Calls to reform executive pay 'understandable', but recommended changes need further thought, say experts

Proposed measures to better link executive pay to company performance, and restrain the growing inequalities between top and average pay, were detailed in a new report published by the Commons Business, Energy and Industrial Strategy (BEIS) Select Committee. The report also made recommendations on how to improve gender and ethnic diversity in UK boardrooms, amongst other things. Its publication comes as the government considers consultation responses to its Green Paper on corporate governance, which sought feedback on some proposals that are favoured in the report, and also some that the report does not support.

The BEIS Committee is the latest body to have its say on the often sensitive topic of remuneration of senior directors. As its report highlighted, the popular view is that "executive pay is causing damage to the generally good reputation of British business". This is because of difficulties in linking pay effectively to corporate performance and growing disparities between levels of pay among senior executives and the average UK worker, it said. This, the report concluded, "serves to undermine public trust in business".

The Committee acknowledged that many companies and investors have taken action in recent times to improve the linkage of executive pay to long-term performance, and to ensure that executive pay is subject to greater scrutiny. However, it has outlined a package of measures which it said are needed to drive further progress. These have much in common with proposals already made by other bodies.

While there is merit in some of the suggestions, further consideration needs to be given to some of the suggested reforms.

The proposed scrapping of long-term incentive plans (LTIPs)

In its report, the BEIS Committee called for LTIPs - more precisely performance share plans - to be "phased out as soon as possible" and for there to be no new LTIPs agreed from 2018 onwards, including in respect of the renewal of existing agreements. It is not clear whether this is in fact  a call for no new LTIP awards to be made from 2018. Although plans typically have a maximum term of ten years before possible renewal, it is of course open to companies to cease using them at an earlier time.

An LTIP, in this sense, is a common model used by businesses to make long term incentive awards to executive directors and other senior managers. It typically sees shares paid out to executives after three or five years based on the satisfaction of performance conditions set at the time of grant. However, the BEIS Committee said LTIPs had not been shown to incentivise performance and may, in fact, "create perverse incentives and encourage short-term decision making".

The Executive Remuneration Working Group, set up by the Investment Association (IA), similarly concluded in July 2016 that the complexity and uncertainty of vesting of LTIPs were major factors driving the disproportionate growth of the pay of FTSE executive directors compared to other workers. For that reason, the IA and some leading investors have encouraged companies to consider alternatives to LTIPs, and to seek shareholder support for a bespoke alternative arrangement where appropriate. The investors have called for innovation and greater diversity across the FTSE, however, rather than complete abandonment of the now dominant LTIP model of executive remuneration recommended in the report.

In place of LTIPs, and to move towards a better system of incentive-related pay, businesses should look at "deferred stock options", or deferred equity, where executives would receive shares as part of their remuneration package but only be able to sell such shares "after set periods of time", according to the Committee.

The section of the report on this recommendation is not as clear as it might be, so we asked the Committee for clarification. The Committee confirmed that the proposal was for contingent share awards with a relatively long vesting period that was tailored to the company's business objectives and time horizons, phased vesting and crucially no express performance conditions.

The term "deferred stock options" is not generally used, even by UK share plan specialists, and in this context it seems unclear. It probably would not be understood to refer to awards of this type by companies using share plans, by employees benefiting from them, or by investors. As reform proposals are developed further it would be helpful if the Committee could clarify this proposal and the reasons for preferring it to other alternatives to the current LTIP reward structure.

It is correct that many LTIPs, or at least the performance metrics attaching to them, are overly complex and it is possible that in certain cases the way such performance metrics operate may have the effect of distorting the behaviour of CEOs or other directors "to affect the share price around the time their shares are due to vest", as the Committee report warns.

It is also the case that their proposed replacement, deferred equity, vesting on a phased basis over a minimum five years, and not subject to performance conditions will, as the report said, "encourage decision making for the long term". However, this does not take account of executive shareholding guidelines operated, in accordance with the Corporate Governance Code and the Investment Associations Principles of Remuneration, by the majority of listed companies, which require the executives to build up and retain a shareholding equivalent to a specified percentage of their salary.

Meaningful salary percentage requirements, matched to the level of awards which the directors may potentially receive under an LTIP, and – as advocated by the Investment Association and a number of shareholder bodies – requiring the holding to continue for a period after the executive has left the company, will also, as the report acknowledged, deter "short-term behaviour" and "decision making according to a single vesting date".

If deferred equity is to be used, thought must be given on the volume of shares awarded, particularly if they are not to be subject to any form of performance metrics. Phased vesting of such awards, even over a longer period, will not placate shareholders and the 'man in the street' unless the amount of such awards is considerably lower than typical current LTIP awards to FTSE executive directors: a reduction of 50% has been advocated on a number of occasions, for example if restricted share awards were to be used in place of LTIP awards. The report mentions this point but not very clearly or with much emphasis.

Bonuses

The topic of directors' bonuses was also addressed in the report. While the Committee said that "there is a place for bonuses as part of a remuneration package", it said they should make up a smaller proportion of total remuneration and reward and incentivise genuine performance rather than routine business conduct.

Bonuses, it said, should be linked to "genuinely stretching" performance targets for "broader corporate responsibilities and company objectives" and not share price value. Bonuses, for example, could be linked to how well directors perform their duties to promote the company or "metrics relating to safety or customer service", the Committee said.

Employee representation on remuneration committees

The Committee also suggested that "the best way of ensuring that the voices of the workforce are heard in pay discussions is to have an employee representative on the remuneration committee itself". It noted that "employee representation on remuneration committees would represent a powerful signal on company culture and commitment to fair pay". Yet, while employee representation would represent such signal, it is not certain that this would deliver the intended result. 

In the first instance, as the report noted, this option may "not work for all companies, particularly multinationals with very diverse workforces" and therefore "should not be mandatory". Which member of staff could represent such a workforce and how would they distil workers’ views to act as an effective ambassador and representative in the remuneration committee?

It is quite possible that, where instituted, the chosen employee representative might be seen as just another sop, resulting in no perceived changes to the company’s overall remuneration structure. The report itself acknowledges this as a possible weakness of proposals to place an employee on the board itself, in a different chapter, but overlooks the similar risk in respect of remuneration committees. Nevertheless, the report notes that it expects "leading companies to adopt this approach".

This reflects the proposal made by Theresa May in July 2016, shortly before becoming prime minister, that employees and other stakeholders should be represented on company boards, about which there has been politically charged comment and debate. The Green Paper also raised alternative methods to "strengthen stakeholder voice" in the boardroom, without putting stakeholder representatives on the board or remuneration committee.

The report does not advocate requiring worker representation on boards, but endorses the encouragement of this and that worker directors "should become the norm". The report notes that employee directors should function as fully engaged directors, in the normal way, but overlooks the importance of members of the remuneration committee being fully engaged with all the board's deliberations in respect of executive recruitment and oversight and the company's strategy, which are essential contexts for determining executive remuneration, especially incentive performance targets and the level of performance achieved against them.

There is a striking and unexplained contrast between the report's measured support for employee representation on the main board and its much stronger advocacy of employee participation on just the remuneration committees of those boards.

Remuneration committee chairperson and voting reforms

According to the BEIS Committee, further reforms to the governance of remuneration committees are also needed. It said that the person who chairs remuneration committees should serve at least one year on that committee before being eligible for the chairmanship. This is to reflect the need for the chairperson to have a full and deep understanding of the company and its pay structures – at both executive level and employee wide – which can only be achieved over time. This is in line with recommendations already made by investors and the FRC.

The report also recommended that the chair of remuneration committees should resign if the committee's directors' pay proposals do not receive at least 75% shareholder approval. This acknowledges that it is the responsibility of the chairman, on the remuneration committee’s behalf, with appropriate third party advisor input, to deliver remuneration proposals which will be acceptable to shareholders.

The Committee also said that if there is a vote of 25% or more against the non-binding approval of an annual directors’ remuneration report, there should be a binding vote to approve the remuneration report in the following year.

However, such votes could be problematic, even if restricted to binding approvals, possibly for each director, of proposed bonuses before payment, proposed salary increases, long-term incentive (LTI) vesting and new LTI awards.

An approval vote is essentially binary. The report does not explain what would happen to the pay of the affected directors should a vote be lost – but presumably, respectively the consequences would be: nil bonus, no salary increase, nil LTI vesting and/or no LTI award.

Those possibilities would place the remuneration committee and the executives themselves under huge pressure to present and accept eminently justifiable and approvable pay outcomes, which is presumably the point. It may be hard, however, to avoid substantial collateral damage to the board’s focus on strategic matters and its overall performance during the year before the binding vote.

It is also very likely that the risk of this outcome will discourage investors from voting against remuneration related resolutions, perhaps abstaining instead. That raises the fundamental problem that shareholder abstentions are simply not recognised in company law and may not be properly analysed and reported in AGM polling statements.

A vote against of more than 25% is the same as a vote in support of less than 75% – the level expected to trigger the resignation of the chairman of the remuneration committee. The report does not make the connection, but in effect the two proposals together would mean that a new committee chairman would face a binding vote, or votes, on the annual remuneration report in her or his first year in the chair.

It is reportedly increasingly difficult to recruit non-executive directors and particularly remuneration committee leaders, and these proposals cannot be expected to improve that.

Disclosures on levels of remuneration

The BEIS Committee gave its support to the publication of pay ratios to highlight the total pay of CEOs relative to other executives and to the average employee, and further recommended that executive remuneration reporting and governance should be set in the context of disclosing much more about the company’s "people policy" more generally, including consistent reporting on levels of remuneration throughout the workforce. The support for CEO pay ratios was markedly less enthusiastic than that of other groups, however, including investors.

Effective "people policy" reporting could be potentially more difficult for companies to handle well than CEO:average worker pay ratios, for example, and may be more effective in terms of curbing any unjustifiable divergence of executive pay growth from the pay growth of other employee groups. It would place executive remuneration reporting and governance in a broader context, which the current requirements already attempt, by way of cross-reference to an accompanying report on remuneration and employees across the company, alongside other aspects of the recently expanded non-financial reporting expected in a company's strategic report.

On a voluntary basis, but almost inescapably, from the 2018 AGM season, "people policy" reporting will probably include details of the latest gender pay gap data with an associated narrative, at least in respect of UK employees of listed groups.

The approach that has been taken in the UK's gender pay gap reporting requirements does not align especially well with the approach to reporting required of groups including quoted companies, however. It seems likely that companies will adopt a variety of approaches and that it may be some time before it is possible to assess how best to integrate gender pay gap reporting alongside quoted company "people policy" and directors' remuneration reporting.

The Committee's overall message

It is clear from its report that the Committee believes greater simplicity and transparency of executive packages are desperately needed.

For businesses, the message is clear: take action to address the current imbalance between executive pay and that of the average worker, or face government intervention, and possible legislation, in the near future.

Lynette Jacobs, Suzannah Crookes and Graeme Standen are experts in executive remuneration at Pinsent Masons, the law firm behind Out-Law.com.