Feature – In depth: Exec reward continues acceleration

Executive pay among the UK’s top FTSE firms has taken on staggering proportions, but shareholder pressure is shifting the way senior management are being rewarded, says David Shonfield

Case study: SMG

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Average remuneration for top executives in the UK has broken through the £2 million barrier. Almost nine-out-of-10 lead executives in FTSE 100 companies now receive over £1 million a year. And eight individuals have packages grossing £5 million or more. There is every sign that pay levels for directors will continue to climb well ahead of inflation and average earnings.

In the past, the usual justification for such pay levels has been that leading companies need to be able to attract and retain top international talent. The market for directors has even been likened to that for footballers.

A case in point is Francesco Caio, who was due to leave his role as chief executive at Cable & Wireless as Employee Benefits went to press. An electronics engineer with an MBA from the management school Insead, he spent five years as a consultant with McKinsey in London, before joining Olivetti and then launching a mobile phone company, Omnitel. He was CEO of Italian domestic appliance company Merloni before setting up a business telecoms company, Netscalibur, from which he joined Cable & Wireless in 2003. Caio’s base salary at C&W was £700,000, plus an annual bonus of up to £1.05 million, with £375,000 guaranteed in the first year. He was granted a further £750,000 in shares, together with options worth a further £2.8 million. C&W also paid him £475,000 in pensions contributions during his time in office.

Whether Caio’s three years in charge strengthened the business is debatable – current earnings forecasts are gloomy and the company may be obliged to break up. Even though his career is not typical of most directors, such individuals are frequently used to justify equally generous compensation packages for others.

Analysis of directors’ pay tends to focus on the FTSE 100, but it is more sensible to look at the top 350. The Directors’ pay report 2005 by Incomes Data Services shows that base median salaries for lead executives in the second tier of companies – the so-called Mid-250 – are around half the level of the top 100: £375,540 compared with £700,000. Median earnings, that is to say, including bonuses but excluding shares, were £1.6 million for the FTSE 100 and £736,000 for the Mid-250.

These figures are from annual reports with year ends between June 2004 and June 2005, so they reflect the position as it was, rather than as it is today. However, the trends are unmistakable. Median salaries have risen by between 6.3% and 8.2%, but the increases in terms of total cash are higher (see table).

The difference between the median and the average is important. The average is boosted by the small minority of executives who received year-on-year increases of between 50% and 100%, while the median reflects the fact that at the other end of the scale there were individuals whose total pay fell by 20% or more. In fact, over a quarter of directors of Mid-250 companies received less cash than in the previous year.

Behind these raw figures, however, big shifts have been taking place in remuneration policies. Increased regulation and tougher accounting standards are starting to have a real impact, not on pay levels or rises, but on the ways in which executives are rewarded, and on the organisation’s responsiveness to shareholder concerns.

One example of the change is media company SMG (see box). As the company itself points out, it is not the only organisation that has responded to shareholder concerns over executive pay, but the extent of its shareholder involvement in shaping the new reward arrangements is unusual.

Although at SMG, bonus scheme maximums remained as they were, and maximum share grants were reduced, Steve Tatton, editor of Incomes Data Services’ monthly Executive Compensation Review, says that, in general, the restructuring of incentives is leading to an increase in potential payments.

Over the past four years, there has been a significant turnaround. In the 2001/2 reporting period salary rises were actually ahead of total cash increases. Over the last three reporting years, however, total cash increases have moved steadily further and further ahead.

In the last year, nearly half of FTSE 100 lead executives received long-term incentive awards compared with 13% in the previous reporting period. On these latest figures, incentives now account for over 50% of FTSE 100 lead executives’ earnings compared with 41% in the previous reporting period.

It looks as though this is a permanent shift, but there is still some way to go in terms of transparency, and of companies being able to justify what they do, whether to shareholders, employees or the public at large.

Option schemes have been heavily criticised – not always fairly, because in some companies options have been under water in that they have not delivered the expected returns – but they are still widespread. In the latest reporting period the proportion of FTSE 100 directors exercising share options rose significantly, from around 12% to 27%.

Some consultants are expressing concern that the general shift away from options is occurring just at the wrong moment in the cycle, and that companies are in danger of losing sight of the value of options as an incentive. Richard Lamptey, principal at Mercer Human Resource Consulting, says: "The whole point about stock plans was to put managers in the position of shareholders. Performance share grants don’t send the same strong message because, while shareholders suffer in a falling market, executives are protected."

As for pay differentials, few companies have been prepared to follow the proposal by the National Association of Pension Funds that they should disclose the differentials between board members and employees in their annual reports.

"Differentials have widened enormously over the past 10 years and this must be a cause for concern. I’ve advised a number of companies where the CEO has decided to peg executive salary increases to the same level as other employees, but the reality is that two or three years later these executives look around and find that they’re way below the market," adds Lamptey.

It may be that the more rigorous approach to pay and performance at executive level will make generous compensation packages less of an issue. However, while employers continue to make extravagant contributions to executive pension schemes, as in the case of Caio, for example, the feeling of them and us is unlikely to disappear. As Tatton says, present trends will "add further fuel to existing concerns about the widening gap between the boardroom and the shopfloor".

Case Study: SMG

SMG came under criticism for its exec pay practices in 2003 and 2004. At the time, PIRC, the pensions funds advisory group, described the earnings targets in the media company’s executive share scheme as insufficiently challenging.

New arrangements were approved by shareholders in June 2005 and directly cover the eight members of the executive management group. However, a further 25 or so senior managers have also been affected by the change in policy as the company feels it makes sense to align the pay arrangements.

Annual bonuses, up to 100% for the CEO and divisional chief executives and 60% for others, are now entirely related to objective business performance targets, whereas previously half were discretionary or related to individual targets. Those with company-wide responsibilities have a bonus that relates to overall profit before tax and operating profit, while heads of divisions have a bonus geared to 75% of divisional performance. Deferred shares have ceased to be part of bonus arrangements.

As for long-term incentives, share options have been abandoned and performance measures are more rigorous.

Total shareholder return determines 50% of the share award, as previously, but is now measured against seven competitors as well as 20 comparable firms. There is no payout for less than median performance. The remaining 50% is determined by return on capital rather than earnings per share as previously. Personal shareholding is built into plans for executives.

HR director Peter McGrath explains: "We needed more on the variable side linked to improved company profit performance. Our short-term bonus plan really didn’t operate as an incentive. It was complicated, and it didn’t pay out and therefore lacked credibility. Our share plans were not meeting their lock-in and reward goals, which were under attack from shareholders, as were all as such plans in the UK, and they were becoming expensive because of new accounting standards."

Shareholders were in fact quite instrumental in the process, for instance, it was they who suggested that divisional CEOs bonuses should be weighted more heavily to divisional results.