TOP EXECUTIVE COMPENSATION.
PART ONE

THE ARCHITECTURE AND DESIGN OF TOP EXECUTIVE COMPENSATION PROGRAMMES.

In the 1980's and 1990's, the design and content of top managers' pay became more and more complex. Nowadays the compensation section of many companies' annual reports need a highly trained specialist to unravel the jargon and often obscure complications of the directors' compensation and benefits programmes. So, for starters, here is a glossary of terms that describe the elements of a typical top executive compensation package

Some Basic Definitions

• Base Pay or fixed pay.
  Usually annual cash pay such as salary.
• Variable Pay.
  Usually some form of cash bonus, which can be annual or longer term, like 3 years (Commonly known as a Long Term Incentive Plan, or LTIP). Bonus is normally paid for hitting financial performance targets, but sometimes for achieving non-quantified targets.
  Sometimes some or all of a bonus payment may be voluntarily or compulsorily deferred for a specified period. Often companies will match the amount of bonus that is deferred. This frequently means double it.
• Share Options.
  There are many variants on Share Option plans, but the basic mechanism is broadly similar. An executive is granted the option to purchase a defined number of shares in the company that can be bought at a time point in the future. This point is known as the Vesting date. At this time, the choice exists to buy and hold, immediately cash in or walk away from the shares. Share options have a positive value if the price at vesting exceeds that at the point of grant. This difference is known as the gain.
  Compensation programmes that have a high share content will create a strong temptation to try to push up the company share price - this can be done in many ways, including having the company acquired. Many share option plans include a provision for vesting on change of control. This means that the value of options can be realised if the company is acquired. Where large grants of options are made as a sort of 'Golden Hello' at recruitment time, there may be a strong temptation to 'release shareholder value' by encouraging a bid relatively quickly!
  A variant on share options is the Performance or Restricted Share Plan. This simply means that participants are typically awarded shares to a specified value with vesting conditional on the achievement of pre-defined long-term performance targets.
• Benefits.
  Non-pay perquisites.
  The most valuable is Pension, which is very expensive to fund. As a very rough rule of thumb, it costs £10 to fund each £1 of pension. Most top managers do not seem to have shared the pain of many ordinary employees, who have seen the value of their current or prospective pensions greatly decreased.
  
  Severance arrangements can also be included as benefits. These are often tied to the length of the employment contract. These days, it is becoming unusual to find contracts of more than one year. However, severance packages can be enhanced by such provisions as pension enhancement and guaranteed bonuses. The recent fuss over the severance package of JP Garnier, the CEO of GSK, concerned a package with a reported value of $22m!
  
  The range of other benefits is wide, including car and chauffeur, private medical benefits for executive and family, death and disability benefits.
  Some of the most interesting benefits are those that are discreetly omitted from annual reports, like use of private jets, company apartments and use of very expensive hotels, sometimes accompanied by spouse. (See short Chapter, "Hope you enjoyed your Stay", on this website).
  
  Finally, to bring some perspective, the median base pay of the top 50 FTSE CEOs in 2002/2003 was "808,000, and annual bonus earned approached 50% of base pay. When Long Term Bonus, gain on Share Options and the value of benefits are added, it can be seen that we are talking big money!
  We will go into this in more depth in the next chapter.

WHAT ARE THE DRIVERS OF COMPENSATION DESIGN?

This chapter is aimed at getting back closer to the basic factors that should influence the design of compensation programmes (although an element of complexity is inevitable).

We will examine What (outcomes, results, actions and so on) managers might be rewarded for, and How (cash, shares) the rewards might be delivered.

What Managers could be Rewarded for- A Range of Different Dimensions

Dimension One - In Whose Interests are Top Managers Working?

There are many groups that may have an interest in the performance of quoted companies and their managers. Some are stronger in their influence than others - and therefore are likely to have a dominant effect on top managers priorities and therefore the design of their compensation packages.

Here are some of those interest groups

• 'Shareholders'

  Conventional wisdom has it that it is axiomatic that managers should run their businesses for the interests of their shareholders. As we have said many times, this almost invariably means institutional investors, ranging from pension fund investors to a plethora of others who use the monies entrusted to them to pursue a very wide spectrum of investment strategies - increasingly, the investment markets are becoming influenced by speculators such as Hedge Funds. Managers who try to satisfy all of these interests are likely to end up very confused!
  Despite this, these days, it is true to say that investors' interests are the dominant factor in determining managers' rewards and behaviour.

  However, there are obviously other stakeholders in whose interest companies could be run.

• Managers themselves

  In the old days, many years ago, the cry was that top managers were a generally unaccountable bunch that ran companies to suit their own interests. This was often true, and certainly did not foster high performance and competitiveness. The rise of 'shareholder' dominance, together with the development of a whole set of concepts and metrics to measure shareholder value creation has meant that managers can no longer get away with feathering their own nests.

  Or can they? It is certain that the top managers of many companies have, and still are, shaping their rewards to suit their own interests whilst proclaiming total commitment to shareholders. And the increasing interest in taking companies out of quoted markets and into the realm of private capital is rendered more attractive by the fact that it is often possible to amass fortunes that would be inconceivable in the publicly quoted domain.
  (See the piece on Rover cars on this website).

• Employees

  These days, it is very rare to hear that any quoted company might be run in the interests of its employees. Any management that was brave enough to admit this would pretty soon be in trouble with investors and the press!
  But, as we shall see, if the interests of employees and customers are strongly aligned, placing the employees' interests towards the top of the pyramid may be very sensible. Also, employees in knowledge occupations are beginning to take care of their own interests if companies will not, so companies that do not make themselves attractive to employees will lose out to those that do.

• Customers

  Research shows that the best companies place the satisfaction of customers needs at the top of their priorities, and align this with a clear focus on developing an organisation that is honed and dedicated to do this.
  However, this is really not of great interest to the bulk of investors, who are more interested in the short to medium term movements of companies' share prices.

• Society at large

  There is a growing interest in Corporate Social Responsibility and also in ethical investment strategies, and companies are falling over themselves to prove that they are good citizens. However, ask any top manager if their tenure and rewards come from being a good corporate citizen or satisfying the needs of investors and you are likely to get a funny look!

• Last, the Enterprise itself

  Jay Lorsch of Harvard Business School found that the managers of the best companies were concerned above all to hand on a stronger enterprise to their successors. That was their fundamental priority.
  These values are echoed by Bertrand Collomb, President of Lafarge SA, the world's largest construction materials company in a letter to the authors. (See the full text of his letter in the Wisdom and Wit Section of the Practise, Cases, Concepts and Ideas section of this website).
  Such a view is quite unfashionable in today's Anglo-Saxon investment circles.

How will Stakeholder Interests affect a Compensation Package?

To Encourage an Interest Primarily in the 'Shareholders' (Investors)

In this case, the most important element of reward is certain to be share-related (share options, restricted share awards or the like). Measures of success are likely to be - growth in the share price, earnings and dividends per share and related measures of shareholder value creation.
In some cases, the currency in which managers are paid may be cash, but the measures can still be share performance related, for example, cash awards for improving share price ranking relative to competitors.

Any of the above factors are likely to cause managers to be very concerned to please the financial markets. This tendency will be exaggerated if share options, which normally have a vesting date before which they cannot be exercised, can be cashed in if there is a change of control in the company.
(The investors in a company that is acquired will usually receive a premium price for their shares, so they are likely to vote for takeovers).

To Emphasize a Focus on Customer Satisfaction.

This is not normally a prime measure for determining top managers' rewards, but if it were so, the design of their packages would be very different.

First, the measures of success would be market, product, customer and competitor related. Such measures as market share, market penetration, customer acquisition and retention, the rate and success of new product development and introduction, the speed of product development and success at research and innovation would be the prime determinants of reward.

It is also likely that the makeup of the compensation package would be very different, with less emphasis on shares, more on base salary and longer term cash rewards, as building market positions is a long term business, and share prices are driven by many factors not related to the underlying performance of a particular business.

To emphasise a Focus on the Long-Term health of the Enterprise.

In this case, the compensation programme for top managers would be based on a 'balanced scorecard' of measures and:

• Have a long-term focus
• Probably emphasise high base pay, rather than elaborate or extensive bonus plans
• Concentrate on measures such as market and customer performance, levels and success of investment in innovation, research and development, as well as measures of efficiency.
• Emphasise long-term value creation as the prime measure of financial performance
• Encourage managers to focus on employee quality, motivation, retention, education and development
• Have a long term share performance element, such as share options with vesting periods of 5 years or more
• Focus on the build-up of wealth and value of benefits, such as bonus pools over long timescales. For example, having bonus deferral periods of 10 rather than 3 years, building up a 'pot' that can be accessed only if the company's performance is good over a long period.

The design of packages that are likely to have the opposite effect would include:

• Generous terminal pay packages that would be triggered by events such as change of control
• Share options that vest on change of control, often granted at the time of joining the company, along with other 'golden hello's'.
• Bonus packages that are very highly geared towards rewarding high (excessive) short-term financial performance
• Pensions that are significantly enhanced as a result of such events as a change of control

The authors once had a colleague who felt aggrieved at what he regarded as an unfair failure to promote him. As his package included generous change of control provisions, his highly vocal prayers for a takeover bid became irksome to his colleagues!

Dimension Two.

Timescales

A second fundamental element in all compensation packages is the time horizons that they encourage. We know that many investors work to rather short time scales, often driven by pension funds. We should also know that the natural rhythms of a large business occur over very long timescales - certainly not those driven by financial years and investors' quarterly league tables.

So, a fundamental question in the design of compensation programmes is the balance between short and long-term considerations, and which of these they predominantly encourage.

There are many views on what time horizons top managers should be working to. We would say that in most circumstances, short of acute crises, it is unlikely that those at the top of large and complex organisations will be able to see the full fruits of their labours in much less than 10 years. To those who demur, we would refer them to Jack Welsh of GE!

How will different Timescales affect a Compensation Package?

Compensation packages that encourage a short-term focus will tend to contain the following elements:

• Large annual bonuses, with a bonus opportunity of more than 50% of base pay
• 'Long-term' bonus plans, with payout periods of 3 years or less, with no deferral provisions
• Large tranches of shares or share options granted on joining or appointment, with no service qualification for grants.
• Share options that vest on change of control
• Performance measures that focus on annual profit or positions in shareholder value league tables computed on an annual basis
• Bonuses paid for completing tasks with a short-term orientation, like 'Appoint Chief Executive'.....(No mention of whether said CEO is appropriate and effective).

Compensation packages that will encourage a longer-term outlook will have a different composition:

• Less emphasis on annual bonuses, probably more on higher basic pay
• Long-term bonus plans, with time horizons of at least 5 years. Where bonuses are paid for short-term results, it is likely that a significant part of the bonus will be withheld for a further period, and enhanced if longer- term performance remains positive.
• Variable pay related to creating sustained value over a significant number of years. For example, one company paid bonus if cash returns exceeded the cost of capital employed over three years, then retained half the bonus and added it to or subtracted it from the bonus for the next 3 years, depending on the performance for that period.
• Share options or share grants that are progressively accumulated in small increments over a long time period
• Benefit packages that encourage service with the company.

Dimension Three.

Company Building or Transactional Management?

In a previous chapter, we made a distinction between transactional strategies, which are predominantly about buying, selling and shuffling assets, and company building, which is predominantly about investing from within to build a strong organisation and customer franchise. As we shall see, the design of compensation strategies can have a fundamental effect on whether managers are encouraged to be primarily business builders or deal doers.

How will Building or Transactions affect a Compensation Package?

It is likely that the sort of programme that will encourage company building will

• Have a long-term focus, for both share-related and cash rewards
• Be based on a 'Balanced Scorecard' of performance measures, including customer and employee development measures, as well as long-term financial Value Creation.
• Emphasise continuity of service and internal promotion
• Feature a long-term accrual of benefits such as pensions.

Readers might like to design their own programmes that would reward and encourage deal-making, transactional behaviours.
For starters, Sir Chris Gent of Vodafone was promised a bonus of £10 million for completing the acquisition of Mannesmann............no mention of whether the acquisition created or destroyed Value!

End-piece - Payment for What Results?

Few would disagree that managers ought to be rewarded for the results that they achieve. Most people would also agree that financial results should be a prime measure of performance.
But after this, we come to a positive minefield of complexity.
What are the best metrics by which to measure financial results? Should it be earnings, returns on capital, returns on sales, Value creation (exceeding the cost of capital invested in the business) - should the prime determinant be profit (capable of endless manipulation), cash generation, or what?
What timescales are we talking about? Annual, 3/5 year, longer than this, through an economic cycle, perhaps?

Or, perhaps we should focus more on the 'vital signs' that determine what the eventual financial outcomes will be. These could include customer acquisition and retention, margins from customers, the rate of innovation and product replacement. Or they could be success in R&D, creating new products or services quicker than the competition. Also, success in developing and retaining scarce skills could be the key to success in some businesses.

Compensation Programmes in the Real World.

In the next Chapter, we will describe the design and content of the compensation programmes for directors of FTSE 100 companies and speculate on the kinds of behaviours that they are likely to encourage and reward.