Executive pay is the most emotive of all corporate governance issues. “But people get caught up in the wrong debate,” according to Xavier Baeten. “Instead of focusing on ‘how much’, it’s better to question ‘how’ CEOs get paid, i.e. how their total remuneration package is structured and what proportion of it is variable.” Baeten Manager of the Centre for Excellence in Strategic Rewards, the Executive Remuneration Research Centre and the Compensation & Benefits Management Programme at Vlerick Leuven Gent Management School.
Most corporate governance codes tend to specify that at least part of executive remuneration should be performance-linked. Studies by Towers Watson and the Hay Group show significant geographical differences in remuneration structure, largely due to different governance contexts (see insets).
The 2009 report by ecoDa on executive pay reveals that the median cash remuneration of CEOs in the EU increased by 74% between 2003 and 2007, mainly due to short-term bonuses increasing. According to the same report, median annual bonuses as a percentage of total remuneration represented 77% in 2003, and 161% in 2007.
Xavier Baeten warns against what he calls over-incentivisation: “When the proportion of variable pay is a multiple of fixed pay or when it dominates targets, executives will focus disproportionately on what affects their variable pay and there’s an increased risk of misrepresentations and non-sustainable, i.e. short-term, behaviour.”
He points out that while long-term incentives (LTIs) should be linked to shareholder value creation in order to encourage long-term behaviour, vesting policies are often such that they drive short-term behaviour instead. This could be remedied by making LTIs subject to a retention period. “By the same token,” he says, “there’s nothing wrong with golden parachutes, provided they’re used as a risk premium, which should be reduced as the executive’s tenure increases.”
Remuneration committees should carefully evaluate how much weight they want to give to pay at risk (variable pay) to drive the right behaviour. A higher proportion of pay at risk may lead to a higher basic pay, as executives would want to be compensated for this risk.
The European Commission established its 2009 recommendations in response to “public outrage”. Xavier Baeten: “I believe in regulating decision-making, i.e. making the remuneration committee mandatory, imposing knowledge requirements on its members and requiring disclosure. I don’t believe in regulating the structure of executive remuneration. Yet that’s the area the regulators have recently started paying attention to, both in Belgium and abroad.”
He adds: “The danger of regulating executive pay structure is that it leads to box-ticking and thereby tends to ignore the strategic importance of executive remuneration as well as its link with corporate governance.”
Xavier Baeten is also involved in a PhD research project exploring the relationship between corporate governance and executive pay. The research considers the regulatory framework on the one hand and firm-level governance characteristics (composition of the board and the remuneration committee, shareholder structure) on the other. It also compares decision-making, executive remuneration structure and disclosure in four countries (Belgium, the Netherlands, France and Germany) in the light of the European Commission’s recommendations.
Important recommendations include bonus deferral and clawback, performance-related vesting of share-based remuneration and the limitation of severance payments. These recommendations have been interpreted quite differently by different member states. One case in point is the golden parachute. The Commission recommends a maximum of two years’ non-variable pay. The Belgian governance code (and the law) stipulates a maximum of 12 months’ basic and variable remuneration (18 months in the case of a motivated recommendation by the remuneration committee), whereas the French code provides for a maximum of two years’ fixed and variable remuneration.
What most codes do have in common is the fact that they acknowledge the importance of linking the bonuses to a multi-year horizon and including not only quantitative but also qualitative criteria, such as customer and employee satisfaction, sustainability, etc. In the field of decision-making and disclosure, member states differ most, due to local differences in legislation, corporate traditions and ownership structures.
Firm-level governance characteristics have a major impact on executive pay. Xavier Baeten: “By far the most important factor is ownership concentration, which has a negative effect on the level of executive remuneration as well as on the occurrence of golden parachutes and the level of share-based remuneration.”
Research shows that the composition of the board of directors directly influences remuneration levels and the proportion of LTIs (risk-based pay). These effects can be explained by so-called social influence processes of reciprocity, authority, and similarity and liking. Fees paid to board members, the number of external directorships of board members and the CEO having a longer tenure than board members all have an upward impact on the level of CEO remuneration, with the latter also encouraging a lower proportion of LTIs. Furthermore, the greater the demographic similarity between board members and CEO, the lower the proportion of LTIs.
The composition of the remuneration committee also has an impact on the remuneration structure: the longer the board tenure of the members, the greater their pay-performance sensitivity. Xavier Baeten: “This observation highlights the importance of a good mix of subject matter experts and people that have been serving on the board long enough to be able to say ‘no’.”
Xavier Baeten feels remuneration committees tend to focus on market rates, whereas they should pay more attention to the structure of the executive remuneration package, pay differentials within the company, and public opinion. The structure should be kept simple; anything too complex would fail to impact executive behaviour.
“I believe the biggest problem is that we still can’t manage to design remuneration packages that truly drive long-term value creation. Not surprisingly, that’s not the focus of the current social debate. It’s an extremely complex technical matter, which is why it’s all the more important to improve the competencies of the members of remuneration committees.”
Vlerick plans to develop a special training programme targeting members of remuneration committees.
Published on 20/09/2010
