The turmoil in the financial markets and the fallout from the credit crunch have only served to intensify the growing scrutiny on executive compensation. This has served to fuel the perception that despite poor corporate performance, senior management continue to be rewarded handsomely while investors, pension fund beneficiaries and employees are left short changed. Although the media tend to focus their attention on the recipients of these ‘egregious’ pay packages, investors are much more concerned with the role played by remuneration committees. Consequently, investors collectively and individually, have published a plethora of long-standing remuneration guidelines detailing rules of best practice. In recognition of the need for flexibility in this challenging environment, this article seeks to focus on the core principles and tenets of an effective remuneration strategy.
Setting the framework
The oft quoted objective of any successful remuneration policy is to recruit, retain and motivate senior executives to create long-term value for shareholders. It also serves as the primary mechanism for aligning management interests with that of their investors. Consequently shareholders place great importance on the structure of executive compensation as a means of mitigating risks associated with the agent-owner division. This is of even greater relevance for smaller companies as they are generally viewed as higher risk investments.
Linking Pay and Performance
The final outcome of a remuneration policy is of less importance then the basis upon which remuneration levels are ultimately determined. In circumstances where management have developed and successfully executed a strategy that has generated significant value, then it is natural that they should be suitably rewarded. However, a credible remuneration policy must ensure that this relationship is equally maintained during times of weak performance. To that end, remuneration policies should be designed to deliver a significant portion of the expected value of total compensation through variable pay (bonuses and long term share based plans).The determination of payouts under the variable elements of remuneration brings us to the heart of this issue. The choice of performance periods, metrics, targets and vesting schedules will ultimately govern the success or failure of any remuneration proposal. Investors would expect remuneration committees to take account of the following:
- Performance periods for long term incentives should broadly reflect the natural business/investment cycle of the company.
- Performance measures should be based on the fundamental drivers of the business. Ideally this would include a mixture of earnings and operational targets. As a general rule we do not consider share price targets to be appropriate as it is difficult to isolate broader market factors from individual corporate performance.
- Targets for threshold and maximum performance should be set to encourage and reward truly exceptional performance. Consequently we would expect earnings and/or operational targets to significantly exceed market expectations and budget for share awards to pay out in full.
Remuneration committees should consider the appropriateness of adopting deferral periods for vested awards and require directors to maintain a minimum shareholding during their tenure.
Mirza Baig is Associate Director of F&C Asset Management’s Governance and Sustainable Investment Team.
A robust and well designed remuneration policy is widely considered as a proxy for a dynamic and accountable management culture and would facilitate the strengthening of trust between boards and their investors. However, companies should be aware that the opposite may also hold true. Therefore, the remuneration committee should take care in ensuring that the details of executive remuneration arrangements are fully disclosed. This should include a narrative of the relationship between the remuneration policy and corporate strategy and an analysis of pay in light of financial and operational performance in the preceding period. We would consider the presentation of the remuneration report for an advisory shareholder vote to be a sign of good practice for companies with an AIM listing. Investors are acutely aware that smaller companies and newly listed businesses often face unique business challenges. Consequently, it is normal and in many cases expected that the remuneration committees design bespoke incentive arrangement tailored for the specific strategic needs of the group. Where such arrangements are likely to prove controversial, companies are encouraged to consult major shareholders prior to its implementation.
With a global recession looming on the horizon, remuneration committees must carefully consider how to achieve the correct balance of rewarding management for navigating through short-term volatility in the market while remaining focused on the goal of long term value creation. Defining such a policy will be challenging and will not always fit neatly into an established model. Therefore, the key to shareholder support will be for companies to build their remuneration strategies upon the three pillars of performance, transparency and accountability.