of increase. To attract top talent, most companies will aim to set pay and the industry mean, some will go for the top quartile and none will aim at the bottom quartile.  The arithmetic is simple. The Remco Chair must be sensitive to market forces and reconcile these with the unique requirements of business. There is no point in being too socially sensitive about remuneration if the top team is not competitive. For without high quality management, company performance will obviously suffer.
 
To balance market forces with business needs, the Remco Chair requires independent information on market trends. Where to turn? Human resources professionals are an obvious source of advice, but may be a problematic one. If the HR director reports to the Chief Executive, this can place him in a difficult position. The independence and authority of the Finance Director towards the Audit Committee is typically greater than the HR Director's authority on the Remuneration Committee.

Independent advice

Another option is for the Remco to take independent advice, as at BP. Gerrit Aronson, Independent Advisor and Secretary to the BP Remco, says: "The Remco shouldn't have to second guess the data that is presented. An independent advisor should provide confidence in data the Remco assesses; and help the Remco resolve contentious issues in a non adversarial way."

Remuneration consultants can provide outside advice. This too poses problems. There is widespread suspicion that emuneration consultants tend to produce reports showing that the executive team is underpaid. "The consultants can fuel a conspiracy of self-interest," says Bryan Sanderson, Chairman of Standard Chartered Bank and a seasoned Remco Chair.

Pay and reputation

The Remco Chair should not be shy to exercise the right to select and control the consultants whose advice he uses. Indeed, it is in the enlightened executives' own interests not to be perceived as overpaid. There is a close link, and it is in the Remco Chair's hands, between pay and reputation.

When it comes to constructing the structure of the package, as opposed to the amount, the particular objectives of the business should lead. Structure, including the balance between equity, base salary and performance related cash bonuses, is the tool by which directors' motivation can be fine tuned to business strategy. Structure must be used to align executives' interests with shareholders.

The former fashion for share options as a way of aligning directors with shareholders is waning in favour of direct share awards. One problem with options is that they can be dependent on factors outside executives' control, such as the stock market, and currency movements. Direct share awards give a clearer incentive.

Performance related bonuses should equally be geared to business objectives, intelligently measured. Rewards must be transparent and simple. If, for example, bonuses for current success are delayed and paid out in downturns, then the impression - however unfair - will be that failure is being rewarded.

Impressions matter increasingly at a time when public scrutiny of remuneration is getting more intense.

Objective formula

The benchmark must be appropriate, whether it be sales, net profit, market share or share price. Broader measures than the purely financial should also be factors in executive and corporate performance. An increasing number of remuneration packages have an objective formula on which rewards are based, but best practice allows for softer factors such as corporate social responsibility, contributions to board thinking, or staff development.

"Goals and targets must be very carefully thought out. They must be the right ones. Of course, there must be financial targets, but these must be balanced by some measure of integrity and behaviour. Reputation is important, increasingly so when financial targets are demanding," says Sanderson.

Equally, the balance between salary, bonus and equity award must match the business's requirements. Packages that include a very heavy equity element, for example, may encourage executives to focus on short term gain at the expense of the long term. It may pay them, for example, to make a highly priced acquisition which lifts earnings and the share price in the immediate future, but risks damaging the interests of long term investors.

If there is a risk that directors' pay packages may take the market by surprise, it will help to minimise upset if the Remco consults institutional investor groups such as the Association of British Insurers. A growing number are doing so. In 2004, more than 200 Remco Chairs consulted the ABI; nearly 80 did so in the first three months of 2005.

Reward success

In nearly all cases, the discussion was felt by Remco chairs to be useful rather than intrusive. Investment institutions are, for example, justly nervous about passing judgment on the amount of pay ,because they feel - despite the perennial media focus on headline rewards - that markets are better qualified to assess totals, says Peter Montagnon, the  ABI's Director of Investment Affairs. Institutions will be more interested in compensation structure, to see that it is line with business objectives and geared to reward success. They have a legitimate interest in advising what works well in driving the business forward while aligning the interests of management and owners.

To summarise, an effective Remco Chair will be guided by several principles. He will:

• Have a good understanding of the business, what drives it and therefore the ability to tailor remuneration to business needs;
• Be prepared to face down the executives when required and to pay up when the market demands it;
• Be able to control the advisers and remuneration consultants;
• Communicate well with shareholders and justify directors' remuneration packages;
• Articulate a clear and sensible policy that the board understands and over which the Remco has control.

To assess whether all these standards are met, Sanderson suggests a simple test. "If you get worried about your company's remuneration policy, just ask yourself what kind of society you want. Companies live in society as well as off society. Can you explain your remuneration policy to your friends?  What would your children think?"

Contributions from Virginia Bottomley, Áine Hurley and  Ian Odgers.

Sources: Combined Code on Corporate Governance - www.fsa.gov.uk/
Remuneration Committee Journal, Issue 3 - KPMG Publication number 210-950

Category: Best Practice