Executive pay: Are we looking at the wrong numbers?

17th April 2012

Plenty of pay scapegoating but scant solutions

Bob Diamond, the Barclays Bank boss, may not consider himself a scapegoat. For by carrying wide public and media opprobrium for excessive pay packets, there is less focus on the others. He will be the subject of increasing salary scrutiny ahead of the Barclays annual general meeting due on Friday 27, April at the Royal Festival Hall. 

As the High Pay Commission reported, it seems almost everyone in the directors' suite is at it – only not so well publicised as Diamond. The report states that the average FTSE 350 director say pay rise 108 per cent between 2000 and 2010 – many "below stairs" employees would have been lucky to keep up with inflation.

Top pay at Barclays has increased 50 fold over the past 30 years, that at oil group BP, 30 times. In 1980, bank bosses earned 14 times the average salary in their firms. Now it is 75 times.

How do they justify it? Largely, firms claim they need to pay so much to recruit "the best talent" and that executive salaries are calculated and approved by remuneration committees consisting of non-executive directors.

Leave aside that the non-execs are often executives elsewhere, frequently sit on more than one committee and have a personal interest in ratcheting up pay levels. Instead ask whether Ukplc is more profitable or more productive or more internationally famed than it was in 1980 – a time when executives received a plain salary and pension; only those in partnerships such as stockbrokers or lawyers had ever heard of the B (bonus ) word.

Where is the performance?

Now focus on the "performance metrics"  those numbers committees use to produce pay awards. The model of base salary plus bonus encourages executives to work to the metric that it favours them over other stakeholders, just as public sector employees cotton on how to work to the target, again to their favour rather than other stakeholders. 

If targets change, so too does behaviour. Target five A-C at GCSE and heads look for the easiest subjects; target five A-Cs which must include English, Maths and Science and the educational curriculum modifies.

Colin Melvin, the CEO of Hermes Equity Ownership Services, a specialist in workplace pension advice, told a recent conference of remuneration committee members that he was aware of the problem. 

He said: "The overall success of companies and our economic futures will be influenced by the extent to which corporate boards, remuneration committees and long term shareholders work together to address a flawed system of compensation."

Dialogue, engagement and voting

But he has no easy solution – just dialogue, engagement and voting power to "ensure executive remuneration is aligned with the long term interests of pension funds and their members."

And as long as it believed that staff above a certain level need carrots to work to the best of their ability (while those below the water need sticks), there is no easy answer.

But in deciding how to vote on pay issues, investors need a transparent version of  performance metrics used and how they can be manipulated.

This blog looks at executive pay in Australia, where the issue is as live as anywhere.

It concludes that metrics can be "moulded" to fit executive pay needs.

A look at the metrics

The most common is earnings per share (EPS) a metric which can be easily enhanced with higher borrowings, used to purchase more assets or buy other companies to produce an increase in earnings while the number of shares in issue is unchanged. This works especially well with low interest rates. The loans go on the balance sheet but investors rarely look at this. If interest rates reverse, then EPS boosts will go wrong. But executives do not repay bonuses – in any case, the director suite is usually a revolving door.

Total Shareholder Returns (TSR) is often used. It measures dividends paid and the share price change over a given period (usually 3 to 5 years).  It can be manipulated by generous dividend policies which, in themselves, will tend to push equity prices higher. This metric encourage firms to pay out to shareholders in the short term while ignoring longer term investment.

The return on equity (ROE) metric measures how efficiently shareholder capital is used to generate profit.  But what do you measure it against?  Often, it is an industry or index peer group. So if your firm drops 10 per cent while the average is down 15 per cent, the ROE comparative looks good. This can allow rewards for (relative) failure. And just like earnings per share, it can be enhanced with debt-funded asset purchases.

Investors can get around this by insisting on Absolute Return on Funds Employed.  This adjusts the after-tax profit to take account of  debt preventing managers borrowing to inflate return on equity.  So a 30 per cent ROE, where debt equals equity, goes down to 15 per cent.

Partha Mohanram, associate professor of business at Columbia Business School, believes the stock market fails to appreciate the difference between productivity-driven growth and investment-driven growth in earnings. It's inherent profitability not profits that count.

Profitability not profits

He says: " The critical factor for any firm's success is its profitability, i.e., how much profit is the firm making relative to the amount of assets that have been deployed. Almost no one looks at profitabil
ity, we focus on raw profits instead, to our detriment." He decries investment bankers who focus on "whether a transaction is going to be "accretive" or "dilutive" to EPS, not on whether the transaction is going to improve asset productivity." He also blames "the business media, which focus on these flawed metrics and increase the pressure on managers to meet rising earnings expectations, even at the cost of declining profitability" and "investors who focus all their attention on whether the firms meet analysts' estimates, harshly penalising firms that miss by a few cents.".

London Stock Exchange begs to differ

Even if there is no clear solution, most agree that something must be done about executive pay. But not all. When the Department for Business Innovation and Skills announced a consultation (not yet finalised) on top pay last September, the London Stock Exchange responded:

"We believe that the UK's current corporate governance regime delivers the right balance to protect shareholders and gives them a say in setting directors' remuneration. We do not believe that the current system is flawed, although greater disclosure within certain limits is always worth considering."

 

More from Mindful Money:

The worst recovery in history

Upside down economics – morality before greed

Towards a language of banking

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