Dim the Spotlight: De-emphasizing Pay for Performance

It is common knowledge that people are not driven solely by the prospect of financial rewards. Yet, in business, motivational tools for top executives—particularly the CEO—almost singularly comprise financial incentives. In 1980, only 10 percent of the UK’s largest FTSE100 companies utilized incentive arrangements (in the form of cash and stock-based variable pay). Today, they are universally employed as a matter of best practice and variable pay accounts for approximately two-thirds of total compensation.

Widespread adoption of financial incentives has contributed to substantial pay increases, in absolute and relative terms. In the United Kingdom, the average compensation of FTSE100 CEOs climbed from £1 million in 1998 to £4 million a decade later, with the ratio of CEO pay to average employee pay nearly tripling. (The figures are, of course, higher for American executives.) The rise in top executive pay has far outstripped growth in share price and other indicators of company performance, with certain incentive arrangements proving counterproductive by encouraging excessive risk-taking and accounting manipulation.

Amid growing sensitivity to widening income inequality in many countries, it is no wonder that executive pay has remained a visible target.

True, CEO pay in 2011 actually lagged behind corporate results, at least in the United States. But the ratios, and the inequality, are holding steady despite efforts, both legislative and voluntary, to slow the rapid ascent of executive compensation. Some reform measures—such as benchmarking pay against “peers” and mandatory disclosure of pay arrangements on an individualized basis—have actually worsened the problem. In fact, the increasing focus on pay by policymakers, 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 clawback mechanisms—some boards are wondering how else they can address this issue.

One possible way forward is to de-emphasize monetary incentives. Most top executives are highly motivated—that’s how they got to the top—and it is questionable whether financial incentives are capable of driving them to exert greater efforts. Outgoing Shell CEO Jeroen van der Veer hit the mark when he told the Financial Times, “If I had been paid 50 percent more, I would not have done it better. If I had been paid 50 percent less, then I would not have done it worse.”

How can policymakers, shareholders, and boards dim the spotlight on executive pay—and moderate its growth?

For governments, transparency has been a favorite tool to combat “excessive” executive pay. In recent decades, disclosure regulations have mandated ever-greater details on individual pay packages. However, the “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.” British economist John Kay asks: “What self-respecting chief executive would accept that he should be paid in the bottom quartile of CEO salaries in comparable companies—although, by definition, a quarter of people must find themselves in that position? Even among City and Wall Street traders and investment bankers, rightly identified as exemplars of greed, 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, policymakers 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, 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 further rights to dictate executive pay—for example, 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, improving disclosure of director candidates’ biographical and other relevant details, and removing impediments to voting. Some countries have been highly innovative in this area: In Swedish companies, 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.

Correspondingly, shareholders should shift their attention from pay matters—which has become a time sink for institutional investors and a headache for pretty much everyone involved—to director appointments. Provided that it is composed appropriately, the board is generally better placed than shareholders to make compensation decisions. As outsiders, shareholders often lack some important information or are unaware of all considerations relevant to devising robust executive-pay packages at individual investee companies.

Deeper involvement in director nominations would likely make shareholders more confident in boards’ pay decisions 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 investee companies’ nominations committee.

Unsurprisingly, the heaviest responsibility will fall upon the board 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 both the United Kingdom and the United States, the perennial criticism of remuneration committees is that they consist principally of corporate executives who are predisposed to approving lucrative pay arrangements because they are highly compensated themselves and cognizant that across-the-board increases in CEO pay may help inflate their own remuneration.

Importantly, boards need to set the right expectations with the top management team, including pushing back on overly aggressive pay demands. In particular, they should emphasize to senior executives that their performance and contributions should not be measured strictly through the lens of compensation and, equally, that the firm will not strive to compete for, and retain, talent based on financial considerations alone. A U.K. remuneration adviser counsels that “clear messaging and managing expectations in advance are critical to helping executives to put their compensation in the appropriate context.”

At a Canadian pension fund with a significant in-house investment function, the board made it clear to senior management that although they will be well compensated (relative to society at large), their pay will never reach the levels at hedge funds and private equity firms.

One North American chairman commented, “to preserve our culture [of moderation on compensation], we avoid hiring eat-what-you-kill people for whom money is the overriding priority.” The board of a leading North American financial institution recently forged ahead with a more moderate, longer-term remuneration program, confident that key executives are motivated by more than compensation.

Last, boards can instill confidence in their stewardship by engaging proactively with shareholders and constructing straightforward, easily understood pay arrangements.

How will CEOs react? 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. A senior management consultant relayed to me last year that “some CEOs find it difficult to reconcile a gracious and humble personal side with a professional expectation to grab as much financial rewards as are available for themselves.”

Exemplars of moderation on pay can be found in different markets. A board adviser recently shared with me that the directors of one American 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.

Even in the financial sector, where monetary rewards assume greater importance, role models exist. In a February interview with the Financial Times to discuss his decision to waive a £1 million bonus amid growing pressure from politicians and the media, Royal Bank of Scotland CEO Stephen Hester stated that “he was happy to be paid less than top executives at rival banks and other listed companies.”

In a Guardian interview, Hester conceded that he was a “commercial animal” but emphasized: “If I only worked for money, I wouldn’t do this job.”

Of course, not every top executive can afford—in financial or competitive terms—to publicly forgo proffered cash. But no one expects CEOs themselves to tamp down the smoldering public outrage over inequality and executive pay.

For policymakers, shareholders, and boards, the continuing economic turmoil presents a unique opportunity to move away from an excessive reliance on financial incentives as a motivational tool and stem runaway compensation. They should move quickly.