Rewarding top managers

How best to link executive remuneration to corporate performance is a key feature of the current boardroom pay debate. Most critics do not condemn high compensation in itself, but the lack of appropriate performance conditions. Government and investors have signalled a desire to attach conditions to incentive packages that provide challenging yet realistic performance goals. The current performance criteria, especially the measures linked to the variable elements of the total compensation package, such as short- and long-term incentives, are often undemanding and too easy to attain.

Financial goals, including those linked to popular performance measures such as earnings per share (EPS) and total shareholder return (TSR), are rarely taxing. As a result, even inferior corporate performance tends to get rewarded. According to business journalist Anthony Hilton, in his analysis of a recent Management Today survey of the link between directors' pay and TSR, executives of companies whose shareholder returns over three years were poor did "rather well out of long-term incentive plans" in 1998.¹ Hilton concluded by declaring that too many incentive schemes are based on the "principle of heads, the management wins; tails, it doesn't lose".

American Norman Augustine concurs, summing up the lack of a correlation between executive pay and corporate performance in the following way:

"There are many highly successful organisations in the United States. There are also many highly paid executives. The policy is not to intermingle the two."²

A summary of the findings from 10 research projects examining the relationship between the levels of executive remuneration and corporate performance can be found in figure 2.1 . Only three report a positive link. Two of these are the most dated findings, suggesting that any positive correlation between executive compensation and performance that existed at one time has declined or completely disappeared. This conclusion was reached by Paul Gregg et al, who found that the previous positive relationship between a company's share value and the remuneration of its highest paid director - recorded between 1983 and 1987 - ceased to exist after 1988.³

Figure 2.1: Linking executive remuneration to corporate performance: summary of 10 studies

FROM CADBURY TO THE COMBINED CODE

The current furore over rewards to UK top managers, especially the lack of exacting performance criteria, stems largely from the controversy provoked by the pay rises and share windfalls to the executives of newly privatised companies. One case that brought the issue of executive pay in the privatised utilities high onto the political agenda was the 75.9% pay increase awarded to the then chief executive of British Gas, Cedric Brown, in November 1994.⁴

Since the early-1990s, three separate initiatives - Cadbury, Greenbury and Hampel - have examined corporate governance issues, including boardroom pay. These three inquiries have, to a greater or lesser degree, influenced developments in the remuneration of senior managers over the past decade, adding to the traditional drivers of executive compensation - such as organisation size, geographical location and industry. Hampel brought the best practice recommendations of each committee together in a combined code, which is attached to the London Stock Exchange's listing rules (see extracts in figure 2.2).

Figure 2.2: Combined Code

Source: The Combined Code, June 1998 (Gee Publishing Ltd)

Even before the spotlight was turned on executive pay by the remuneration policies of privatised water and energy companies, a degree of unease was being expressed over executive remuneration. Although the Cadbury Committee had been established to examine the financial aspects of corporate governance following the Maxwell Communications scandal among others, it was nonetheless forced to consider the issue of executive pay. Cadbury's main recommendation in terms of senior management compensation were as follows:

In 1995, the Greenbury Committee was asked to "identify good practice for determining directors' remuneration, and prepare a code of practice for use by UK plcs", in addition to building on the work of Cadbury. The Committee's 59-page report endorsed the following points:

Former-ICI chairman Sir Ronald Hampel was charged in 1997 with heading a committee to look again at corporate governance. Its report, published in 1998, broadly followed the recommendations of the two earlier committee findings, except that it gave support to the awarding of shares (not options) to non-executives directors. It also suggested that remuneration committees should make only recommendations on directors' compensation to the full board, not make decisions on its behalf.

The impact of Cadbury, Greenbury and Hampel on executive pay has been in five main areas: remuneration committees; disclosure; separation of the roles of CEO and chair; long-term incentives; and shareholder approval of remuneration policies.

Remuneration committees

Whereas the Cadbury Committee recommended that companies should appoint remuneration committees consisting of only or mainly non-executive directors, Greenbury went a stage further. It approved the establishment of independent remuneration committees directly accountable to shareholders and consisting exclusively of non-executive directors. In practice, by the time Greenbury's proposals were published, most large companies had already established remuneration committees in line with the Cadbury view. Indeed, a follow-up Cadbury inquiry into compliance with its best practice recommendations, reported a big increase in disclosing the existence of remuneration committees among the UK's top 500 companies: rising from 26% in 1991-92 to 86% in 1993-94.⁵

The fact that only board directors are members of remuneration committees has been criticised for helping to inflate executive pay. The Greenbury code states that non-executive directors should be independent, with "no personal financial interest other than as shareholders in the matters to be decided, no potential conflicts of interest arising from cross-directorships and no day-to-day involvement in running the business".⁶ The combined code also stipulates independence (see figure 2.2). Several companies stress remuneration committee autonomy in their annual reports. Asda, for example, makes the following declaration:

"The remuneration committee … consists of the non-executive directors all of whom are totally independent and are not involved in the day-to-day management of the business."⁷

An example of the typical remuneration committee's terms of reference can be found in figure 2.3.

Figure 2.3: Remuneration committee's terms of reference - an example

Source: Invensys, annual report and accounts 1999, p.39.

Pros and cons

Confining remuneration committee participation only to board members means that directors set each other's pay. Under such circumstances they may have an indirect interest in maintaining salary levels. In 1998, investment body PIRC established a "virtuous circle" between 46 companies, using Marks & Spencer as a starting point. By way of an illustration, the then M&S deputy chairman Keith Oates helped to set the pay of BT's group managing director Bill Cockburn; he sat on the remuneration committee at Centrica (the former trading arm of British Gas) whose chairman Sir Michael Perry is a member of M&S's remuneration committee. According to Stuart Bell, head of research at PIRC, this practice helps to fuel pay increases:

"The fact that they all sit on each others' remuneration committees means any sense of objectivity is lost. What then happens is that what is acceptable for one company quickly becomes the norm in another and everything gets ratcheted up."⁸

The TUC has also highlighted the potential for directors to help set each other's pay. In its analysis of 300 directors in the UK's top 50 companies, the TUC revealed that 11 non-executive directors were on the remuneration committees of half of these organisations, and that this close-knit group held almost 40 non-executive directorships between them.⁹

There is some evidence to support the notion that separate compensation boards can ratchet up executive pay levels. Ezzamel and Watson found invariably that a "cosy collusion exists between executive and non-executive directors, who sit on each other's remuneration committees and thereby bid up executive earnings".¹⁰ Similarly, Main and Johnston reported that companies with remuneration committees had significantly higher levels of executive pay than elsewhere.¹¹ Also, O'Reilly et al, drawing on earlier research, suggested that members of remuneration committees use their own earnings level as a benchmark (social comparisons), and "possibly ending up with something higher".¹²

A study by Conyon and Peck of 94 large publicly traded UK businesses confirmed the findings of these earlier research projects.¹³ It reported that "companies adopting remuneration committees or with high proportions of outsiders on those committees generally had higher levels of top management pay". However, and importantly with regard to corporate performance, the authors also noted that "management pay and company performance are more aligned when there is a higher proportion of outside directors on the main board or a high proportion serving on a remuneration committee". This finding suggests that remuneration committee monitoring can successfully link top management pay to corporate performance and, hence, bring it more in line with the interests of shareholders.

Long used in the US, remuneration committees consisting predominantly of outside directors have several advantages. Non-executive directors, by virtue of their independence, act as a counter-balance to the power and operational interests of executive directors. According to Main and Johnston, the rationale for a remuneration committee is to "exert an influence on top executive pay… that should be in the interests of the owners, i.e. the shareholders."¹⁴

The unitary structure of UK (and US) boards consists of an executive (inside), which acts as the decision-making body, and a non-executive (outside), whose role includes decision control.¹⁵ The absence of an independent remuneration committee, therefore, simply provides the opportunity for senior executives to reward themselves. By contrast, the presence of outside directors is the best way of determining compensation programmes that align management and shareholder interests. As the accountancy body CIMA - the Chartered Institute of Management Accounts - states, a remuneration committee "demonstrates to stakeholders that remuneration is not set by a committee of beneficiaries."¹⁶

Certainly the growth of companies attaching performance conditions to executive incentives, a trend documented by several studies, suggests that remuneration committees are aligning management and shareholder interests, albeit at a slow pace. In addition, the social comparison theory noted earlier would also apply. Although a non-executive director using his or her own salary as a benchmark could push up earnings, directors whose own pay is subject to meeting performance conditions are likely to insist on similar criteria when determining the wage structures of their colleagues elsewhere.

Disclosure

Greater transparency of executive earnings was a primary aim of both Cadbury and Greenbury. Both committees recognised that disclosure is vital in effective monitoring of executive remuneration and good corporate governance. The latter called for the annual report and accounts to contain a remuneration committee report, setting out "pay practice policy" and divulging "extensive details on all the elements of remuneration packages, giving the information for each director by name". It also recommended disclosure of "how performance is measured, how rewards are related to it, how the performance measures relate to longer-term company objectives and how the company has performed over time relative to comparator companies".

Again, most large companies were, in line with the Cadbury recommendations, already publishing details about executive remuneration before Greenbury reported. A report by Coopers & Lybrand, looking at the effect of Greenbury's proposals, found that most of the code's disclosure requirements, with the exception of pension entitlements, were already in place.¹⁷ The study, which was based on the views of executives in 16 top UK companies, also reported widespread concern among participants about the level of disclosure.

This point was also highlighted by the Hampel committee, which was of the opinion that disclosure of individual remuneration packages should be retained, but was critical of the level of information provided in annual reports, believing that transparency had become too complicated.

The extent of disclosure of executive remuneration now common in the UK is illustrated by J Sainsbury. In line with schedule B of the combined code - remuneration report content - the food retailer's 1999 annual report and accounts includes a six-page remuneration committee report detailing the company's approach to top management pay and outlining in detail the pay packages of individual executive directors.¹⁸

Although disclosure of executive remuneration is fairly extensive, the performance conditions and how they are linked to incentive schemes - something recommended by Greenbury - is less comprehensive, according to a DTI-sponsored survey conducted by PricewaterhouseCoopers.¹⁹ While the majority (74% for short-term schemes and 57% for long-term plans) of FTSE All-Share Index companies broadly disclosed how performance is measured, information on how compensation relates to performance is not so common, especially data relating to short-term awards. More than half (52%) of the 298 companies examined provide no data on how short-term incentives are related to performance; few companies (5%) disclose how performance measures relate to long-term company objectives; fewer still (3%), report the company's performance vis-à-vis its industry competitors; and only 4% show how the company has performed over time against a "well-known" stock market index.

Pros and cons

Disclosure of executive remuneration is an essential element of corporate governance, which was defined by Cadbury as the "system by which companies are directed and controlled". Given the potential for managerial and shareholder interests to diverge (see figure 2.4), disclosure performs a regulatory function, reducing the possibility of concealing abuses and of managers pursuing their own self-interest. It also recognises and promotes accountability, enabling shareholders to better monitor and assess board performance and executive compensation. The Hampel report on corporate governance noted that: "Public companies are now among the most accountable organisations in society."

It was noted in chapter one that providing information about executive remuneration to all stakeholders, especially about how incentive plans operate, can engender trust and greater acceptance of payouts linked to good performance. A US report took the view that disclosure of directors' remuneration helps to legitimise "an inherently conflicted process".²⁰

Hampel was concerned that disclosure and the widespread use of salary surveys by remuneration committees was pushing up boardroom pay. And the combined code warns remuneration committees to "use such comparisons with caution, in view of the risk that they can result in an upward ratchet of remuneration levels with no corresponding improvement in performance".

A 1997 Institute of Directors (IoD) publication, Directors' remuneration, also identified a "slavish emphasis" on pay tables and salary surveys, which was partly being fed by greater remuneration disclosure in annual reports, as fuelling top pay.²¹ The findings of a report based on the views of 342 chairman of UK plcs only partially supports this view. It found that less than half (43%) of participants believed the greater disclosure of directors' pay had led to a "ratcheting up" of overall total compensation because it allows easier comparisons.²² However, the study also reported that 73% of directors viewed the current debate about UK corporate governance as having been too preoccupied with issues of accountability rather than business prosperity.

Nonetheless, most remuneration committees adopt a comparative analysis to assist in the determination of directors' remuneration, so there is every possibility that salary "leapfrogging" does occur. SmithKline Beecham's remuneration committee, for example, takes into account directors' remuneration in 21 global companies, mostly competitors in the pharmaceutical industry such as Bristol-Myers Squibb and Merck, to establish its own compensation levels (see case study 4, Case studies). Similarly, the remuneration committee determining individual compensation packages at investment business Amvescap, refers to a "peer group of comparatives and the industry in general" to ascertain appropriate remuneration levels.²³ Although both compensation boards rely on benchmark data from outside consultants, it is undoubtedly the case that disclosure of executive remuneration in the UK and US is a major source of information.

The Amvescap and SmithKline Beecham examples highlight the popular corporate defence for using comparators: namely the competitive nature of the global executive labour market. BG, giving evidence to the 1995 House of Commons employment select committee on directors' pay, compared the compensation of directors of overseas oil and gas companies to justify a large salary increase for its own chief executive. This comparison was valid in BG's view, because the company had to "compete to recruit top executive talent with necessary commercial and international experience".²⁴

Separating the top jobs

Cadbury's guide to best practice suggested that the roles of chairman and chief executive should be separated to ensure no individual has complete decision-making control. Cadbury's view is in line with principal-agent considerations which suggest that splitting the two roles can prevent opportunistic management behaviour (see figure 2.4). Concentrating power in one individual is seen as detrimental to the checks and balances required to monitor CEO behaviour. Boyd has claimed: "Holding a highly symbolic position of board chair would provide the CEO with a wider power base and locus for control."²⁵

Where the two roles are combined, the boardroom presence of independent non-executive directors can mitigate CEO influence. Because outside directors have little affiliation to the business other than their directorship they are perceived to be more independent. By contrast, inside directors are likely to be loyal to the CEO and more prone to opportunistic behaviour. For this reason, Cadbury also stated: "It is essential that there be a strong independent element on the board, with an appointed leader."

In the US, there has been much criticism of combining the roles of CEO and chair. Evidence suggests that there is a higher tendency towards duality in the US than there is in the UK. One study estimated that separation had occurred in only 20% of US companies, but that the trend was in that direction with American Express and General Motors both opting to establish independent chairs.²⁶ It was fairly common in the UK to couple the two functions. However, since Cadbury's proposals the proportion of executives performing the dual role has been declining, especially among large companies.²⁷

Boots is one of the few major UK companies where the two roles are still combined. One company that has only recently split the top jobs is Marks & Spencer, which had operated with a chairman and deputy until the appointment of chief executive Peter Salsbury in November 1998.

Pros and cons

Some commentators have suggested that robust board control of management decision-making is less likely where the chair and CEO roles are combined. It follows that this duality may result in a higher level of top management compensation than is the case where the roles are separated. Nonetheless, there is little evidence to indicate such an outcome. One study found that combining the CEO/chair functions did not appear to shape top management pay.²⁸ This was also the conclusion of another report detailing the effect of corporate governance issues on executive pay.²⁹

Long-term incentives

In terms of actual remuneration practice, Greenbury was instrumental in raising the popularity of long-term incentive plans (Ltips), indicating that they were potentially better at aligning management and shareholder interests than existing share option arrangements. The Greenbury report stated:

"Other forms of long-term incentives may be as effective, or more so, than improved share option schemes in linking rewards to performance, encouraging directors to build up shareholdings in their companies, and thus in aligning the interests of directors and shareholders."

Before Greenbury reported, and against a backdrop of adverse publicity over the "windfall" gains from share options to some executives of the privatised utilities, there was mounting concern as to the relative incentive value of such schemes. Some of the problems with share options were highlighted by mining conglomerate Rio Tinto when the company revised its executive remuneration package in the mid-1990s:

Following Greenbury's recommendations, Ltips became a popular addition to the executive remuneration package, and in some cases, as the Rio Tinto example illustrates, they replaced existing share option schemes. In one of the first examinations of the proportion of companies establishing an Ltip in the aftermath of Greenbury, Hay Management Consultants found that almost half (49%) of the 69 FTSE 100 companies questioned had established a long-term incentive scheme other than share options.³¹ United News & Media's approach is typical of that taken by many companies. The newspaper and television group explains: "When the Ltip was approved by shareholders it was agreed that no further grants of executive share options would be made to directors of the company."³²

Yet the initial enthusiasm for Ltips has now receded, and the trend is back towards share option schemes. A number of companies, including Rio Tinto and Unilever, have simply reverted to a share option arrangement, though it is common for Ltips and share options to operate side-by-side. A 1997 study by the Monks Partnership, the remuneration advisers, found that only 7% of companies had ceased to grant share options to executive directors.³³ The report made the following comment:

"Many of the alternatives to the share option plan are complex and potentially costly to administer. Share options may better meet the needs of some companies."

A further study also highlights the continued prevalence of share option schemes. Although the joint 1998 IDS/Arthur Andersen survey of FTSE 350 companies reported more Ltips than share option schemes in the top 100 for the first time, it also recorded "renewed popularity" of share options, with 28 new schemes established in 1997/98.³⁴

The relative merits of share options and long-term incentive plans are examined in more detail in chapter four.

Shareholders' role

The LSE's listing rules have since 1996 required new share schemes and long-term incentive plans to be subject to shareholder approval where they relate to corporate performance over several years; commit shareholders' funds for more than one year; or dilute equity. Greenbury suggested that boards and remuneration committees should reflect each year on whether to seek shareholder endorsement of their remuneration programmes. However, though urging companies to adopt best practice, all three committees have eschewed regulation of executive remuneration. Sir Adrian Cadbury maintains that professional shareholders should play their part:

"We set out the guidelines. Boardrooms will address them differently and it is perfectly clear that institutions have a responsibility to take action and exert influence. But this is where the debate ought to be: between directors and shareholders."³⁵

While the Government appears to agree that statutory controls are unnecessary, it is likely to pursue a greater direct role for investors by providing a framework that allows shareholders to exercise some influence on companies' remuneration policies. Its favoured approach is to provide either:

One reason why the Government is seeking to provide shareholders with a mechanism to control executive remuneration is the fact that relatively few companies let investors vote on their remuneration committee's report. According to the PricewaterhouseCoopers study (above), only seven companies - 3% of the 270 examined - did so in 1998. The seven were: BT, Garban, GKN, Premier Oil, Scottish Media Group, United News & Media and Wassall.

Pros and cons

A 1995 IoD document came out against subjecting executive remuneration to formal shareholder approval, with one of the reasons being that this would "place upon shareholders a burden which most of them would not be interested in exercising and may not be qualified to exercise".³⁷ Indeed, though the level of voting in the UK is on the increase, only around 39% of large British institutional shareholders vote at annual general meetings, compared with around 83% in the US.³⁸

Aside from the absence of a statutory requirement, there are several factors discouraging shareholders from exercising their votes. Under the current approach investors have only two options available to them should they oppose a company's executive remuneration policies and where the remuneration committee does not forward its report for shareholder approval. Investors can either vote against the company's annual report and accounts, or they can oppose the re-election of non-executive director who is a member of the remuneration committee. Both are radical steps. Most investors would be reluctant to vote against the annual report or dismiss a non-executive director, especially on the issue of remuneration.

However, one of the main reasons institutional investors do not oppose executive remuneration policies, even if, for example, share options result in a dilution of equity, is that corporate performance tends to exceed overall increases in executive pay. US figures for 1998 illustrate this point: whereas total CEO compensation of the largest 200 companies increased by 38%, shareholder returns rose by 39%.³⁹ Also, most criticism of executive remuneration tends to come from smaller investors and trade unions. This highlights a further potential drawback of giving shareholders the right to question compensation practice at annual general meetings; the possibility of "nuisance" resolutions.

Institutional investors can influence remuneration policy in other ways. It is common for companies to consult major shareholders on proposed remuneration changes to ensure they meet investors' performance objectives. Hermes chief executive Ross Goobey has explained:

"When we have reservations, we succeed in forcing a company to change its ways before we are obliged to vote against the board in a public meeting."⁴⁰

Shareholders do occasionally flex their muscles and win significant improvements to remuneration packages that originally lacked sufficiently tough performance conditions. This was the case at advertising business WPP in 1995.⁴¹ Institutional investors forced the company to amend a proposed new pay package for the chief executive in four ways. First, the CEO would receive no further share options. Secondly, the 2,721,296 phantom share options awarded without performance conditions were withdrawn and replaced by a scheme linked to increased share value and performance against the FTSE 100 index. Thirdly, TSR and EPS performance conditions were attached to the company's capital investment plan. Finally, the CEO was barred from participating in the performance unit plan that awards bonuses to executive directors.

At other times, however, large investors have acquiesced, ensuring the adoption of controversial remuneration packages despite the opposition of smaller shareholders. The 1995 boardroom pay package at British Gas is a case in point. Shareholders at the company's annual general meeting generally backed a PIRC resolution critical of the new executive remuneration package, but proxy votes ensured it was adopted.

REMUNERATION IN TODAY'S BUSINESS CLIMATE

Aside from the impact on executive remuneration of the investigations into UK corporate governance, several other factors strongly influence current executive remuneration practices.

Market forces

The apparent non-existence of a significant correlation between executive pay and corporate performance suggests that in reality remuneration committees take other factors into account when developing compensation packages. The labour market for senior managers is an important feature in determining executive remuneration. Competition is one of the main corporate defences against charges of excessive top management rewards. This argument is especially visible in companies with a global presence (see British Gas example, above).

The need to pay competitive salaries is recognised by the Government. Stephen Byers, the Trade and Industry Secretary, confirmed this in an address to institutional investors:

"We need to recognise that in a global economy world class performance must be rewarded with world class pay."⁴²

Globalisation - the process of global economic integration - has created a world market for executives. One of the main reasons behind Rio Tinto's reversion to share options in 1998 was because its FTSE Plan was too "heavily focused on the UK".⁴³ Executive remuneration policy at specialist engineering group TI, which operates in more than 30 countries, is based on the philosophy of offering "internationally competitive total compensation packages".⁴⁴ Cable & Wireless ensures the base salary of its chief executive is internationally competitive and reflects "his value in a global employment market" by "reference to the total remuneration for CEOs in a comparator group of major international telecommunications companies."⁴⁵ Similarly, remuneration at music business EMI reflects "the need to recruit and retain top calibre international management having regard to remuneration levels and practice in the international music and entertainment industry".⁴⁶

The global nature of the executive labour market, coupled with the growth in companies operating on a world stage, means that senior management compensation in many companies is influenced by remuneration practices elsewhere, rather than simply levels of pay. Share options, for example, are a large element of executive remuneration in the US, accounting for more than half of total CEO compensation in the largest American corporations.⁴⁷ Other countries, including recently Germany and Japan, have followed the US model. Rio Tinto explains the rationale for re-establishing share options, describing them as "a well established element in remuneration schemes internationally and, as such, will provide appropriate incentive arrangements for a global mining group".⁴⁸

A further feature of the global executive labour market, and one casting a shadow over domestic remuneration policy, is the growing tendency for overseas executives to run UK companies. Richard Regan, head of investment at ABI, has estimated that in 1998 around half of the UK's top-paid executives were American.⁴⁹ US executives clearly expect US-level and US-style compensation.

Also, high-calibre senior managers are in short supply worldwide, adding to upward pressure on executive pay. This was the conclusion of a 1999 survey of directors' pay by the Monks Partnership. It said the significant growth in executive pay identified by the study was possibly "due to the shortage of able executives who have the skills and experience to successfully manage complex business in an increasingly competitive international marketplace".⁵⁰

Performance measurement

Despite the paucity of many performance conditions for executive incentives, the trend in the UK is definitely towards attaching specific benchmarks to elements of the executive remuneration package. An IDS Management Pay Review study of the FTSE 350 in 1998 found that companies were placing more emphasis on performance-related compensation.⁵¹ Also in 1998, a study of executive pay by consultants William M Mercer reported a closer link between directors' remuneration and corporate performance than in 1995.⁵² It also predicted that this trend would continue, "moving more closely to the US experience and provide greater gain for directors for good performance and greater pain for poor performance".

The flip side of increasing the proportion of at-risk remuneration by attaching performance conditions to the variable elements of directors' pay - which are increasingly making up a bigger slice of the overall package - is for larger incentives. Executive Compensation Briefing, for example, reported in 1999 that share option plans worth "up to 10 times total earnings are being granted in schemes newly approved this year, up from the previous accepted standard of four times earnings for normal options".⁵³ The report gave the example of the Airtours scheme which allows a grant of options equal to 10 times earnings (including bonuses) over a six-year period.

However, companies offering large incentives tend also to be the leaders in attaching tough performance criteria. A recent example is that of Pearson. The media group's 1999 AGM approved a new Ltip - the Pearson Reward Plan - which requires a boost to the company's share price of at least 25% over the next three years before the 90 senior executive directors and executives of its main operating subsidiaries can take advantage of it (see case study 2, Case studies for details). Another case is BP Amoco. The company, recently established from a merger between BP and Amoco, will reward top executives with shares worth twice basic salary should the business become number one in the world in its sector.⁵⁴

The ABI, supported by the NAPF, has recently announced new guidelines for share-based incentive schemes that attract robust performance conditions and are "objectively costed, well-designed and form a coherent part of the overall package". The ABI's previous "informal" limit of four times' salary for the value of directors' share options is no longer viable. As the ABI's guideline principles explain there has been a:

"general move towards grants of awards which are a much more central part of the overall remuneration package and away from the traditional concept of subsisting options within a four times limit. In light of developing practice, including the emergence of Ltips, the increasing use of market-purchased shares to satisfy vesting of wards, and the conclusions of the Greenbury and Hampel reports and the provisions of the combined code, it is appropriate to reassess the practical application of the guidelines and their underlying principles."⁵⁵

Of course, the choice of performance criteria can significantly affect the level of reward. Bull market conditions on the world's stock markets have greatly boosted the value of share options as they are commonly tied to measure of share value, for example.

Share ownership

Both UK and US investors increasingly like executives to maintain a specific personal level of equity in the business. This is based on the premise that a stake in the company will better align executives and shareholders' interests because personal wealth is at risk unless the company's share value continues to increase. There has been a change in emphasis from thinking like owners - the rationale behind share options - to being owners. Between 1992 and 1997, half of America's top 100 companies issued share ownership guidelines for executives.⁵⁶ US ownership guidelines on shareholdings range from five times base salary in the utilities and energy industries to 18 times basic pay in the service sector.⁵⁷

SmithKline Beecham's adoption of share ownership guidelines in 1997 was one of the first in the UK. The pharmaceuticals business requires its chief executive to acquire a shareholding worth at least four times base salary and other executives to own shares to the value of three times base salary (see case study 4, Case studies).

A growing number of UK companies have followed SmithKline Beecham's example and are encouraging senior managers to acquire an equity stake in the business. United Utilities, for example, states in its 1998 annual report:

"Share ownership is generally regarded as an effective means of aligning the interests of executives and shareholders. The Group promotes greater ownership of shares in the company through the making of incentive awards in shares and through encouraging executive directors to accumulate and hold shares with a value approximating their annual salary."⁵⁸

Elsewhere, NatWest Bank also promotes share ownership among its senior executives, who are similarly requested to build up a shareholding amounting to at least their annual salary.⁵⁹ GEC has established a personal shareholding policy for executives receiving share options that requires them to amass a target shareholding in the company with a market value equal to annual salary or, in the case of the most senior executives, twice their salary.⁶⁰ British Aerospace is another company requiring executives to gradually build up stakes to the value of twice their salary.

The ABI is also favourable towards greater share ownership among executives:

"Institutional shareholders are generally supportive of companies which encourage their senior executives to build up meaningful shareholdings in the companies for which they work. The design of incentive schemes, especially where this facilitates the retention of a significant portion of shares to which participants become entitled, can be of considerable significance in achieving this objective."⁶¹

Figure 2.4: Determining executive remuneration

The principal agent model is commonly used to explain the remuneration of top managers and chief executives. In essence the shareholders (principals) delegate the decision-making authority to managers (agents).

In large corporations principals tend to rely on incentives tied to corporate performance to ensure agents act in the shareholders' best interests. This is because the separation of control from ownership means that managers do not necessarily act with the shareholders' interests in mind, but instead focus on their own economic self-interest. Whereas shareholders seek to maximise profitability, managers may prefer to pursue separate objectives, such as sales, managerial utility and growth, especially as maximising profits is costly in terms of effort. Dismissal is the other side of the incentive coin. Poor performance raises the threat of management dismissal and so acts as an incentive for agents to behave in the shareholders' interests.

A key factor potentially preventing the interests of principals and agents from converging is the presence of asymmetric information. Shareholders cannot perfectly monitor the agents' activities or the company's investment opportunities, enabling managers to pursue their own goals. Moreover, it is only in retrospect that the quality of managers' decisions becomes apparent. Because there is no effective mechanism to properly assess executive effort and decision-making, measures such as shareholder value act as a substitutes to gauge management performance.

The optimal contract

The solution to the agency problem - to act in his or her own self-interest - is for compensation to increase with shareholder profit. However, this produces a conflict between incentives and insurance. Potentially, there is a high level of risk to the executive from attaching remuneration to a financial yardstick such as total shareholder return. Three factors drive executive remuneration: economic climate, industry-specific conditions and management ability. Industry/economic factors are outside the control of management and can adversely affect share value and so reduce that proportion of executive compensation based on TSR. The principal cannot offer the agent full insurance - a constant wage, independent of financial performance outcome, for example - to mitigate possible losses because it is the only mechanism available to ensure the manager gives maximum effort.

One way of reducing the level of risk from factors outside the control of executives, such as big swings in the stock markets, is to link some elements of compensation to measures of relative corporate performance. As Martin Conyon and Dennis Leech explain:

"Since the contract is ideally designed to elicit high effort then rewarding the manager relative to benchmark companies filters out economy/industry-wide noise. It is more difficult for an individual company executive to claim performance is low due to high effort and bad luck if benchmark companies within the relevant sector are performing well."⁶²

An example of a company adopting this approach is Cadbury Schweppes. The confectionery to beverages group uses TSR as a performance condition for awards made under its long-term incentive plan. The company's TSR, however, is compared against a "weighted average TSR performance of a peer group of both UK and non-UK 'fast moving consumer goods' companies".⁶³

It follows that a compensation system that involves a degree of risk, should also provide a sufficient level of incentive to induce the correct behaviour. Yet the evidence indicates a fairly low level of executive reward for boosting shareholder value. In the UK, an increase of around £1 million in the share value of a company resulted in an additional average rise in CEO salary of £50.⁶⁴ A similarly small incentive was found in the US. Michael Jensen and Kevin Murphy estimated that for every additional $1,000 change in shareholder wealth, CEO wealth increased by $3.25.⁶⁵

Aside from agency considerations, which assume a correlation between executive pay and company performance, other factors can significantly influence the remuneration of senior managers. Sales is a case in point and trade is often presented as the main alternative to profitability in shaping directors' remuneration. Studies support the view that company size, which indicates a managerial preference to pursue firm growth, is an important component in deciding the level of executive compensation. William Baumol, for example, found in 1967 that executive salaries appear to be "far more closely correlated with the scale of operations of the firm than with its profitability".⁶⁶ However, Conyon and Leech explain that the link between executive pay and company size may simply reflect the need to give executives in larger companies higher rewards because the costs of incorrect decisions are potentially greater in such enterprises than in smaller ones.⁶⁷ Sherwin Rosen believes that profitability and sales are both crucial in determining executive pay.⁶⁸

Corporate governance and company ownership are both important influences on executive remuneration. The inability of principals to directly monitor agent effort is greater when company ownership is diverse.⁶⁹ Moreover, there is little incentive for individual shareholders to incur the costs of monitoring executive performance because they will only reap a proportion of any gains. Under such circumstances, executives have ample opportunity to pursue their own goals rather than profit maximisation. Corporate governance - referring to the manner in which companies are directed - can ensure executive effort is channelled into delivering profitability by enforcing pay for performance contracts. According to Michael Jensen, boards represent shareholders and serve as their "first line of defence against a self-serving management team"..⁷⁰

A further constraint on opportunistic management behaviour can come with the concentration of share ownership. Large institutional investors can influence corporate decision making and so discourage agent malfeasance (see above for example of investors influencing corporate pay policy).

¹     Hilton A (1999), "Weighing up the fat cats", Management Today, July, pp46-51

²     Augustine N (1982), Augustine's law (American Institute of Aeronautics and Astronautics, New York)

³     Gregg P, Machin S, Szymanski S (1993), "The disappearing relationship between directors' pay and corporate performance", British Journal of Industrial Relations, March, pp1-9

⁴     IDS (1995), "British Gas board wins pay vote", IDS Management Pay Review 173, July, pp2-5

⁵     Cadbury A (1995), Report of the committee on the financial aspects of corporate governance: compliance with the code of best practice (Gee, London)

⁶     Best practice provisions: directors' remuneration - Section A: remuneration committees

⁷     Asda annual report and accounts 1998

⁸     Quoted in The Observer, 11 October 1998

⁹     You scratch my back, TUC (1998)

¹⁰    Ezzamel M and Watson R (1997), "Wearing two hats: the conflicting control and management roles of non-executive directors", in Keasey K, Thompson S and Wright M (eds), Corporate governance: economic and financial issues (Oxford University Press), p73

¹¹    Main B G M and Johnston J (1993), "Remuneration committees and corporate governance", Accounting and Business Research, vol 23, pp351-362

¹²    O'Reilly C A, Main B G M and Crystal G S (1988), "CEO compensation as tournament and social comparison: a tale of two theories", Administration Science Quarterly, vol 33, pp257-274

¹³    Conyon M J and Peck S I (1998), "Board control, remuneration committees and top management compensation", Academy of Management Journal, vol41 (2), pp146-157

¹⁴    Main and Johnston, see note 11, above

¹⁵    Fama E and Jensen M C (1983), "Separation of ownership and control", Journal of Law and Economics, vol 26, pp375-393

¹⁶    Executive Remuneration, The Chartered Institute of Management Accountants (London, 1996), p13

¹⁷    The Greenbury effect: company reactions to the Greenbury report on directors' remuneration, Coopers & Lybrand (1996, London)

¹⁸    J Sainsbury plc, annual report and accounts 1999, pp27-32

¹⁹    Monitoring of corporate governance aspects of directors' remuneration, DTI/PricewaterhouseCoopers (1999)

²⁰    Report of the National Association of Corporate Directors blue ribbon commission on director compensation: purposes, principles and best practice (1995), p19

²¹    Directors' remuneration, Institute of Directors (1997, London)

²²    Clarke R, Conyon M and Peck S (1998), "Corporate governance and directors' remuneration: views from the top", Business Strategy Review, vol 9 (4)

²³    Amvescap report and accounts for 1998, p61

²⁴    Evidence to the House of Commons Employment Select Committee on The remuneration of directors and chief executives of privatised utilities (1995)

²⁵    Boyd B K (1994), "Board control and CEO compensation", Strategic Management Journal, vol 15, pp335-344

²⁶    Kay I R and Lemer D (1994), "Paying the separate chairman", Directors & Boards, vol18 (3), pp47-50

²⁷    Conyon and Peck, see note 13, above

²⁸    Ibid

²⁹    Conyon M J and Leech D (1994), "Top pay, company performance and corporate governance", Oxford Bulletin of Economics and Statistics, vol 56 (3), pp229-243

³⁰    "Executive pay at RTZ plc: case study 25" in Stredwick J (1997), Cases in reward management (Kogan Page)

³¹    Hay Management Consultants (1996, London)

³²    United News & Media plc, annual report and accounts 1997

³³    Incentives for directors & managers, Monks Partnership, January 1997

³⁴    Directors' pay report 1998, Incomes Data Services/Arthur Andersen (London)

³⁵    The Guardian, 22 July 1998

³⁶    Stephen Byers, secretary of state, DTI, speech to institutional investors, 19 July 1999

³⁷    The remuneration of directors - a framework for remuneration committees, Institute of Directors (1995, London)

³⁸    The Times, 20 July 1999

³⁹    "Who wants to be a billionaire?", in a survey of pay, The Economist, 8 May 1999, pp12-15

⁴⁰    Quoted in The Economist, 8 May 1999

⁴¹    IDS (1995), "Investors force WPP to reduce bonus", IDS Management Pay Review 174, August, p9

⁴²    See note 36, above

⁴³    Rio Tinto, 1997 annual report to shareholders, pp56-57

⁴⁴    TI Group, annual report 1998, p44

⁴⁵    Cable & Wireless, annual report and accounts 1998

⁴⁶    The EMI Group annual report 1998, p25

⁴⁷    Rappaport A (1999), "New thinking on how to link executive pay with performance", Harvard Business Review, March-April, pp91-101

⁴⁸    See note 43, above

⁴⁹    Quoted in the Financial Times, 20 July 1999

⁵⁰    Monks Partnership 1999

⁵¹    IDS (1998), "New FTSE 350 survey", IDS Management Pay Review 211, September, pp2-9

⁵²    "Is executive pay set to increase? Trends in the US/UK suggest it will", William M Mercer news release, 16 July 1998

⁵³    Executive Compensation Briefing, summer 1999

⁵⁴    BP Amoco annual report 1999

⁵⁵    ABI (1999), Share-based incentive schemes - guideline principles

⁵⁶    Marquardt E P (1999), "Aligning compensation and stock ownership", in Risher H (ed), Aligning pay and results (AMACOM/ACA), pp101-118

⁵⁷    Watson Wyatt survey of executive pay 1996, in Kay I T (1997), CEO pay and shareholder value: helping the US win the global economic war (St Lucie Press, Boca Raton), p111

⁵⁸    United Utilities annual report and accounts 1998

⁵⁹    Reported in The Guardian, 19 July 1999

⁶⁰    The General Electric Company annual report and accounts 1998, p42

⁶¹    ABI, see note 55, above

⁶²    Conyon M J and Leech D (1994), "Top pay, company performance and corporate governance", Oxford Bulletin of Economics and Statistics, vol. 56 (3), August, pp.229-247.

⁶³    Cadbury Schweppes, annual report and form 20-F 1998, p.68.

⁶⁴    Main B G M (1992), "Top executive pay", working paper, Department of Economics, University of Edinburgh.

⁶⁵    Jensen M C and Murphy K J (1990), "Performance pay and top management incentives", Journal of Political Economy, vol. 98, pp.225-264.

⁶⁶    Baumol W J L (1967), Business behaviour, value and growth (Macmillan, New York).

⁶⁷    Conyon and Leech, see note 62, above.

⁶⁸    Rosen S (1998), "Contracts and the market for executives", in Werin L and Wijkander (eds), Contract economics (Blackwell, Oxford), pp.181-211.

⁶⁹    Vickers J and Yarrow G (1988), Privatisation: an economic analysis (MIT Press).

⁷⁰    Jensen M C (1993), "The modern industrial revolution: exit and the failure of internal control mechanisms", Journal of Finance, vol. 48, pp.831-880.