Journalists are not known for their multimillion-pound pay packages, but Peter Job was an exception. In 1993, soon after the former foreign correspondent was appointed Reuters’ chief executive, the news agency’s board introduced a new pay structure. Mr Job’s “long-term incentive plan” would not only make him a very rich man, it would up the ante for how British chief executives have been paid ever since.
By 2015, Britain’s average blue-chip chief executive was paid £4.3 million (€5 million), 430 per cent more than 1998, according to consultancy Manifest – or three times as much after accounting for inflation. Over the same period average wages, worth £28,000 (€33,000) in 2015, according to the Office for National Statistics, rose only about 12 per cent in real terms. In the United States, the pay gap has widened even more dramatically.
Executive rewards have become so out of kilter that politicians have begun engaging in a debate that was previously off limits in most free-market economies. Even US president Donald Trump, not known for his socialist outlook, has called executive pay “disgraceful” and a “total and complete joke”. The comments, made on the campaign trail in 2015, mirror US investors’ criticism of egregious pay packages, especially when performance has been weak.
In the UK, though, the mood is actively reformist. Reflecting increasing public disquiet about elite pay, the government in November published a Green Paper on governance reform. Proposed changes to the preliminary report, for which the consultation process closes on Friday, include more frequent binding votes by shareholders on pay and the obligatory disclosure of ratios comparing the pay of chief executives and mainstream staff.
At the same time investors are clamouring for an overhaul of ill-designed, excessively generous pay schemes. David Pitt-Watson, a former executive at Hermes and now executive fellow at London Business School, says Britain’s “social contract” is at risk. The populist backlash evident on both sides of the Atlantic in recent months may even pose an existential threat to capitalism, some fear – an angst that is spurring more momentum for change than there has been for years. “There’s an absolute consensus now that executive pay is out of control,” says Mr Pitt-Watson.
Long-term incentive plans
The beginnings of today’s chief executive bonus culture looked far more promising. Back in 1993, under Reuters’ innovative “LTIP” (long-term incentive plan), Mr Job was granted a potential 77,920 shares with performance conditions attached. To qualify, he had to ensure Reuters was among the top 30 companies in the FTSE 100 in terms of “total shareholder return” – a measure that combines share price growth and dividend payouts. He succeeded, earning shares that were worth £460,000, or 39 per cent of his £1.2 million total remuneration in 1995.
Peers at the time had never heard of LTIPs. They relied instead on decent salaries, generous pension contributions, an annual bonus and, in some cases, a dose of share options. But inspired by the Reuters example, an LTIP revolution quickly took hold, as companies and their investors warmed to the idea of rewarding relative performance over a longer period.
“It was felt that options, which we had hitherto used, were not a satisfactory reflection of performance since they rose and sank to some extent with the tide,” Mr Job says. “We had to move to relative performance against the index, and we had to have a longer time horizon.”
So persuasive was that thinking that, today, an LTIP is part of the remuneration package for every chief executive in the FTSE 100 index. But the change in the pay mix has not worked out as planned. Over the past 25 years, a combination of factors has ratcheted up the value of bonuses, particularly LTIPs. Executive greed has been indulged by boards nervous of losing top talent and an industry of remuneration consultants that has thrived on an arms race to design top-quartile pay packages.
Simon Wolfson, chief executive of Next, the clothes retailer, is convinced that the influence of pay consultants has been magnified by competition between boardrooms, made possible by rules requiring the detailed disclosure of individual pay. “No board wants their CEO to be in the bottom quartile,” says Mr Wolfson, who has distributed £8 million of his bonuses to staff, convinced that his own rewards were excessive.
With political populism on the rise and growing economic evidence against such pay packages, investors, many of whom previously defended high pay as a motivator of better performance, are now campaigning for change.
Addiction
In the UK, LTIPs are in the crosshairs. “LTIPs are not fit for purpose any more,” says the head of stewardship at one UK asset manager. “They’re like any opiate. They have become an addiction.”
Paul Lee, head of corporate governance at Aberdeen Asset Management, agrees. “A number of us are willing companies to think again about the structure of pay. We don’t want them to be trapped in the structure of an annual bonus and a three-year LTIP. That structure probably does work for some but it can’t be a one-size-fits-all approach. They need to break out of this box. It really isn’t working.”
Moving away from LTIPs should allow “quantum” – investor jargon for the amount people are paid – to come down sharply. A study last year by industry lobby group the Investment Association concluded that replacing LTIPs with “restricted” shares, batches of equity that must be held for five to seven years or more, with few or no performance conditions attached, could reduce the headline value of bonuses by 50 per cent. LTIPs often pay out on a sliding scale with very high maximum entitlements if triggers are met. Restricted shares would be more certain, justifying the argument for a smaller number.
“Restricted shares would be a good way to bring down quantum,” says Angeli Benham, a governance expert at Legal & General, “and in the process address public concern about high pay.”
The views of the public never used to matter much to hard-nosed investors. The priority was for a company to have the best possible leadership. But the rise of populist politics since the global financial crisis has altered attitudes. The growing gap between the pay of ordinary people and the packages enjoyed by blue-chip chief executives is blamed for helping to fuel a backlash against the “metropolitan elite” – evident in everything from the Brexit vote to Mr Trump’s election victory.
The pay ratio of the average blue-chip chief executive to the average worker, about 140 times in the UK, has escalated from about 33 times in 1984, according to Tom Gosling, remuneration expert at PwC. Pay growth in the US has been even more extreme. A report last spring by the AFL-CIO union, which stripped management roles out of average worker pay, calculated a multiple of 335 times. Two decades ago it was below 50.
Recent corporate departures have shone a light on the issue on both sides of the Atlantic. Rex Tillerson, the former ExxonMobil chief executive who has been named as Mr Trump’s secretary of state, is in line for a $180 million payout from the oil group. Gary Cohn, the former Goldman Sachs number two who was appointed director of Mr Trump’s national economic council, was granted expedited rights to a package worth $285 million.
In Germany, Martin Winterkorn, the former Volkswagen chief, was granted a performance-related bonus of nearly €6 million even as he resigned in the wake of the emissions-cheating scandal. By comparison, UK disputes, such as shareholder dissent over the £14 million pay deal granted to BP boss Bob Dudley in a lossmaking year, look almost modest.
Some governments have begun tentative crackdowns. In the Netherlands, bonuses are capped at 20 per cent of salary for top bankers. But such moves are rare. And no one expects US reforms in this area. For all Mr Trump’s rhetoric, his administration is widely expected to undo a requirement, under Dodd-Frank legislation introduced in 2010, that companies reveal the ratio of employee pay to that of their chief executive.
The UK, then, may be in line for the most profound change. According to Bloomberg data, only the US and Switzerland pay their chief executives more than Britain – one reason, perhaps, why Theresa May promised it was a priority to address the divide between Britain’s haves and have-nots when she became prime minister in the summer.
Mrs May was criticised by some over her November Green Paper on governance. It watered down some of her initial ideas, dropping, for example, the plan to bring worker representatives on to boards. But measures to oblige the disclosure of chief executive-to-worker pay ratios and more frequent investor votes on pay would still represent one of the most powerful initiatives by a G7 government to tackle the issue of the gap between the elite and the mainstream.
Economic rationale
Reformist investors, though, are motivated by more than a desire to pacify the populists. There is a growing body of data to support an overhaul of executive pay, and a move away from LTIPs in particular, on economic grounds.
Nearly two-thirds of the jump in British chief executive pay over the past couple of decades has been driven by LTIPs, which continued to increase even when overall remuneration dipped for a couple of years from 2012, according to Manifest. One irony is that many of those bonuses, ostensibly granted for long-term performance, have worked against genuinely sustainable management. “There is a massive amount of evidence now that they’re counterproductive,” says PwC’s Mr Gosling.
Recent analysis by the Purposeful Company Taskforce, which Mr Gosling co-ordinates, found that “so-called ‘long term’ incentives with performance-based vesting actually encourage short-term behaviour as vesting dates and triggers approach”. Research and development spending, capital investment and other long-term decisions can be shelved to allow LTIP targets to be hit, the research found.
Economists such as Andrew Smithers say this dynamic is a cause of Britain’s weak productivity, when compared with much of continental Europe, where executive pay is lower and productivity is higher.
At an individual company level, poor pay structures can cause bad behaviour. Investors say a textbook case is Tesco’s old LTIP programme, which prioritised earnings per share growth and may have encouraged management to overstate profits by more than £250 million.
According to academics at Lancaster University Management School, the poor alignment of bonuses and performance is evident if pay inflation is compared with more sophisticated, long-term measures of success than total shareholder return. Median economic returns on capital for Britain’s 350 biggest listed companies were less than 1 per cent annually over the 11 years to 2014, compared with an aggregate 82 per cent real-terms rise in chief executive remuneration.
Even using total shareholder return (TSR), which reflects share price growth and dividends, there are gross anomalies in the pay and performance of the best-paid chief executives.
The pay package of WPP’s Martin Sorrell is legendary, though his 2015 remuneration of £70 million did at least reflect strong shareholder returns. By contrast, BP’s Mr Dudley, paid £13.3 million, generated negative TSR over one, three and five years.
Comparable figures for the best-paid US chief executives are just as mixed. Expedia’s Dara Khosrowshahi, the top earner according to Equilar, earned total pay of $95 million, but also oversaw some of the best TSR numbers. Viacom’s Philippe Dauman, on the other hand, who was the third best-paid boss until he was ousted last year, generated negative TSR returns.
For shareholders, it is a sharp reversal of traditional thinking to imagine that paying a company boss less could help corporate performance. But the growing size of pay packages promises to spur change. Investors have shown a greater readiness in recent years to vote against excessive or badly structured pay schemes both in the UK and US. If their interests are now aligning with those of policymakers and the general public, some believe an era of executive pay deflation may finally dawn.
"CEOs get paid beyond the dreams of most people," says Aberdeen's Mr Lee, who expects the headline value of some bonus deals to halve this year. "Of course £5 million is still a lot of money but it's going to be more tolerable than £10 million." – (Copyright The Financial Times Limited 2017)
