Executive pay too much or too little?
By Mark Bussin who can be contacted at [email protected]
; 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 companys 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
companys 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
performanceis 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 companys 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
individualsand in this regard the design of compensation systems
has a pivotal role.
>> The dos
# Individual performance measures should be based on the
individuals 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 organisations sphere of influence should be
taken into account in the design.
>> The donts:
# Excessive targets
# Overly restrictive caps
# Changing goal posts inadvertently,
# Clouded criteria
# Discriminatory target setting
# Lack of justification for discretionary intervention
# Insufficient communication
FINALLY THERES ONE MORE IMPORTANT DOTAKE 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 companys 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 HERES THE BIGGEST SURPRISEALTHOUGH 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".
