Executive compensation is a very visible area of corporate governance that has generated much media and regulatory attention in the past decade. The debate has centred on the large sums received by executives, and the suspicion that these individuals have some considerable say in the amounts they are receiving. Because of this, codes and regulations have been brought in to try to curb large payouts, with varying degrees of success.

The remuneration committee

The remuneration committee is a formally constituted committee of the board of directors, responsible for determining executive remuneration. Best practice in most countries is that it is comprised solely of non-executives.

The principal duties of a remuneration committee includes determining (in agreement with the full board) the broad remuneration policy and setting the individual packages for the executives. As a minimum, the committee should have responsibility for deciding the pay of the company chairman, the executive directors and the company secretary. In practice, its responsibilities often go deeper into the organisation than this, with some committees supervising the broad policies, if not the individual detail, for the top 100 or more executives in the company.

Although the remuneration committee has formal responsibility for the determination of executive pay, in practice it is impossible for its members to do this on their own. Executive pay is a complex area, and in order to set remuneration policies that will be acceptable to executives and shareholders alike – and meet the company’s strategic objectives – a detailed knowledge is needed of the business’s operations and of current practices in corporate governance and HR respectively. This cannot be done by a group of non-executives who are only at the company two or three days a month, and who are not necessarily experts in HR or governance best practice. Thus, the remuneration committee must rely on advice from others.

The key parties supporting the committee will be HR professionals, remuneration consultants and the company’s CEO and chairman.

HR professional

The basic role of the HR professional (often in conjunction with the company secretary) is to administer the committee. This includes everything from preparing agendas for meetings and collecting data on comparative salary levels in other companies to liaising with consultants.

In many companies, HR professionals do more than this, providing input into the committee and suggesting and researching new schemes. Committees are very reliant on this HR input and a high level of trust is necessary between the committee members and the HR professionals.

Remuneration consultants

Many companies use remuneration consultants as an additional source of advice, and to provide expert knowledge of other companies’ practices and a detailed understanding of scheme design. They also have experience of what institutional investors see as acceptable, and will often carry out shareholder liaison in conjunction with the company.

If consultants are used, the committee should be closely involved in their appointment and in setting their terms of reference. In recent years, some consultants have been seen as being too close to the executives, and remuneration packages have become too rich. Certain companies now use separate remuneration consultants to advise the executives (on pay generally) and the committee (on executive pay), to avoid this perceived conflict of interest.

CEO and chairman

Although CEOs will not attend meetings at which their own remuneration package is discussed, they need to have a role in designing the overall scheme. If we assume remuneration policies affect performance for the rest of the organisation it would be foolish to ignore their potential at this highest level. Thus, executive pay is not just a governance issue, but also affects company performance.

Moreover, in determining reward, the committee will require the CEO to provide feedback on the performance of subordinates, just as the chairman will give feedback on the performance of the CEO. The chairman will also be involved in decisions as to the overall scheme parameters, but will have no input into deciding his/her own pay.

In some companies, the CEO might also advise non-executive directors on whether their proposals will be acceptable to the rest of the executive management team. The committee members have the difficult task of determining how to meet executive needs without creating too rich a pay structure.

Within these parameters, every remuneration committee is unique. My research has found that, although companies can “tick the boxes” to show that they have good governance processes, different organisations do this in different ways. In some, the committee is driven by non-executives: they have input into the committee agenda; they employ and liaise with the consultants; and they include executives in their meetings only when they want. In other companies, the executives themselves may control the process, with relatively few meetings of the committee each year and the agenda largely set by the HR professionals and the CEO.

Given this range of practices, some questions for members of the remuneration committee to consider are:

• Who sets the agenda for committee meetings?

• How many meetings are there a year and is this enough?

• Who employs and briefs the consultants?

• Who attends the committee meetings?

A further necessity for committee members is to keep their skills up to date and be aware of changes in governance regulation and practice. Non-executives need this regular update in order to perform their committee duties to an acceptable standard. However, they should take care to balance these governance requirements with an understanding of the company’s specific business needs.

Determining executive pay

The remuneration committee needs to take two basic decisions on executive pay: how and how much. In other words, the pay structure and the level of pay for target performance must be determined. In setting pay policies and packages, the remuneration committee will be aware of broad structures used in executive reward.

For example, in the UK, the Combined Code on corporate governance, followed by all listed companies, sets the remuneration committee a conundrum that is almost impossible to solve. The Code states that remuneration should be sufficient to “attract, retain and motivate directors of the quality required to run the company successfully”, but not more than necessary for that purpose. The problem is that it is difficult to establish for any individual how much is “necessary”.

Committees are rightly nervous about losing good executives due to inadequate reward packages and may err on the side of caution, in this case high pay. Accordingly, standard practice is to use executive reward packages in comparable companies as a benchmark. This relates to the level of pay, potential bonuses, and, to some extent, to pay structures.

Variable pay

In the US, the UK and western Europe, the proportion of pay that is related to performance has been increasing in recent years. This is seen as good governance practice.

The Combined Code in the UK mandates that “a significant proportion” of executive pay should be performance-related. Recent surveys of FTSE 350 companies by New Bridge Street Consultants, a UK-based organisation specialising in executive remuneration, show that the levels of maximum annual bonus and long-term awards are both increasing. However, it should also be noted that the performance conditions attached to these appear to have become more challenging as well.

The annual bonus is designed to focus executive attention on matters that are seen as important in the short term. Profitability is widely used as a performance measure, but companies may adopt both financial and non-financial measures, and individual and team-based ones. The measures and targets adopted in any year should be tailored to reflect the company’s strategy and objectives.

In the UK, bonus levels are set as a multiple of salary. For example, a company might state that it will pay 70 per cent of salary for on-target performance, with a maximum of 100 per cent for exceptional performance. These figures are important for evaluating how generous a bonus scheme is, but analysing past bonus trends is equally relevant. Thus, a scheme that offers a payout of 70 per cent but that has only ever paid out 40 per cent is not as generous as one that offers 60 per cent and has always paid out that amount.

The level of performance at which the minimum bonus is earned should also be examined – does this represent a reasonable level of achievement, or is it effectively just part of the fixed pay? Institutional investors are taking more of an interest in the amounts of bonus paid, and the underlying performance measures and targets.

Although bonuses have generally been paid in cash, in the UK it is becoming increasingly common for companies to defer part of the bonus payment. For example, half the bonus might be paid in cash, with the other half invested in the company’s shares. The shares will vest after, say, three years and, if certain performance conditions are met, the company will add additional shares to the award. In this way, a short-term award is used to align executives with longer-term shareholder interests.

Long-term awards

In broad terms, long-term awards fall into two categories – share option schemes and long-term incentive plans.

Share option schemes

Executive share options, normally issued at the current share price, are widely used. In the UK, options are generally exercisable at the holder’s discretion after three years, subject to the achievement of a performance target, such as growth in earnings per share. Performance conditions on options have been best practice in UK governance for a decade.

In the US, the norm is to vest shares in annual tranches. UK-type performance conditions are rare because past accounting practices meant that options with performance conditions attached usually needed to be expensed on the profit and loss account. As a result, reported earnings were reduced. Meanwhile, options without such conditions had no impact on profit and were disclosed by way of note. Recent changes in accounting standards mean that now all options are to be expensed, thereby eliminating this discrepancy.

Because options only pay off if the share price rises, it has been argued that they align the interests of executives and shareholders. However, the structure of options is such that the alignment is less than perfect. For a start, if the share price falls, the option-holder fails to make a gain but, having been given the options on top of a remuneration package, does not lose anything. This distinguishes him/her from the shareholder, who actually paid for the investment. Thus, options are an upside-bet only.

This gives executives with underwater (out-of-the-money) options an incentive to take risks in the company’s business, in the anticipation that a good outcome will lead to profits on exercising the options, whereas a fall in share price carries no personal financial loss (although they risk losing their jobs). Thus, the shape of an option differs from that of a restricted share, discussed below, in that the share-holding executive can still receive a reward even if the share price falls, whereas the option-holding one cannot.

Furthermore, a company where the executives have a lot of outstanding options may have an incentive to limit its dividend payments, as dividends pay cash to current shareholders at the expense of the future share price. Neither of these features of options could be said to add to shareholder value.

Although options have been very common in the past, they have been used less in recent times. This reflects several factors. First, a fall in stock markets has meant that option gains are no longer a sure winner for the executives. Further, international financial reporting regulations have changed, so that a company issuing options will now face a charge against profits. Accordingly, many companies have altered their long-term award arrangements, and long-term incentive plans have become more common.

Long-term incentive plans

Many companies use long-term incentive plans (LTIP) in addition to or instead of an option scheme. They take various forms, but often involve the issue of restricted shares, which will vest after a period of years, subject (in the UK but often not in the US) to the achievement of certain performance conditions.

It is notable that whereas the most common performance condition on options is the achievement of a certain level of growth in earnings per share, for long-term incentive plans the most common measure is total shareholder return, the combined dividend and capital gain return to shareholders over a period of time. Companies are rewarded for their relative total shareholder return compared to an index or a group of peers.

The advantage of using total shareholder return as a performance measure is that it is aligned with shareholder return, and is perceived to be outside the immediate control of the executives.

The disadvantage of using this performance measure is that it can be difficult to identify a suitable group of peers. Further, having determined that peer group, natural wastage through takeovers or insolvencies may deplete it, which can cause problems for the benchmarking company.

At the same time, such schemes tend to be complicated and it can be difficult to discern quickly where the company ranks against competitors at any given moment. Finally, share prices reflect investors’ anticipation of future results rather than actual performance. Basing executive pay on this market perception means that such performance measures can be subject to market error or manipulation rather than rewarding executives for their actual performance.

Meanwhile, earnings per share growth has the advantage that it is perceived to reflect the directors’ performance, is easy to understand, audited, and does not rely on the vagaries of the market.

However, any accounting measure can be manipulated, which is one reason why institutional investors often prefer total shareholder return. Also, until recently, traditional targets for earnings per share growth rarely reflected the growth needed to generate real value for shareholders. Institutional pressures have led to performance targets being increased in recent years.

Future trends in governance

In the past decade, the level of governance regulation relating to executive pay has grown substantially but the effects have not always been the intended ones.

Likewise, compulsory disclosure has increased considerably our knowledge of how individuals are paid and how committees work. However, most commentators argue that increased disclosure has led to greater executive pay inflation – once directors knew what their peers and competitors were earning, they demanded to be paid at least that amount, with the resultant upward ratchet in salaries and variable pay. Given the pressure for fuller details of individual pay to be disclosed (for example, in Germany, where few companies comply fully with the voluntary disclosure code) it will be interesting to see how this affects pay levels internationally.

Continued regulation in this area seems inevitable, as governance codes and ratings become more widespread and comprehensive. Whether this will result in “better” executive pay – however that may be defined – remains to be seen.

Ruth Bender is a lecturer in finance at Cranfield School of Management. Prior to becoming an academic she was a corporate finance partner at Grant Thornton. Her research focuses on how FTSE 350 companies determine their executive remuneration policies and packages.