Pay Back Time: Expect Shifts in Executive Compensation as it Comes Under Increasing Scrutiny

Pay Back Time: Expect Shifts in Executive Compensation as it Comes Under Increasing Scrutiny

Written by Judy Ward, Illustrated by Nigel Buchanan

Written by Judy Ward, Illustrated by Nigel Buchanan

Originally Published: Plan Sponsor Europe | Summer 2010

Royal Dutch Shell’s February announcement, following a shareholder revolt, that it would freeze executive directors’ salaries for a year as it reviews their compensation packages speaks to the reality of Europe’s compensation controversy: It is not just for banks anymore.

“Financial services got all the headlines, but executive pay is being scrutinized across all industries”, says Dan Perrett, a London-based Principal at consultant Hewitt Associates LLC. Look for that scrutiny to continue, says Vicente Cunat, a lecturer in finance at The London School of Economics and Political Science (LSE). “We are going to see to what extent these companies are able to attract talent”, he says of the impact. “They want to attract the right people. At the same there, some compensation may have been excessive.”

In April 2009, the European Commission issued new guidelines aimed at curbing pay abuses for directors at listed companies. The non-binding recommendations suggest that member states take steps such as limiting terminated directors’ severance pay to two years of fixed pay and requiring companies to explain the methods they used to determine whether a director met bonus and long-term incentive criteria. Some nations have taken action: Roughly a year ago, for instance, Germany’s Bundestag passed legislation intended to limit salaries of members of management boards at listed companies.

The defining event of Europe’s current executive compensation moves was the output from the September 2009 G-20 summit in Pittsburgh, “where a bunch of nations came out with what seemed like a fairly coherent set of agreed-to principles:, says Geoff Gottlieb, Senior Managing Director of Executive Wealth Management Ltd., which designs and administers global executive compensation and investment plans and has offices in the UK, Switzerland, and the US. “There is nothing new in that whole discussion, in terms of the features of compensation policy. What this amounts to is making it more onerous than it has been in the past.”

Here are a half-dozen trends to keep an eye on:

More say on pay: Close scrutiny of executive compensation began more than a decade ago in the UK. In 2002, for instance, Britain instituted The Directors’ Remuneration Report Regulations, which include a “say on pay” provision that requires an annual shareholder vote on director pay.

Two organizations in the UK play a particularly key role: the association of British Insurers (ABI) and National Association of Pension Funds (NAPF). “The UK executive pay market may be characterized by light-touch government regulation and responsibility delegated to institutional investors”, Perrett says. For any major UK company, “the compensation committee is very concerned about what the ABI thinks,” says Mark Hoble, a London-based Partner at consultant Mercer. He and his Mercer colleagues often meet with the ABI about clients’ proposed executive-compensation changes, and he predicts that will spread elsewhere in Europe with similar institutional groups. “These institutional investor bodies are talking to each other,” he says. “More companies are going to do what we do here; Take any changes to these groups for discussion, and, essentially, approval.”

The increase in executive-compensation transparency in the UK “has got positives and negatives,” Perrett says. “The negative side is that it fuels salary inflation: It does make it easier for executives to see what others are paid. Overall, I think it has been quite positive in that it forces companies to disclose their policy.” They have to reveal things such as the metrics used to set executive compensation, the amount paid short term versus long term, and the proportion of fixed versus variable pay, he says.

Other countries such as France and Germany have started taking steps towards transparency. “The common theme is that they [companies] have to comply, or explain the process,” Perrett says. “They set out best practices, but are not legally binding requirements. Where they wish to deviate, they give an explanation of why it is not best for their company.”

For companies faced with a need for more disclosure, “they need to look at their remuneration proposals through the eyes of investors”, says Tom Gosling, a London-based Partner at PricewaterhouseCoopers. “This is going to require companies to work a lot harder to get an understanding of what their investors care about, in terms of executive pay. The biggest thing to focus on is: How do they build that engagement?

Together performance requirements: Hand-in-hand with increased institutional investor influence and disclosure in the UK have come tougher performance requirements on executive compensation, Gosling says, particularly with long-term incentives. Other European nations can expect something similar. “That means a couple of things. One is introducing them where they did not have them at all before. The other piece is a question of how tough the hurdles are.” Before, an executive might pass the hurdle if a company’s earnings growth exceeded the consumer inflation rate by a couple of percentage points. However, the UK has seen gradually toughened requirements, such as a higher percentage-going requirement and adding competitors’ performance as an additional factor. “The other side of it is that award levels have gone up to compensate for their reduced value: Awards are less likely to pay out but, when they do pay out, they are larger,” he says.

Financial-sector companies have gotten the most press for toughening award standards, but Hoble says that some companies outside the industry have started adopting UK banks’ moves. They include taking risk into account more fully when measuring executives’ performance and awarding bonuses. “In reality, what that means for the compensation committee is that they need to make sure they have enough information about whether a given level of performance is long-lasting or not,” he says, adding that, in the UK, these committees tend to work closely with audit committees. “They need to determine if it is just one great year, or if that performance is sustainable over time.”

New clawback provisions: If a company’s performance does not prove long-lasting, these provisions increasingly can come into play. A clawback allows and an employer to take back variable pay given to an executive if certain pre-specified things happen, such as the need to restate financial results because of an executive’s fraud or misconduct. They have become trendy in the United States: about 40% of S&P 500 companies now have callbacks, according to a report released earlier this year by The Corporate Library, a corporate governance and executive compensation research firm.

The European Commission recommends that companies adopt clawbacks, which Gosling says already have surfaced in the UK and are becoming standard in The Netherlands, too. “It is going to come in fairly rapidly” in Europe, he says. Most of the clawbacks introduced pertain to short-term bonuses, he says, typically for two years on bonuses already paid. For bonuses earned but deferred, he says, the clawback provision could apply for three or four years.

In the United States, critics point to the potential difficulty of definitely tracing results such as financial restatements to the actions of a specific executive. Even if employers can enforce the provisions, some in Europe already wonder about clawbacks’ effectiveness. “It is a way to put more of the wealth of the CEO [and other senior executives] at stake,” Cunat says. “I am not sure that they were not exposed before. Many CEOs have a lot of stock as a large percentage of their wealth.”

Fewer options, more performance-based shares: Most long-term incentive plans in Europe revolve around shares rather than cash, Hewitt found in its 3010 “Report on Eurotop 100 Directors’ Remuneration,” with only 5% of Europe’s 100 largest companies indicating they have a cash-based plan. The highest long-term incentive awards go to executives at Swiss companies, with a median expected value at 2.50% of salary. At the other end of the long-term incentive scale sit the Nordic countries, at 41% of salary.

Options continue to fall out of favor in Europe, Hewitt finds, with performance share plans (PSPs) now the leading type of long-term incentive. (Executives might get shares based on their company’s earnings per share over a three-year period, for example.) Fifty-five of the Eurotop 1000 offer PSPs, versus 49 that grant options. “The use of options got generally hit when accounting rules were introduced that employers have to expense them,” Gottlieb says. French companies still use options the most commonly among European employers, Hewitt finds, with Spanish companies utilizing them least. 

Asked if options play a big role in the UK as they sometimes have in the US, Hoble says, “Not now.” He adds that “there was a backlash against options, because they are not seen as clearly aligned with shareholders’ interests. When the market dropped, we saw some senior management asking for options to come back. Being granted options in the trough of the market is very smart, if you can do it but, for the most part, that is being resisted.” 

Potential deferred comp retirement plans: US-style deferred compensation plans, intended as a retirement benefit, have not played much of a role up to now. “Deferred compensation is not used for retirement planning in Europe as it is in the US,” Gosling says. Many countries have strong state-provided retirement benefits, and many employers still have generous defined benefit plans, but these US-style deferred compensation programs may begin to surface, starting in the UK.

Previously in the UK, Gosling says, long-term incentives have been thought of as a way to align executives with shareholders. In the future, they also could become a major source of retirement income for executives. “There is a huge focus at the moment on supplemental retirement plans for executives,” he says. “We have just had tax changes in the UK. [that take effect in April 2011] that very significantly reduce the value of qualified plans for executives.” The new takes rules make qualified plans a very unattractive benefit for anybody earning £130,000 (€148,447) or more, he says, since they will pay up to an additional 30% tax on the benefits.

Effectively, it will kill the use of qualified plans for anybody earning £130,000 or more. That is leading companies to review their executive compensation approach,” Gosling says. “They are wondering if there should be a baseline retirement benefit for all employees, and then a deferred compensation plan for executives.”

Leaner termination provisions: This has been among the most controversial issues in Europe lately, with executives like former Royal Bank of Scotland Group PLC CEO Fred Goodwin coming under fire. After the bank reportedly posted the largest annual loss in UK corporate history and collapsed, Goodwin took heat for refusing to forgo a £693,000 (€791,260) annual pension package. Vandals even attacked his Edinburgh home last year, with The Wall Street Journal reporting that a group claiming responsibility sent an e-mail saying in part: “We are angry that rich people, like him, are paying themselves huge amounts of money, and living in luxury, while ordinary people are made unemployed, destitute, and homeless.” He later agreed to give up some of it.

“There was quite a political storm in the UK, because the UK taxpayer now owns Royal Bank of Scotland,” Gosling says. “Some of the biggest controversies in Europe related to people who have gotten big payments upon their termination,” he says. “There is a big push to limit the amount of compensation someone can receive to one or two times salary, but also to limit the augmentation of their pension benefit.”