Executive Remuneration Principles and Practice - Coursework Example

EXECUTIVE REMUNERATION PRINCIPLES AND PRACTICE TABLE OF CONTENTS Introduction…………………………………………………4 2. Aspects of Fair Remuneration……………………………..4 2.1 Remuneration Decisions………………………….5 2.2 Issues in Remuneration…………………………...6 3. The High Pay Commission Final Report…………………7 3.1 The Importance of Pay……………………………7 3.2 Entrepreneurialism……………………………….8 3.3 Understanding Pay for Performance…………….9 3.4 Performance Related Pay…………………………9 3.5 Accountability…………………………………….10 3.6 Pay Matters……………………………………….10 4. ABI Principles of Executive Remuneration………………10 4.1 Remuneration Committee Guidance…………....11 5. Conclusion………………………………………………….13 6. References…………………………………………………..15 Abstract The paper discusses the executive remuneration principles and practice in the UK from the perspective of the reports published by the Association of British Insurers (ABI) and the High Pay Commission Report. 1. Introduction Executive remunerations has always been an important topic of discussions in many forums, especially the corporate governance issue. This was one of the primary topics for financial economists. According to the comparative analysis, it is evident that there were few of the fundamental needs as well as general judicial principles came into light because of the past and present debates. There was a big financial crisis in 2007. The remuneration practices for the executives in large financial institutions and industrial firms played a large role in that crisis.1 The main slogan of these debates was "there should be a fair compensation". The meaning of this line can be implied in the following ways 2 : To attract the best directors there should be an adequate remuneration which include incentives for serving the shareholders and increase their value. At the same the remuneration should not be so high that it costs the company for the long run 2. Aspects of Fair Remuneration For gaining a big profit, the managers or the agents interest does not necessarily match with that of the shareholders.3 They run the show according to their convenience and satisfaction, even if that hurts the shareholders sentiments. This can cost the firm to lose a strategically important acquisitions offers and even a takeover decision as well. This might increase the value of the shareholders but the position of the managers will be at stake. If we look into the matter in this aspect, then a fair remuneration is that which is given as per the market condition and value. This should be decided by a healthy negotiation. The second important factor in this regard is disclosure or precisely a better transparency.4 This is also important as far as the accounting is concerned. This acts as an important monitoring tool that deals with the fairness of remuneration. This is beneficial for the company as well as the market authority and the stakeholders that help them put forward a strenuous auditing activity. 2.1 Remuneration Decisions The people who are in charge of remuneration decision, decide on the remuneration that may not be a fair one and also it lacks transparency. Improvement of the corporate governance policies makes the task of decision-making easier. Promoting fair regulators, negotiations and also few best practices act as boosters to this step.5 There are chances that new and improved decision steps are being added. The purpose of this is not only limited to the creation of an independent board that has an internal remuneration committee, but also to allow the shareholders to be an important part of the remuneration process.6 In addition to the above, the compensation should be in line with the performance. This will increase the performers approach to the job and also the value. There should be a correlation between performance and pay. This is according to the EU Commissions Recommendation of February, 2005. If we look at the report, the compensation policy and the related transparency has been improved, which is regulated under the Sections 420 and onwards of new UK Companies Act and also in line with the articles 225-237 of French Commercial Code.7 2.2 Issues in Remuneration Though there are measures, there were problems that arose due to the unfair and non-transparent remuneration arrangements and ultimately the undue crisis. The measures that were suggested for this were all temporary and short lived. According to a doctrine of America, the independent directors draw many non-economic and economic incentives.8 If not, they try to get along with the companys arrangements that are meant for the top executives of the company. The aim is basically to get re-elected for the post, for which they need the support of the executives. There are many social factors which also play a part in it. Though most of the directors have shares in the company, they avoid taking the financial incentives meant for the executives and stay away from the expensive route of fighting with the CEO.9 In spite of transparencies in compensation packages, shareholders still remain in dark as there are many inside play which takes place regarding the rent, miscellaneous expenses etc. Another factor is that the indicator choice is complicated where the pay is based on the equity. These indicators can be easily manipulated by inflating the share prices. However, in case of the pay based on the simple share options, the managers have all the control including the creation step.10 As far as corporate governance is concerned, it is good to have independent directors, however, the shareholders should have few controls, and most importantly the corporate elections should be conducted in an honest manner.11 Additionally, the corporate democracy should have the power to de-throne the board if they are not satisfied with the performance of the board. According to the Financial Stability Forum Principles, the firm has every right to monitor and oversee the remuneration system. This is because the firm should be ready for any crisis and should have a good remuneration policy in place to deal with crisis. It is always good to be prepared and look for remedies when any crisis situation arises. 3. The High Pay Commission Final Report As per the Financial Reporting Council (FRC) and UK Corporate Governance Code, the Remuneration Committee should be sensitive employment conditions and pay in the group while setting executive pay, particularly while determining annual salary increases. 12 Policy Recommendations In order to create greater accountability, following policy recommendations have been put forward by the Commission.13 If implemented properly, the reforms will not only deal with accountability issues, but will also deal top pay escalation with a focus on fairness. 3.1 The Importance of Pay It has been a classic argument that an employees fairness sense within an organization is dependent on the belief that they are paid fairly vis a vis employees who are paid similarly. This argument has however been challenged by various academicians. Martin and Crosb have revealed that relative deprivation is also experienced by the employees when they compare rewards with employees falling in the higher income bracket. 14 A number of studies have been undertaken in this regard which reveal that within a given organization, employees in the lower strata not only compare their rewards with their peers, also with rewards which upper strata employees receive, and wherever there is significant gap, it results injustice feelings. This injustice in turn erodes employee engagement. In a University Departments study, Pfeffer and Langton discovered that where there was bigger dispersion of salary, employees were found to be more dissatisfied, even when the pay was directly related to their productivity. 15 The increase in top pay has made the economic case of getting to grips increasingly apparent. When there exists extreme pay inequality levels, it has a direct impact on: Entrepreneurialism Growth Economic Instability Sectoral Imbalances Social Mobility 3.2 Entrepreneurialism An essential feature of UK economy is the existence of small businesses and innovations. Nearly 46% of all workers in private sector is accounted for by small businesses (employing less than 50 people). But still it is argued entrepreneurialism is discouraged by the growth in pay at the top. 16 In fact it does make sense avoiding such a huge amount of risk; when independent wealth opportunity awaits, it does not make sense risking your own capital and your family home. The case for the discussion of fair pay on pay inequalitys social impacts has its main focus on povertys impact which has given rise to several questions. How are intergenerational unemployment and poverty traps created by wage disparities? Even in a rich country as UK, how does poverty and deprivation affect mortality rates? But this is only one half of the story because the matter of concern is not just the pay at bottom, but the pay at top as well. Social comparisons are not limited to companies only but are prevalent across the society. 17 However, whenever the gap widens, it leads to social unrest, instead of encouraging aspiration or cohesion 3.3 Understanding Pay For Performance Its a common belief that the individuals can be encouraged to behave in a certain manner by the effective use of bonuses and variable pay. There has been observed performance related pay boom across the private sector, and now this principle is being encouraged within the public sector as well. In finance companies, for people at the top of pay spectrum, this principle has been stretched and has become a key driver in top pay escalation. 18 3.4 Performance Related Pay The incoming conservative government and the changed approach to top pay which prevailed in the year 1979, is responsible for the present outlook to executive performance related pay. A successful link between executive pay and company performance has not been established by any reputable study till now. On the contrary, evidence challenging the connection between performance and pay has become more and more compelling. In past few years of recession, the disconnect between performance and pay has become prominent. This happened because over the period, a huge bonus payments growth had gone ahead of market capitalization, pre tax profit and earning per share. 19 While the study of economics preaches that individuals are motivated by financial incentives; as per the psychologists, this relationship is more problematic. According to Professor Dan Ariels work, there can be negative performance effects due to high reward levels. In fact, in all experiments conducted by his team, lowest level of performance was recorded on all tasks with the highest level of rewards.20 3.5 Accountability The corporate world is witnessing a blame game. Over the past year, most people who have interacted with the Commission have come to recognize that there has been a dramatic escalation in the top pay which has not been linked to. 21 Because of this there is resentment which demands immediate action and attention. But no matter who is responsible, non executive directors, shareholders or the executives; always someone else is blamed for their responsibility or faults. There has been a total loss of accountability in top pay and the normal competition rules have been suspended. 22 3.6 Pay Matters How individuals are paid affects their behavior. It influences motivation and employee engagement. On an economic level, it affects entrepreneurialism, social mobility and growth. A business model which has the corporate profits accruing to a handful of people is faulty and unsustainable in the long run. 23 Hence, government and businesses are urged to seriously consider the commission findings and take immediate action for beginning the restoration of trust and build a sustainable and fairer economy. 4. ABI Principles of Executive Remuneration ABI has laid down a few important principles of remuneration and a number of entities have been assigned specific roles. Some of the important roles expected by the ABI include the following (ABI, 2011): The Role of Shareholders- ABI members acting as institutional investors have an interest in creating long term value for the ultimate clients. ABI is responsible towards clients who are pensioners and individual savers. The Role of the Board of Directors- The shareholders appoint the board of directors to run the companies. When determining remuneration, they require having a fiduciary duty for acting in the interest of their shareholders. They are responsible for companys long term success and accountable for the community, the employees, customers, suppliers and the environment. The Role of the Remuneration Committee- The Remuneration Committee is expected to promote shareholders interests while setting executive remunerations. Like directors, four committee members are made accountable for the remuneration structure and quantum to the shareholders. 4.1 Remuneration Committee Guidance For the Remuneration Committees, the ABI has framed a set of guidance to help the Committee apply Principles of Remuneration of the ABI. Some of the important guidelines are mentioned hereunder: 24 The Remuneration Structures- Avoid undue complexity and form incentive structures having long term focus. The Fixed Elements of Remuneration Base Pay -The role of the individual must be reflected by the level of base pay that he gets, along with conforming to the rule of paying what is necessary. Pensions- At the time of considering total executive remuneration, the provision of pension should be recognized by the Remuneration Committee as it represents a large cost to company. Annual Bonuses- Following the corporate strategy, annual bonuses should include performance incentives as well as achievement rewards. Long Term Incentives- The strategy implementation and creating share holder value which is decided as per the the companys strategic objectives is rewarded by Long Term Incentives. The share holders of the company have a very strong preference for the financial metrics which can be connected to value creation. This is used in deciding incentive structures in the long term.25 Quantum- Another matter of concern for the share holders is the quantum of remuneration. Rewarding success is undermined by levels of pay wherein corporate performance is not reflected, along with representing excess rent extractions. In order to fulfill this responsibility, specific reference points should be looked out for by the Remuneration Committee which will help to judge the suitabilty of quantum. Executive Shareholdings- Significant shareholdings should be built in the company by its senior executives and group of executive directors. The holding requirements should not include the unvested share based incentives and these requirements should not be considered performance metrics substitute under the plans which are share based.26 Special Awards And Ex Gratia Payments- Generally, the special awards are not quite favored. These exceptional awards are rendered unnecessary by an effective remuneration planning which involves a proper balance of long and short term plans, performance targets which are selected and annual grants (ABI, 2011). Clawbacks And Malus- In order to prevent executives from receiving rewards which are undeserved, a recognized way is to include malus provisions and clawback in executive contracts and scheme designs. Pay For Employess Below Board Level- When the Remuneration Committee determines executive remuneration, it should be cognizant of pay elsewhere in a group and consider them.27 Taxation- In order to pay the participants for any variations in the status of their personal tax, any executive remuneration element should not be changed by the Remuneration Committee. Contracts And Severance- The principles and guidance contained in NAPF and ABI statement on the UK Corporate Governance Code and Executive Contracts and Severance should be followed by the companies.28 5. Conclusion Although there have been useful principles and recommendations put forward by the ABI and the High Pay Commission, there are still certain issues related to UK executive remuneration. There were many useful suggestions provided in order to prevent and avoid unfair behavior by ABI and the Commission. One of the suggestions was to reduce the unexpected gains in the equity based plans. This will help separate out same of the gains that resulted from the stock price because of the market fluctuations. 29 The relation between the bonus plan and performance will surely improve because of this. This would also regulate the unfolding of the equity incentive. This also gives the executives a particular time frame to unfold themselves, helping the company avoid the tough situation it may face during the crisis situation. The transparency will get improved and the accounting treatment will have options to bank upon. Most importantly people will realize the value of money when deciding the remuneration. 6. References Association of British Insurers (ABI) Principles Of Remuneration http://www.ivis.co.uk/PDF/ABI%20Principles%20of%20Remuneration290911.pdf (accessed 12 December 2011) Bertrand, M. and Mullainathan, S. ‘Are ceos Rewarded For Luck? 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Executive Compensation and Principal-Agent Theory, Journal of Political Economy, 102, 6, 1175-1199. Policies, Dear CEO Letter, 13 October, www.fsa.gov.uk/pubs/ceo/ceo_letter_13oct08.pdf , 1994 (accessed 10 December 2011) HM Revenue and Customs (United Kingdom) (2009), Approved Company Share Option Plans, www.hmrc.gov.uk/shareschemes/csop_general_ees.htm#9, 2009 (accessed 10 December 2011) Myners, P. Review of the Impediments to Voting UK Shares, Report to the Shareholder Voting Working Group, United Kingdom, 2007 Ozkan, N. CEO Compensation and Firm Performance: An Empirical Investigation of UK Panel Data, available at SSRN: http://ssrn.com/abstract=1102703. 2007 PricewaterhouseCoopers UK Non-Executive Directors Reach Balance between Pay and Accountability; Media release, 22 August, www.pwc.co.uk/hull/press_release/uk_non_exe_directors_reach_balance_between_pay.html, 2008 (accessed 12 December 2011) The High Pay Commission Report http://highpaycommission.co.uk/wp-content/uploads/2011/11/HPC_final_report_WEB.pdf , 2011 (accessed 11 December 2011) Walker, D. A Review of Corporate Governance in UK Banks and Other Financial Industry Entities — Final Recommendations, London, 2009 Read More