31.Whilst the causes of upward pressure on executive remuneration are many and varied, the structure of pay packages also plays a part. Figure 1 demonstrates how, over time, basic salary has formed a slowly shrinking proportion of pay, but this has been more than compensated by increases in other elements, such as annual bonuses and longer-term share-based pay (LTIPs). Since the 1990s, shareholders have increasingly pressed for the pay of chief executives (and all executive directors) to be linked to company performance. Consequently, ever more complex incentive schemes have been developed and have driven the rise in executive pay. The FRC acknowledged that the greater uncertainty in the current remuneration structure has led to an increase in rewards available. Too often in the past the system has been gamed: if downward pressure is applied in one area, such as LTIPs, it is compensated for somewhere else.
Long-Term Incentive Plans (LTIPs) are an element of remuneration that provides a number of shares, realisable over a time period, usually three years. The number of shares is based upon sometimes complex performance measures including a range of company performance indicators, such as sales growth, profits and cash flow. LTIPs were introduced to help strengthen the link between remuneration and performance over the longer-term and replaced tax-effective share options originally introduced in the 1980s. Critics argue that LTIPs work against transparency (they cannot be valued when awarded) and can distort executive behaviour, who may take decisions in order to meet specific performance targets but are not in the long-term interests of the company.
Restricted shares (sometimes called deferred pay) are an element of share-based remuneration which can be realised only after a set period of time (normally greater than three years). The value realised is determined by share price at the time of vesting. The release of the shares is not contingent on performance targets being met. The aim is to encourage and reward decision-making for the long-term benefit of the company, rather than the pursuit of specific financial targets.
32.The greater uncertainty and longer-term nature of these incentive-based elements have led executives to demand—and boards to award—packages which include higher pay opportunities. If performance targets linked to these LTIPs are insufficiently stretching, or, to put it another way, if company performance exceeds expectations, pay outs will inevitably rise. Upward pressure on executive remuneration has been largely a reaction to investor demands over many years to link pay to performance and to defer awards over longer and longer periods of time. As an increasing proportion of pay has been linked to performance, pay packages need to be well designed to avoid external economic or political events producing vast and undeserved awards, as at Persimmon. The strength of the link between CEO performance and Total Shareholder Return in the short term is in any case debatable, given the impact of external factors and the performance of other decision makers within the business. In principle, we believe that there should be greater certainty in executive pay. This should be balanced by a significant reduction in the maximum that may be earned and that the rewards from good performance should be more evenly shared: there should be a stronger and more visible link between rewards at the top and bottom.
33.The previous Committee argued for a move away from LTIPs, on the basis that they can distort decision making, towards long-term restricted share plans. Provided they vest over a sufficiently lengthy period, this approach should encourage and reward genuine long-term decision making. There is some academic evidence suggesting that long-term restricted share plans have a causal link with both innovation and profitability. The shift away from LTIPs is supported by some institutional investors, but by no means all, particularly those in the US, where there remains a strong attachment to incentive-based pay and where time-vested restricted shares are deemed to be insufficiently performance-related.
34.We heard evidence that LTIPs are not generally long-term enough, or effective in influencing executive behaviours and, worse, allow for gaming. Some witnesses argued that more companies have been adopting policies based on restricted shares rather than LTIPs, but we have found that so far there are very few. Others had withdrawn proposals after talking to shareholders. Clare Chapman, remuneration committee Chair at Weir Group, told us how difficult it had been to persuade a disparate group of shareholders of the benefits of moving towards longer term restricted share schemes that linked rewards of executives to those of investors more closely. Many companies are reluctant to propose alternations to pay policies which risk being unpopular with investors: they are concerned that the weaker direct link to company performance can lead to a perception of “rewards for failure”.
35.The FRC, in its proposed revisions to the UK Corporate Governance Code, sets out that remuneration schemes should promote long-term shareholdings that support alignment with long-term shareholder interests. In line with a recommendation of the previous Committee, it suggests that vesting periods should normally be at least five years. We welcome this improved wording, and were told that most companies bringing forward new pay policies in 2018 are indeed including a vesting period for LTIPs of at least this long. Some argued that the FRC should be more explicit in recognising the validity of other incentive models to LTIPs, such as restricted shares. The FRC Code stops short of giving a general view on the use of LTIPs or structure of pay. Similarly, whilst the Minister was among witnesses who saw a case for greater simplicity, she did not see a role for Government in determining levels or structure of pay. Fund managers, as we discuss later, are unlikely to press hard for change even though, according to The Investment Association, there are some concerns around the increased pay potential with higher proportions of variable pay. These are accentuated by the evidence that long-term institutional investors are gradually being replaced by funds whose managers are seeking short-term gains rather than the creation of longer-term value. We recognise that most listed companies will not be putting new pay policies before shareholders in a vote until 2020. However, without external pressure before then, and given the different views on the use of incentives in pay packages, any reform is likely to be slow.
36.We do not subscribe to the “superstar CEO” theory, under which it is natural for ever larger companies devote relatively tiny proportions of their profits to recruiting the most expensive CEOs on the market. We do not believe that there is a shortage of talented people prepared to lead organisations in return for high but not excessive pay. There are so many variables in large organisations competing in an unpredictable global market, and the evidence is at best ambiguous on the impact of individual CEOs on company performance. Executive pay does not operate as a normal market due to the lack of open competition in recruitment and limited financial impact of paying what are exorbitant amounts for an individual. Companies typically choose to benchmark executive pay offers to the external market in their sectors rather than their own internal pay structures, thereby further entrenching the disconnect between pay at the top and amongst the general workforce. There are exceptions. Witnesses were supportive of greater use of profit-sharing schemes, including executive directors, and limits on the pay ratio between CEO and workforce, such as that used by John Lewis. We agree with the Minister that we should not be too prescriptive, but firmly believe that everyone in a business contributes to its success and should share in the profits, rather than seeing the top executives enjoying unimaginable riches. Fair pay is also a signal of good corporate governance: “companies who do not treat their own people fairly may find it hard to persuade customers and suppliers that they can expect a better experience.”
37.We believe that executive pay should be simplified, more obviously geared to promoting companies’ long-term objectives, and be linked more closely to that of the workforce as a whole. Greater transparency and simplicity will help shareholders hold boards to account. We favour a simple structure based on fixed basic salary plus deferred shares, vesting over a long period, but subject to conditions to avoid “rewarding failure”. Care needs to be taken to ensure that reforms are coherent as a package and do not permit gaming. We also support the greater use of profit sharing or other schemes designed to share profits more evenly. Over time, the proportion of variable pay (including bonuses, share options and profit sharing) should be reduced substantially. The increase in certainty associated with proportionately more fixed pay should, if well managed, lead to a reduction in total remuneration awarded. As a matter of practice, and to reduce the risk of Persimmon-type awards and associated reputational damage, we recommend that remuneration committees should set, publish and explain an absolute cap on total remuneration for executives in any year. The new regulator should be more prescriptive and interventionist, where necessary, in pursuit of these objectives and be prepared to publicly call out poor practice or behaviours.
38.We have argued that the element of pay that is not basic salary should move away from annual bonus towards share ownership, so as to better align pay with long-term shareholder outcomes. Figure 1 supports the premise that over-generous annual bonuses have been used to help suppress basic salaries without impacting on overall rewards. When 80% of executive pay is incentive driven, as is typically the case, the scope for generous engineering is wide. Whilst increases in base salary have been modest, annual bonuses have continued to pay out well above expectations (or target levels).
Figure 5: bonus pay outs in FTSE 100 as a proportion of bonus opportunity
Source: FIT Remuneration Consultants and New Bridge St
For the last nine years, the median maximum bonus opportunity for FTSE100 CEOs has generally been around 180% of basic salary (200% in 2013). The actual amount paid (target achieved) has tended to average around 75% of the maximum available. Thus, typically, a FTSE 100 CEO earning a basic salary of £1 million could expect to receive an annual bonus of a further £1.35 million, in addition to share awards, which may add a further £1.5 million.
39.We recognise the value of an annual bonus in encouraging progress towards specific short-term targets and in rewarding genuinely outstanding performance, but do not believe that it should remain such a major component of pay. As one witness summarised: “[t]he evidence seems to suggest that the kind of financial incentivisation everybody is trying to operate does not actually produce the goods.” Following the financial crash, EU regulations in the financial services sector capped bonuses at 100% of fixed pay and 200% with explicit shareholder approval. There is a strong case for a similar cap to be applied via the Corporate Governance Code, if not legislation.
40.This reduced level of annual bonus should be less focused on financial performance measures based on profits and more aligned with the social responsibilities of companies and engagement with the full range of stakeholders, including employees, not just investors seeking a return in the short-term. At present, performance metrics for bonuses are maintained on a scorecard approach, featuring a range of criteria, but are generally most heavily weighted towards financial performance such as profits, rather than measures aimed at driving increased productivity in the longer term, such as those relating to investment and skills. Typical weightings for non-financial measures, for example, relating to employee engagement, workforce development, community or health and safety goals account for only around 10%-15% of total bonus opportunity. This may be partly due to shareholder preferences and proxy agents’ tendency to advise that financial targets should form the majority of total bonus opportunity.
41.We heard that “very few” FTSE100 companies have linked their long-term and short-term incentive plans to broader corporate responsibilities rather than financial targets, although there have been some discussions between companies and shareholders on making targets simpler and more stretching, and limited evidence of improved reporting. Analysis suggests that only 15% of FTSE100 companies include customer satisfaction as a bonus objective. One investor told us that the incentive system used in the UK is “too short term”. Others argue for incentives to relate more to environmental, social and governance (ESG) objectives, particularly in the light of growing evidence of a positive correlation between strong ESG policies and good financial performance. We heard that some companies had now increased to 30% the proportion of its bonus scheme tied to long-term measures such as innovation, technology and customers. The TUC advocates a 10% limit in the amount of total pay subject to incentive pay and that any incentive schemes for executives should be open to all staff on similar terms.
42.We recognise that a move away from hard financial targets towards softer metrics which may be more difficult to measure has the potential, if not managed properly, to enable bonuses to become less challenging to secure. This risk can be mitigated by careful benchmarking by the remuneration committee and limiting the overall amount of performance-related pay. Clear reporting of performance against personal objectives will also provide a safeguard against gaming. Chief executives, and shareholders, should be stewards of the long-term and broad interests of their companies rather than pursuing short-term financial goals: they should be rewarded accordingly. We believe that the performance measures governing the payment of annual bonuses should be aimed at encouraging and rewarding increased productivity and also support the company’s wider responsibilities under section 172 of the Companies Act to have regard to the interests of its customers, suppliers and workforce. We recommend that the new regulator engages with investors to develop guidelines on bonuses to ensure that they are genuinely stretching and a reward only for exceptional performance, rather than being effectively an expected element of annual salary.
43.We have advocated greater alignment in the way in which profits are shared between executives and employees. The same should apply to pension contributions. As we have seen, there has been a tendency for a crackdown on one element of pay to lead to corresponding increases in other elements. Pension contributions is one such area, where chief executives in the FTSE 100 have enjoyed pension contribution rates around 25-30%, while their employees receive around 9%-10%: an unacceptable example of weak corporate governance and flagrant disregard for any notion of fairness. The new Corporate Governance Code contains a provision that pension contribution rates should be aligned with the workforce and this is amplified in The Investment Association’s remuneration principles. This has not stopped two major banks, Lloyds and HSBC, seeking to flout the spirit of the Principles by offering substantial alternative pensions advantages to their chief executives, to compensate for the alignment of pensions contributions. It is reassuring to see that investors and staff have protested. There are indications that some companies are now acting to ensure greater alignment. This should have happened much sooner. We welcome The Investment Association’s announcement in February 2019 that it will monitor and flag up any company that pay pension contributions to new directors in a way not aligned to the majority of the workforce and we recommend that the new regulator seeks public explanations from any company that fails to deliver alignment on pensions contributions.
91 See paragraph 4.
94 Professor Alex Edmans (), [Wilson]
95 See Fourth Report, Corporate Governance, , paras 87-94.
96 Professor Alex Edmans ()
97 Eg Hermes and Norges.
98 Eg Hermes, , [Duguid]; [Chapman], [Wilson], [Ni-Chionna], [Marshall], PwC (), Employment Lawyers Association ()]; a consultation by proxy agent ISS in 2017 indicated more favourable attitudes amongst investors to restricted shares (47% of respondees) but still indicated a significant split.
99 [MacDougall], Professor Alex Edmans ()
100 The Investment Association () cites examples of Premier Oil, Kenmare Resources and Pets at Home, as well as Weir Group; Institutional Shareholder Services (ISS) ()
101 The Investment Association (), ICSA: The Governance Institute (), Big Innovation Centre, The Purposeful Company (), Hermes Investment Management (), [Ninian]
102 , , [Chapman]
103 ICSA: The Governance Institute (), PwC (), Glass Lewis ()
104 Big Innovation Centre, The Purposeful Company (), ICAEW ()
105 PwC ()
106 [Williamson], , , [Tolhurst], PwC ()
107 The Investment Association ()
108 IPPR , Prosperity and justice: A plan for the new economy 2018, citing Stirling A and King L (2017) Financing investment: Reforming finance markets for the long-term and Haldane A (2016) The costs of short-termism, in Jacobs M and Mazzucato M (eds), Rethinking capitalism: Economics and policy for sustainable and inclusive growth.
109 [Cotton] citing LSE research on this point.
110 Professor Alex Edmans ()
111 Trades Union Congress (),
112 ICAEW ()
115 [MacDougall], [Wilson]
116 The EU Capital Requirements Directive IV took effect from 1 January 2014.
117 [Cotton], CORE Coalition & Oxfam GB ()
120 For example, ISS, UK and Ireland , December 2018.
121 CIPD ()
122 Glass Lewis ()
123 Purposeful Company ()
125 CORE Coalition and Oxfam ()
126 [Chapman], [Sears]
127 Trades Union Congress ()
128 PwC ()
129 [Ninian] [Stirling]
130 Financial Times, , 16 February 2019
131 Investment Association , 21 February 2019
132 See The Times, , 17 March 2019, and , 19 March 2019
133 PwC (), Trades Union Congress ()
Published: 26 March 2019