Executive remuneration

Transcription

1 Executive remuneration in high definition A high definition, risk-adjusted approach to benchmarking Instinctively executives know that one pound of base salary, one pound of target bonus and one pound of expected LTI value are not equivalent in terms of perceived value. However, when organisations consider total compensation benchmarking, this often involves simply adding these components together. Hay Group has developed a model that analyses the uncertainty, volatility and risk of pay to help companies gauge package competitiveness. This approach allows clients to assess whether pay volatility and pay quantum are in step, how the package is likely to be perceived by new hires and whether the volatility/risk of pay is appropriately aligned to the board s risk appetite. This article explores how our approach works and the implications of different risk-adjusted market positioning Hay Group. All rights reserved

2 1 Executive remuneration in high definition Compensation Risk Index (CRI) Developed by Dr. Eric Engesaeth of Hay Group and the TiasNimbas Business School in the Netherlands, the Compensation Risk Index (CRI) is a risk-adjusted benchmarking tool which assesses whether pay volatility and pay quantum are in step. It is based on the degree to which expected and actual pay quantum differ and measures the extent to which the package is truly at risk. The CRI has been rigorously tested to academic standards. While pay analysis is conventionally focused on pay levels and pay structures, using the CRI can help focus pay analysis on strategy, including desired appetite for risk as highlighted in figure one. Figure one: focusing pay analysis on strategy CRI focuses on this side Pay Traditional benchmarking focuses on this side Strategy Regulatory influence Management Pay at risk: performance conditions, deferral, clawback and malus Business risk require Returns require Shareholders The CRI encapsulates several aspects of pay risk, including the incentive mechanism, the extent to which short and long term performance conditions are met, and for the equity element, share price movement. Once calculated, it is possible to rank a peer group by the expected level of reward offered to individuals and by the volatility of that reward. A CRI analysis typically maps peer group companies as in figure two.

3 2 Figure two: pay volatility matrix Above median Expected reward Below median A Free ride Risk Above median B Situation with significant risk; strong corporate governance is needed Below median C Low risk; attracts a risk averse individual D Potential retention / hiring issue When considering the competitiveness of pay packages in relation to the above, it would be logical for companies to target quadrants B or C, should they wish to attract either a more risk-seeking or risk-averse executive. In normal circumstances, quadrants A and D are less attractive. It is possible to envisage scenarios where companies would wish to design pay packages that are high in terms of expected reward but low risk (quadrant A). However, providing a very high level of pay with a very low level of risk could be classed as a free ride where quantum is not offset by risk to the reward package. Few if any companies would wish to position themselves with low, risky pay (quadrant D). It is possible to rank a peer group by the expected level of reward offered to individuals and by the volatility of that reward Hay Group. All rights reserved

4 3 Executive remuneration in high definition Pay risk and business risk The relationship between pay and business risk is very much in the spotlight of regulatory attention and is something that companies are increasingly focused on. In figure three we have calculated CRI for FTSE 100 chief executive pay by sector over three years up to 2008, at the onset of the financial downturn. Figure three: CRI scores by sector Interestingly, when we compare CRI scores or pay risk with business risk, the sectors with the riskiest pay are not necessarily the riskiest in terms of business risk when looking at unadjusted beta by sector, as shown in figure four. For example, the financial and basic materials sectors had the two highest median levels of business risk at the time (figure 4), but by contrast offered relatively low risk pay arrangements to individuals (figure three). Sector Compensation Risk Index Energy Technology Communications Consumer non-cyclical Industrial Financial Consumer cyclical Utility Basic materials Figure four: 2008 beta by business sector in the FTSE Sector Median upper quartile Median lower quartile Unadjusted Beta FTSE 100 Consumer cyclical Industrial Financial Consumer non-cyclical Technology Basic materials Energy Utilities Communications

5 4 Pay volatility and the banking sector As an example of how incorporating the CRI into pay analysis might work in practice, the below graph looks at the Total Direct Compensation of chief executives at eight major European banks and considers quantum in relation to pay volatility. The graph shows that while the general expected pattern of low pay, low risk or high pay, high risk broadly prevails, there are still anomalies in terms of pay volatility. One example is bank F which provides high pay with low risk, potentially reflecting disproportionate pay or possibly a current or past recruitment crisis. By contrast, banks C and D provide high pay with an above median level of pay volatility. Although on the face of it this might seem logical, this is only so if this positioning fits with the business strategy of the relevant bank. If for example, the bank is primarily a utility, predominantly engaged in lending in the retail market, providing a highly volatile pay package might drive excessive risk-taking. On the other hand, pay at banks A and B is at median with high risk, potentially leading to retention issues. Figure five: Compensation Risk Index versus Total Direct Compensation in European banks 1 10 Bank D Total Direct Compensation million 9 Bank C 8 Bank F 7 6 Bank B Sample TDC median Bank G Bank A Bank H 2 Bank E Compensation Risk Index Sample CRI median 1 Total direct compensation is calculated on latest actual salary, policy target STI and latest policy maximum LTI awards. Data is the most recently published information, typically the 2011 accounts Hay Group. All rights reserved

6 5 Executive remuneration in high definition Pay design implications How can business risk and pay volatility be factored into pay package design? It is clear that pay quantum and pay volatility are not the only factors affecting an executive s attitude to business risk-taking. Personal wealth, existing company shareholding, desired and actual executive turnover and personalities are all very important if we are to understand and anticipate the sort of business risks executives are likely to undertake. However, CRI offers an additional dimension to benchmarking which allows organisations to consider some of the potential implications on pay design as follows. Pay structure Risk dampening Neutral Risk amplifying Likely actual outcome Relative pay volatility that is lower than relative business risk Relative pay volatility that is similar to relative business risk Relative pay volatility that is higher than relative business risk Typical pay policy characteristics May be appropriate in these cases Higher than market fixed element Variable element of pay that is linked to operational measures Possibly a strong discretionary element Companies wishing to achieve strong disincentive for risktaking Higher than market fixed element Relative to market, greater reliance on the less leveraged delivery mechanisms, for example deferred bonus or performance shares with an EPS performance condition Substantial shareholding requirement Companies operating in mature markets wishing to sustain current behaviours towards risk-taking Use of highly leveraged delivery mechanisms such as share options or highly geared share matching arrangements Strong focus on relative performance Stretching performance scales Companies in a situation of a turnaround, perhaps in a critically important search for new valueenhancing strategies

7 Conclusion The relationship between pay policies and business risk is in the spotlight of regulatory attention and is something that companies are increasingly focused on. In this context, companies should: be mindful of pay volatility when testing the competitiveness of pay packages both at board and senior management levels consider the link between pay volatility and business risk low pay volatility can help restrain risk-taking behaviour but may be a hindrance if a strategic shift is needed. High pay volatility may be desired but for the pay package to remain competitive, high pay volatility needs to be linked to high expected pay quantum consider the full spectrum of factors which impact on risk-taking behaviour and primarily the fit between roles, business risk appetite and individual personality and personal circumstance. Simon Garrett Director, executive reward United Kingdom e simon.garrett@haygroup.com Eric Engesaeth Practice leader executive reward Netherlands e eric.engesaeth@haygroup.com For further information or to speak to a Hay Group consultant, please contact: t +44 (0)

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