Rethinking the purpose of pay

If boards are to persuade management to focus on creating long term value, they need to question the purpose of pay.

It’s a troublesome time to be chair of a company’s remuneration committee given the range of issues on the agenda. For starters, there is the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry and the Australian Prudential Regulation Authority (APRA) report into the Commonwealth Bank highlighting the role of incentives in encouraging poor behaviour. Add to that the backlash from shareholders through the two-strikes rule, press headlines over perceived excesses in executive pay and new regulatory interventions on components of pay.

Boards in all sectors have a tall order: to implement future-proof pay structures that will satisfy myriad stakeholders whose interests do not always converge. There has also been a range of responses on how to influence corporate culture to better serve shareholders, customers, employees and the community. Reactions from remuneration consultants, proxy advisors and regulators suggest the optimal approach is to redesign executive and staff incentive plans to be more explicitly based on long-term value creation.

This is apparently to be achieved through initiatives such as tightening of performance standards within annual key performance indicators (KPIs) and introduction or lengthening of deferral periods for short-term incentives (STIs), long-term incentives (LTIs) and consideration of malus. In effect, the thinking seems to be that since incentive design got us into this mess, a redesign will fix it.

These responses largely involve tinkering with the current model and continue to privilege incentives as the main tool for corporate leaders — which is often at the expense of serious analysis of how long-term value is really created, and appropriately thoughtful management.

Shareholders demand that executives have “pay at risk”. Headhunters say incentives are critical in the war for supposedly rare executive talent. Some directors confide that they are actually quite content with fixed pay and the occasional bonus, but are obliged to implement incentive plans to satisfy shareholder and executive demands.

Complicating matters further, remuneration disclosures have become so long and complex they tend to obfuscate rather than enlighten observers on exactly how remuneration structures support, or corrode, sustainable value creation.

With rare exceptions, most disclosures on remuneration are the same. They almost always purport to aim to “attract, retain and motivate” through a mix of fixed, short-term (based on a “balanced scorecard” set of KPIs) and long-term incentives (until recently, almost always dependent on relative total shareholder return relative to a defined peer group and an earnings measure). Pay outcomes are eerily similar.

The 2018 Australian Council of Superannuation Investors (ACSI) survey CEO Pay in ASX 200 Companies showed that about one third of ASX 100 CEOs received bonuses equal to 80 per cent, or more, of their potential maximum payout, and the median outcome was 70.5 per cent of maximum. ACSI noted that “ASX 100 CEOs are more likely to lose their jobs than their bonus” and that “bonuses continue to resemble variable fixed pay”, rather than at-risk performance pay.

Not only is there some scepticism about the way these plans actually operate, their persistence flies in the face of a substantial body of behavioural science research showing extrinsic rewards rarely work except for narrow, repetitive tasks. Daniel Pink, author of several books on work, management and behavioural science, argues that proffering extrinsic rewards for predetermined goals in such environments narrows thinking, sublimates conceptual thought and diminishes intrinsic motivation. Jonathan Finlay, head of remuneration governance at Minter Ellison agrees, noting that “when a board puts large enough incentives in front of employees their good judgement will be subverted and their intrinsic motivation dulled”.

Finlay, who has 35 years’ experience in the field, claims, “if you task them with too many KPIs, they will focus on the one or two that represent the best money for effort trade-off”. He further says, “a board’s best defence against conduct risk failure is the intrinsic motivation of employees. One guaranteed way of increasing the risk of conduct failure is to strengthen employees’ extrinsic motivation at the expense of their intrinsic motivation.”

Acknowledging hard-wired financial incentives have led to undesirable outcomes has led to remuneration plan tweaks, including the use of so-called “soft” measures, such as those relating to culture proposed by CBA when it received its first strike from shareholders in 2016.

The CEO of the Australian Shareholders’ Association (ASA), Judith Fox MAICD, notes that it is appropriate for boards to set targets around culture, but maintains the ASA is sceptical about providing incentives to executives for hitting those targets. “Achieving targets related to culture can be likened to making budget — it should not warrant an extra payment.”

Another tweak implemented by many companies in response to shareholder criticism has been to increase deferral periods for “earned” incentives, or to extend performance periods for long-term incentives as if it is possible for the performance of an organisation to be neatly mapped to the tenure of its leaders plus the mandatory three or four years, (a truly laughable claim for some sectors, such as mining, where the fruits of investment can take decades to realise).

Incentives and these kinds of tweaks can, in the main, be characterised as defensive. They are based on an assumption that executives won’t act in the best long-term interests of companies unless they are in place. Not only does this reflect poorly on the executive talent selection process, it invites inevitable gaming and work-arounds.

Using incentives as a proxy for management promotes a dubious assumption that people are purely economic creatures. Incentives narrow thinking, so objectives not on the horizon at incentive design time are sidelined. They subjugate other, more meaningful forms of reward such as developing others; they rarely encourage teamwork, and they create a culture wherein the people who are most incentive-driven are the ones who strive to obtain (and inevitably achieve) leadership positions, often to the detriment of our institutions, the economy and society.

Rethinking remuneration

So how should boards rethink remuneration in the current climate? Here are a few suggestions from the experts.

1. Develop a remuneration policy genuinely supportive of, and tailored to, the unique characteristics of the organisation.

Daniel J Smith, general manager of proxy advisory firm CGI Glass Lewis, says boards should, for example, consider “whether they are overseeing a high-growth speculative company or a mature business preserving and growing capital, providing income stream and steady employment within the community — and disclose properly to shareholders how remuneration supports such positioning”.

2. Make an unblinkered consideration of what leading a particular organisation is worth.

This requires suspending market comparisons and ascertaining what the candidate/incumbent is prepared to work for. Bob Joss, the former Wells Fargo CEO who is credited with introducing US executive pay practices to Australia when he joined Westpac in 1993 on the then astronomical salary of $1.9m (with $36m–$45m in incentives over his six-year tenure), concluded that companies fail to apply basic market principles in paying executives. He argues boards should take stronger negotiating positions and many companies could get the job done for a lot less.

3. Have a clear view on what demonstrated competency should be covered by fixed remuneration.

Fox is adamant that directors should think long and hard about the forgotten purposes of fixed remuneration — often a large sum.

“It is arguable that the incentive for measures such as maintaining a positive culture ought to be getting to keep your job,” she says. It is worth examining why, at the lower echelons of an organisation, one is expected to be happy to exchange one’s labour and perform to set standards for a fixed amount of money and the opportunity to progress, and yet at the top, pay must be doubled or tripled for performance — especially when, according to ACSI’s 2018 report, the average fixed pay for an ASX 100 CEO is $1.91m, or $36,730 a week.

To enhance teamwork, pay levels should not be divorced from actual contribution to value creation, which has occurred when CEO pay becomes a function of market belief in a corporate superstar, ignoring the multitude of factors, including decisions of former executives, a competent board, the toil of the total workforce that contribute to an organisation’s success and favourable market conditions for the company’s products.

4. Examine assumptions about aligning the interests of executives and shareholders without corroding other stakeholder relationships.

Having completed years of research on company value creation, Denis Kilroy, managing partner of KBA Consulting, claims, “the true economic obligation of a listed company to its investors is to build an enduring institution that can create wealth for its shareholders on an ongoing basis, with an explicit and unwavering focus on the long term. Importantly, the longer the time horizon, the more the interests of all the company’s stakeholders align.” SEEK provides an example of a company with that long-term focus and a differentiated remuneration policy that supports it. The company has taken a brave step in eschewing STIs altogether.

Conversely, it is critical to maintain an open mind about how, and with what type of shareholder, “alignment” occurs. Roger Martin, former dean of the Rotman School of Management at the University of Toronto, claims equity-based compensation is an incentive to increase expectations, not performance, and that the rational response to equity-based incentives is to game the system.

In what could be seen as a cynical view, he argues that, “since [CEOs] spend most of their time trading value around rather than building it, they lose perspective on how to contribute to society through their work. Our theories about the fundamental goal of corporations and the optimal structure of executive compensation are fatally flawed.”

Not all Australian boards have the depth of skills in human capital management to properly consider and interrogate remuneration structures. For some, there remains a stubborn, if unspoken belief, that experience with leading large teams and having been in receipt of an executive pay package, provides sufficient expertise to oversee this critical realm.

As we have seen from a multitude of scandals, and despite the vast amount of effort expended by remuneration committees on this issue, that can be insufficient in certain circumstances. Greater capability at board level in these areas will help take the necessary steps to fix the model.

Amanda Wilson is principal at Zeno Consulting. She was formerly CEO of Regnan and head of performance and reward at CBA

Questions for Directors

Objective

How is long-term value created? What conditions support this? What stage in the business cycle is the business? How is performance defined for multiple stakeholders?

Philosophy

What should be the defining characteristics of the reward program for executives and all staff to support the objective? Market competitive? Differentiated? Fair? Encouraging of teamwork? Proper account of risk? Pass the pub test? Maximise retention?

Reward total target remuneration

What is the real talent market for this role? What assumptions have been made in selecting market comparators? Would someone as competent do it for less? What are the internal relativities between executives? How does it compare to the average national wage? How important is remuneration to executives versus other benefits of leadership?

Reward elements (fixed, STI, LTI)

Is there necessity at all for each element? What are the minimum expectations for fixed remuneration? Are LTIs simply deferred STIs? What behaviour will they encourage? What behaviour may be discouraged? What are the longer-term ramifications for executives and shareholders?

Reward instruments (cash, equity, equity-based)

Has due weight been given to supporting the objective, benefits, risks, level of complexity, administrative/compliance costs, personal circumstances of executives in determining appropriate reward instruments? Are they genuinely appropriate for the business or copying predominant practice?

Malus

Is there scope for the return of performance-related compensation as a result of the discovery of a defect in the performance?