Is it time to move the carrot?

COMMERCIAL PROFILE - PRICEWATERHOUSECOOPERS:Systems involving executive rewards and short-term goals need to be overhauled for a sustainable future, writes MARY O'HARAof PwC

THE ONGOING debate around bonuses and risk-taking has placed executive reward at the forefront of the corporate agenda. Various interested parties, including shareholders, institutional investors, regulators, industry bodies, media commentators, and even management teams say executive compensation systems are in need of significant reform.

Regulatory bodies worldwide are taking the opportunity to reassess both their own good practice guidelines and the role of the investor in challenging boards about remuneration policies. Current practices, it is observed, are not only too short-term oriented, but also have largely failed to meet either of their key objectives: motivating executives and aligning their reward with shareholder outcomes.

Clearly, action needs to be taken to transform the governance and design of executive pay. However, making fundamental changes will be difficult, since in many cases the level of trust between companies and their shareholders in the area of remuneration is now low.

Bringing about change will require an improvement in this trust. As a first step, improved consultation with shareholders should aim to create greater support for the judgment of remuneration committees and more trust in executives to act responsibly.

What might the new landscape look like?

There is a widely held perception that the short-termism inherent in incentive plans contributed substantially to the current crisis. In particular, there is concern that risk and compensation are not always closely aligned. For example, an executive might be able to take a bonus based on a mark-to-market profit in one year, that becomes a loss in subsequent years.

Organisations need to ensure remuneration models are tailored to business strategies, moving away from a follow-my-leader mentality. Simplification will be critical to success, with fewer complex incentives and a greater focus on long-term arrangements to achieve alignment.

There is a realisation that bonuses should be driven, not by an annual measure of performance, but on performance measured over a period that is closer to, if not beyond, the life of the activity in question. Incentives should not require or encourage executives to execute a quick “flip” when the potential for the most value creation is over the longer term.

Need for clarity and transparency

There is an obvious need for clarity and transparency around the area of “pay for performance”, with a focus on rewarding outputs, not effort. This requires a clear articulation of what constitutes performance, with skill and luck separately identifiable.

Already there are signs that organisations are taking steps to replace short-incentive payouts with long-term programmes featuring higher degrees of equity or deferral.

Many are also considering making the eventual receipt of deferred bonuses subject to longer term performance: so-called clawback.

Enhanced employee engagement

Recent studies suggest that there should be a better balance between the financial management and motivational aspects of reward than was evident in the past.

The non-cash rewards (benefits and pensions and so on) as well as intangible rewards (career development opportunities, improving work climate and so on) cannot be ignored.

Any perceived difficulty in assessing the competitiveness of the total reward packages must be overcome and, more importantly, the value of same communicated.

Many companies are also attempting to shift their cultures towards a more group-wide performance orientation. In particular, senior executives need a more group-based compensation plan to spur broader collaboration between business units.

Introducing a broader percentage of pay based on group performance may seem simple enough. But in practice, there is likely to be considerable resistance.

For example, executives whose actions and commitment are delivering strong returns will likely resent seeing their compensation diminished by loss-producing business units.

The future role of governance

Rewards most certainly need to guard against excessive risk taking. But equally, compensation systems need a means of discouraging the taking of insufficient risks. Striking the correct balance may be difficult, and no system is likely to be perfect, but it is essential that organisations begin to do a better job of linking risk to performance.

Good corporate governance should have substance as well as form. Being a remuneration committee member is, and should be, a tough job. There is a need for committees to be more informed and questioning, to exercise more discretion while at the same time avoiding divisiveness over pay.

Executive pay should reflect the nature of supply as well as the demand for talent. For average performers, this will mean that pay will come down, but for the best performers, it will continue to grow, as individuals are differentiated based on the value they add to the enterprise.

Pay is part of the equation that can assist in supporting skilled executives to perform to the best of their abilities. High potential pay for performance, responsibly governed, is a force for good.

In the wake of the economic turmoil over the past 12 months and the calls for stronger governance, this fundamental message needs to be remembered, emphasised and communicated.

Undoubtedly, there is a need for balanced compensation systems that offer long-term incentives, as well as alignment between strategic business objectives and sustainable performance and an appropriate adjustment for risk.

Remuneration committees will need to be better informed and more challenging around the question of pay, but without losing sight of the key role which reward plays in the retention and motivation of key talent.

Recent events have removed the luxury of a long timeframe to fix remuneration models – change is required now. Achieving change will be an immense task for all involved, particularly remuneration committees.

But we all need to rise to the challenge. If we do not, then there is a risk that we will lose the freedom to use pay as a force for good, motivating executives by rewarding success.