Executive pay – too much or too little?
By Mark Bussin who can be contacted at ; www.21century.co.za
1. The issues
Generally executive pay in SA is linked to performance and our governance is on par with international standards. The international trend of linking more of executive pay to performance is a good principle. Our executive bonus percentages are not out of line with international standards. The exceptions are rare and a "few swallows do not make a summer". Once formulae have been agreed with executives, one should honour them, even if in a few years time. Reneging on the payment because it seems too much is breaking the contract.
Decisions taken at the time are normally based on market forces, and even though the hunt for the next Enron is an international sport – agreements are agreements. For example, in year 1 of Coleman Andrews’ SAA contract the formula for his bonus was agreed upfront. The formula was in line with best practice and attractive enough to attract a person of this calibre into the job. A few years later, when it came to doing the calculations on the agreed formal the bonus payout had to be honoured, relative to the initial agreement, which was in excess of R250 million. A lesson that could be learnt from this is that a good and well-designed incentive scheme should also cover some principles on how the targets are to be met.
There have been other examples in industry where big bonuses are paid not due to productivity or good business but because of exchange rate and currency fluctuations. Most well designed schemes out in some provisos regarding this and it has become increasingly popular to include provisos on the company’s values as well e.g. honesty, integrity, etc.
Market forces play a dominant role in remuneration decision-making and staying competitive is a crucial retention factor. SA executives are "low hanging fruit" for international headhunters because of their good general management skills and the perception that they are hard working. Quite a number of South African organisations have listed overseas on overseas stock exchanges, especially the London Stock Exchange. The top echelons of those organisations have quite correctly benchmarked their salaries with their European counterparts. The effect of that quite often is that it increases the pay gap between the most senior South African executives and the South African expatriate executives by sometimes up to 5 times. In some organisations this creates envy or tension.
Against this backdrop, we need to maintain reasonable pay ratios between the highest paid and lowest paid worker. We are in line with international norms in this regard and need to maintain this.
Our remuneration committees are generally very effective and do a good job. We generally exceed international norms in the governance arena, and our committees can be commended for this.
The visible links to the value add and wealth generation needs to be clear when awarding large bonuses. Few analysts have a problem with large payouts when it is commensurate with performance. In the USA the reporting covers the mechanics of the bonus schemes. We are in the fledgling stages of transparency and reporting, and with time we should move to this level of reporting.
Retaining our top executives in a skills shortage environment means aggressive incentive schemes to reward top performance in a complex environment. With a strong link to organisation performance, these schemes should be encouraged.
2. Guidelines useful in scheme design
# Bonus schemes will focus on the achievement of specific short-term objectives and will be contracted at the commencement of the remuneration period. The scheme/s must drive the business strategy and objectives of the organisation. Therefore the company’s bottom line performance in terms of profit and return on assets are of paramount importance.
# Bonus schemes must support company as well as divisional objectives. Whilst the performance criteria and measures will reflect this, individual performance will also be rewarded.
# Bonus schemes must motivate employees to achieve set objectives. To maximise incentivisation, communication with participants on progress relative to set targets must be regular and target setting must be relevant to the line of sight of participants.
# Bonus schemes and the concomitant targets will be simple, measurable, achievable (with an element of stretch), realistic and time bound.
# Bonus scheme eligibility should be fair and equitable within each job level. Where employees stand to gain differing amounts, these must be based on clearly evident, pre-determined performance measures and contribution levels in order to ensure defensibility.
# The incentive scheme must be self-funding.
# Individual bonus rewards will be uncapped (but subject to executive scrutiny).
# The schemes should provide handsome rewards for excellent performance and penalise performance below on-target level.
# The scheme design must reflect sound corporate governance principles.
# The design of performance targets must be reviewed annually to reflect continuous improvement in line with shareholder expectations and reflect changes to organisational strategy.
# Variable pay schemes do not form part of the conditions of employment for employees. The rules and conditions may change substantially from year to year.
3. General design considerations
A study by Shelley Taylor and Associates, quoted in the Economist, showed that executive pay--and the extent to which it is linked to performance—is one of the top twenty issues investors care about.
A study undertaken by Ernst and Young indicates that investors are placing increasing value on a company’s intangible assets and that the quality of executive compensation is one of the top ten issues taken into account.
A study by Hope and Hope estimates that 50% to 90% of the value created by a company comes from the management of intellectual assets, rather than the management of physical assets. Ulrich points out that in the service sector value is created by relationships founded on the competence and commitment of individuals—and in this regard the design of compensation systems has a pivotal role.
>> The do’s
# Individual performance measures should be based on the individual’s specific activities that create value in support of business objectives
# Performance enhancement is best achieved when participants are individually accountable for their performance objectives
# Financial threshold performance levels should account for cost of capital and be benchmarked against peer group performance levels
# Cost benefit studies and sensitivity analyses are imperative during the design phase
# Employee values and cultural considerations should be taken into account in scheme design
# Differing degrees of difficulty to achieve objectives should be factored into the design
# Aspects outside the organisation’s sphere of influence should be taken into account in the design.
>> The don’ts:
# Excessive targets
# Overly restrictive caps
# Changing goal posts inadvertently,
# Clouded criteria
# Discriminatory target setting
# Lack of justification for discretionary intervention
# Insufficient communication
FINALLY THERE’S ONE MORE IMPORTANT DO—TAKE ACCOUNT OF CURRENT TRENDS IN INCENTIVE SCHEME DESIGN:
# Trends in major US corporations show that rewards granted under incentive schemes are increasing. The most common methods of funding plans are based on financial performance criteria. In order of popularity these are earnings per share, operating income and return on assets. Notably the two most popular methods do not account for cost of capital--but its use is increasing.
# The most commonly used bases to determine threshold performance levels are the company’s budget, year-on-year growth, investor expectations, and peer group performance. The most defensible methods are currently only third and fourth on the list.
# Financial performance measures are increasing at the individual level. The average weighting of these is up to 75% of bonuses.
BUT HERE’S THE BIGGEST SURPRISE—ALTHOUGH THE MEDIAN BONUS PAYOUT LEVEL AT EXECUTIVE LEVEL IS 75% OF ANNUAL BASE SALARY, MANY COMPANIES PAY BONUSES AROUND THE 200% MARK TO TOP PERFORMERS AND THERE ARE INSTANCES AS HIGH AS 500% FOR THE "RAINMAKERS".
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