Given the growing sensitivity to widening income inequality in many developed economies, it is no wonder that criticism of soaring executive pay has intensified.
Attempts to slow the rapid ascent of executive compensation have made little headway in North America, Western Europe, and Australia. Some reform measures — such as mandatory disclosure of pay arrangements on an individualized basis and benchmarking pay against "peers" — have actually worsened the problem. In fact, the increasing focus on pay by policy makers, shareholders, and the media has magnified its importance as a gauge of success for top executives and created a vicious cycle of ever-higher pay demands.
Having implemented the latest reforms on executive pay — such as tightening the restrictions for disposal of vested stock awards and putting in place "claw-back" mechanisms — some boards are wondering how else they can address this issue.
As I have written previously, I believe that most top executives are highly motivated, am dubious that financial incentives really drive them to exert themselves more, and accordingly, think that monetary incentives should be de-emphasized. Here are some specific suggestions for doing that.
Transparency has been a favorite tool that governments have employed to try to combat "excessive" executive pay. In recent decades, disclosure regulations have mandated ever-greater details on individual pay packages. However, this "naming and shaming" approach has largely backfired. Rather than embarrassing executives, compensation disclosures have fostered a culture of envy among their ranks and turned pay into a mechanism for "keeping score." In his book Obliquity, British economist John Kay observes that "even among City and Wall Street traders and investment bankers, bonuses come to matter as much for the kudos they confer as the cash they generate."
Instead of continuing to single out executives for public humiliation, policy makers should — in their drive to enhance accountability — employ transparency in a less-personal manner. For example, they could require boards to disclose or explain the link between pay arrangements and strategy and risk management, how pay levels in other parts of the firm are taken into account when devising executive pay programs, the rationale for any significant divergence in the growth rate of compensation between top executives and front-line employees, and amounts clawed back from executives when performance deteriorates.
Additionally, in lieu of granting shareholders additional rights to dictate executive pay (e.g., through a binding "say on pay"), legislators and regulators could strengthen shareholders' capacity to hold boards accountable by bolstering their ability to elect and remove directors. Some countries have been highly innovative in this area. In Sweden, the largest three to five shareholders are invited to sit on the nominations committee to screen and propose director candidates for shareholder approval at the annual general meeting.
Shareholders should shift their attention from pay matters (which has become a time sink for institutional investors) to director appointments. As outsiders, shareholders often do not possess all of the information or be aware of all considerations that are relevant to devising robust executive pay packages at individual investee companies.
Deeper involvement in director nominations would likely give shareholders greater comfort in delegating pay decisions to boards and reduce the temptation to second-guess, particularly when boards diverge from conventional practices. One European fund manager, for example, seeks to meet every individual nominated for the board at their investee firms. In Sweden, most institutional investors take advantage of opportunities to sit on the nominations committee of investee companies.
Boards of Directors
To start, the board should ensure that the compensation committee is suitably independent and diverse so that its members will be attuned to sentiments on pay inside and outside the firm. In the U.K. and U.S., the perennial criticism of compensation committees is that they consist principally of current and retired corporate executives predisposed to approving lucrative pay arrangements. The remedy: make sure these directors don't dominate the committee.
Importantly, boards need to set the right expectations with top management and should push back against overly aggressive pay demands. In particular, they should emphasize to executives that their performance and contributions should not be measured strictly through the lens of compensation and that the firm will not strive to compete for and retain talent based on financial considerations alone. (The board of a Canadian pension fund with a significant in-house investment function made it clear to senior managers that they would be well compensated relative to society, but their pay would never reach the levels of hedge funds and private equity firms.)
In the same vein, when doing succession planning, the board should be attentive to candidates' attitudes towards pay and should avoid people whose overriding priority is money.
Finally, boards can build confidence in their stewardship by engaging proactively with shareholders and constructing straightforward, easily-understood pay arrangements.
How Will Executives React?
Contrary to popular belief, unilateral actions by firms to moderate pay will not inevitably precipitate an exodus of executives and other professionals. Even when a firm does not offer top dollar, staff may remain if their work is stimulating and enriching.
Given their competitive personalities and the highly personal nature of pay, many CEOs may resist any attempt to reduce the quantum of remuneration. Others, however, may welcome a less-intense spotlight on compensation as a measure of achievement and success.
Exemplars of moderation on pay can be found in different markets. A board adviser recently shared with me that directors of one U.S. company had to repeatedly urge the CEO to accept what they felt was a well-earned bonus. Similarly, a remuneration consultant told me that some European CEOs are quite measured in their pay demands and wish to set a good example.
The continuing turmoil in the global economy offers policy makers, shareholders, and boards a unique opportunity to move away from an excessive reliance on financial incentives as a motivational tool and stem run-away executive pay. They should take full advantage of it.
This blog first appeared on Harvard Business Review on 03/08/2012.