Category Archives: Executive Reward

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June 23, 2015

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Banking pay, Executive Reward, HR, Pay Regulation, Reward, Reward Strategy

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Time, value and a bonus

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Introduction

I was at a City lunch in a conversation with a senior executive of an American bank and her partner, a gifted financial analyst.  We discussed the impact of bonus accrual accounting standards on balance sheets.  Then she made a startling statement.  “The accruals cost us millions, but the executives value their bonus at a fraction of its face value.”   We then spent two hours discussing that statement.

In both women’s eyes the issues are the trends in executive compensation to long deferral periods, bonuses held in stock and the potential value reduction through future downward adjustment and claw back. The issue for executives is economics 101.  A dollar has less value tomorrow than today and uncertainty over the number of tomorrow’s dollars reduce the value still further.  Yet, the increasing costs of executive incentives weigh heavy on the corporate balance sheet and in the eyes of the shareholder advocacy groups.

Pressures on bonus structures

The demand for longer bonus deferral periods reflects the perceived risk horizon of the impact of executive decisions.  The driver for deferral into stock is to increase executive alignment with shareholder interests.  Increasing conditionality around claw back of bonuses paid and value reduction of unvested payments is a reaction to executive misdemeanors.  All of these are worthy objectives – but they come with unintended consequences.

Impact

The cumulative impact of these changes is that the face value of the incentives becomes close to meaningless to the recipients.  Future value becomes unknowable.  Long deferral periods lead to great uncertainty as to value (the very basis of the Black Sholes calculation).  Stock value is heavily impacted by external events such as market crashes. Decisions made in good faith can, with several years’ hindsight; look wrong if not negligent, leading to high levels of management risk aversion.  The cash flows on which an executive has to base her future become smoke and mirrors.

Organisational penalties

The core of a reward strategy is to attract, retain and motivate.  If the recipient of a reward does not value the payment at the same level as the cost to the organisation, the strategy fails. Motivation and retention is reduced if lower value than the cost is attached to the award.  Yet, the balance sheet, P&L and share dilution have heavy organisational effects in both dollar and reputational terms.

The impact on the individual executive’s behavior is also meaningful.  Risk aversion becomes important to avoid penalty.  Capital protection rather that appreciation becomes a driver to reduce future uncertainty.  As we have seen in some labor markets, upward pressure on base salary and thus dollar certainty is increasing.

Unintended consequences – lose lose…

We are at a tipping point.  Remuneration costs are rising, for executives value is falling; external criticism is increasing rapidly as is remuneration regulation. There is a vicious circle of increasing face value to make future value meaningful; something of a tail chasing strategy. The system is broken.  Not yet beyond repair, but the longer the malaise festers the more painful the eventual solution.

A root and branch review is needed and needed now.  Executive compensation has always been complex and opaque.  Its death rattle is now being sounded – at least in its current form.  The reward profession needs to move contemplation from its navel to this vexed subject before it is too late; although what the alternatives are I shudder to contemplate.

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August 9, 2013

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Executive Reward, HR, Pay Regulation, Reward, Reward Strategy, Risk

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A time travelled reward strategy; Who?

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Introduction

I was listening to the excellent “Dr Who at the Proms” on the radio.  The music was evocative of different times and alien terrains.   A thought struck me; what would the reward landscape look like in ten years’ time? Two alternative possibilities collided in my mind: a sort of Matrix like choice of different futures, a red pill or a blue pill? These were:

  • A continuation of what had gone before with ever increasing inequality between high and low paid
  • A more equal, transparent approach with some convergence between the levels.

This article will be looking at the outcomes of these two scenarios and the different pressures that may lead to one or the other becoming the new reward reality.

Continuation of the status quo

A troika of forces support the status quo.

  • The self-interest and power of those who benefit from the current system
  • A lack of political will to make changes; perhaps connected to first point.
  • As the economy improves the supply and demand equation will reassert itself.

There is a large amount of vested interest in the status quo.  This is not only from the direct beneficiaries of high pay; but also from those who benefit indirectly.  The barrier between board rooms and politicians together with senior public servants has always been porous.   Politicians and public servants often move in to corporate board rooms following retirement from “public service”.  It may be argued that waiting for those who currently hold the levers of power to reduce their future earnings potential in the private sector is like turkeys voting for Christmas; unlikely to happen.

Although outside the parameters of this article there is some interesting research to be undertaken on the issues of power and ideology as they relate to the economics of reward.

Even when the global economy is in recession it is difficult to attract the right calibre of staff in to executive management positions.  Or, if we look at the highest paying sector (putting aside football players and those in the entertainment industry), in to investment banking.   Getting the right people in role can make a great difference to organisational and financial success. When Stephen Hester was unexpectedly removed as CEO of RBS, its share price fell by about 7%.   At the top levels it is a seller’s market, with, arguably, an increasing international dimension.  There is anecdotal evidence that top mangers’ prefer moving in to private equity where rewards are higher but less transparent.  Likewise the increasing, and in my view, mistaken, prescriptive approach by the USA, EU and regulators on financial services pay, has the potential to lead to a flight of talent to less regulated shores; much the same as we have seen in the past with corporate tax planning.  This means a race to the top for the best talent with organisations worried about falling behind their competitors; the stairway is to heaven for the high paid.

There are considerable forces of inertia to be overcome before we can travel to a more progressive pay landscape.

What will the status quo pay landscape look like?  I used some data from the excellent MM&K survey of executive pay to develop a model.  The current position in the UK FTSE 100 (the UK top 100 companies by capitalisation) is:

  • Average FTSE 100 CEO remuneration:       £4,516,474
  • Average FTSE employee pay:                       £        33,957
  • Ratio of employee to CEO pay                                    133

If we look at the last ten years, the average increase in CEO remuneration has been 5.8% and 3.9% for employees.  I build a Monte Carlo simulation (with a heroic assumption that the increases were normally distributed and appreciating that ten data points is not a good sample) that showed there was a 50% probability that the following would occur;

  • In 2022 average FTSE 100 CEO remuneration:        £7,972,054
  • In 2022 average FRSE employee pay:                       £      49,668
  • 2022 ratio of employee to CED    pay                                       161

So inequality between those at the top of the pay scale and those on the average wage would get progressively worse.  A “Hunger Games” scenario with a large population of lower paid supporting a small population of very high paid.

There is a counter argument to this approach.  As the Institute of Fiscal Studies reports:

“Income inequality in the UK fell sharply in 2010–11. The widely-used Gini coefficient fell from 0.36

to 0.34. This is the largest one-year fall since at least 1962, returning the Gini coefficient to below

its level in 1997–98. Although this reverses the increase in this measure of income inequality that

occurred under the previous Labour government, it still leaves it much higher than before the

substantial increases that occurred during the 1980s”.

Thus, income inequality is a moveable feast with volatility making it difficult to confirm a consistent trend given the constant transformations of the tax and social security structures.

A more equal, transparent approach with some convergence between the levels.

There are a number of important pressures that indicate that this is the more likely outcome; albeit occurring over a long period.  As Jon Terry of PwC, a globally recognised FS reward expert, notes they can be broken down in to three broad areas:

  • External pressures
    • Pressure from shareholders
    • Pressure from the regulators
    • Economics
    • Cultural pressures

External pressures

I had a very interesting conversation with Cliff Weight, another internationally recognised reward expert, from MM&K.  This was on the subject of the balance of power between shareholders and executive management.  It is my view that in the past shareholders were more relaxed about the quantum of pay. This is because they were making a good return on their equity.  That situation has now changed.  Return on equity has, in many sectors, reduced considerably.  At the same time the percentage being spent on executive remuneration has risen.  Shareholders are now taking a much more detailed interest in the balance between what they earn and what the “talent” gets paid as a percentage of revenue.

It is also worth mentioning the role, particularly in the US but increasingly in other countries, of the activities of shareholder advocacy groups such as Institutional Shareholder Services (ISS).  I am not a fan of their somewhat tick box approach; but I fully appreciate that they do an important job in highlighting what may be seen by some, as poor pay practice.  Institutional shareholders are increasingly (although perhaps wrongly) relying on the advice given by these organisations.  The pressure on pay is always downwards.

A similar downward pressure is beginning to be exerted by the regulators; albeit often accompanied by prescriptive, counterintuitive and sometimes downright stupid regulations. There is a good summary of the latest UK regime on remuneration reporting here.  A downward pressure on remuneration by regulators is a clear and present danger to the maintenance of the status quo.  Linked to this are the regulatory requirements, initially in financial services, but likely to move to other industries, to hold sufficient risk based capital to support operations in the event of black swans, unlikely but catastrophic events.   This reduces the risk capital that can be invested in higher risk; higher return activities, so, picking up the issue in the paragraph above, reducing the potential returns to shareholders.

Economics

There are two opposing economic pressures affecting this debate.  Shareholder returns are dropping, as discussed above.  There are structural changes taking place that indicate that we may never see a return to the fifteen per cent plus returns before the financial crisis.  If that is the case there is going to be considerable downward pressure on remuneration in order to ensure a more “equitable” division of return between capital providers and employees.  The counter argument is that if there is a return to high inflation (and that has a high possibility in my view) and good economic growth, there is the likelihood of higher relative returns, while the scramble for labour intensifies and earnings at the top of the ladder explode.

Currently the balance appears to be in favour of the economic constraints on equity return leading to downward pressure.  But, as previous booms and busts have shown little is impossible, even if very improbable.

Cultural pressures

This is the most interesting of the downward pressures on pay.  I discussed this issue extensively with Cliff and Jon.  There is a clear consensus between the three of us that there are strong undercurrents of social pressure to increase transparency and have a more equitable distribution of pay.

These pressures are coming from all levels and in some cases some unexpected directions.  We are currently seeing the senior executives of some large organisations preaching pay restraint and greater responsibility.  Although, as the recent CIPD report on “Rebuilding trust in the City” (of London) shows there is a long way to go and some leaders still work on the basis of do not do what I do, do as I say.  But, this apparent change by the changing leadership of some large organisations is an interesting trend.

It can also be argued that those currently coming in to the system or beginning the climb up the greasy pole of corporate life have a different approach to reward, work and life balance.  Perhaps there is something less of a drive for personal gain and more a realisation of the importance of social contribution; we can but hope.

I am unsure that issues of high pay have yet entered the popular consciousness; a bit like the zombies in “World War Z”; we know they are bad but we are not going to come across one in real life.  Very few people have even indirect experience of high pay either in an absolute or relative sense.  Thus, while there is a broad sense of moral outrage driven by an often misinformed media; there is a limited popular demand for restraint on high pay and even less of an understanding of labour market economics or the complex nature of senior reward.

Having said that, social pressures are leading to what Jon Terry described as a “noticeable shift” in attitude by those both at the top of the tree and those who are working their way up the branches.  It is not yet revolution but is most certainly evolution.

What is clear is that social pressure is building up a head of steam and will have, perhaps, a defining effect on the reward landscape a decade hence.

Conclusion

My travel in to the future of reward is complete.  The evidence supports the scenario that in ten years’ time we will have a more transparent, more equal, reward landscape.  It is also likely to be an extremely regulated environment, particularly for high pay.  The issue is that state intervention starts to look like pay policy and pay policy, as history has shown, seldom works and discourages an open market in reward with frequent unintended consequences.

Executive Directors, consultants, remuneration committees, regulators and last but not least, reward professionals must start to prepare themselves for the changes that are beginning to appear on the horizon of the reward landscape.  It must be acknowledged that the future seldom turns out the way we expect; but there are sufficient broad trends emerging to at least give a probability of a more equal approach on pay.  In some ways this becomes a self-fulfilling prophecy.  If we start to think and prepare for a more transparent and equal pay environment it is more likely to happen.

Acknowledgements

I would like to thank two globally recognised reward experts, Jon Terry of PwC and Cliff Weight of MM&K for sharing their insights on the subject with me.  However, all the views expressed in this article are mine alone.

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July 5, 2013

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Banking pay, Emerging Markets, Executive Reward, HR, Metrics, Reward, Reward Strategy, Strong analytics

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Rewarding Reward Podcast http://www.idavidson.podbean.com/

Ian Davidson Reward podcast

I have produced the fourth podcast in the series “Views over the City”  http://www.idavidson.podbean.com This podcast covers pay and reward issues on a global basis.  This podcast includes:

For more on Banking remuneration see: https://iandavidson.me/2013/06/12/rebuilding-trust-in-the-city-of-london/

“I was at a recent meeting in the City of London to launch the document “Focus on rebuilding trust in the City” a Chartered Institute of Personnel and Development (CIPD) survey of staff in financial services in the City of London on trust and their employment relationship”

For more on Executive pay https://iandavidson.me/2013/06/18/balance-of-power-executive-pay-and-shareholders/

“There is considerable controversy over levels of executive pay.  There are a multitude of stakeholders or would be stakeholders pugnaciously striving for influence.  Remuneration committees are supposed to control executive remuneration.  However, as the MM&K recent survey shows, FTSE CEO Remuneration increased, on average, by 10% in 2012.  Why are shareholders allowing this to happen?”

For more on strong analytics:

https://iandavidson.me/2013/05/30/strong-analytics-3/

“As a reward specialist I am asked questions like, what is our pay inflation going to be next year?  I used to go away, do research and say 2.4% – having used the historic average.  Of course it was never exactly 2.4% so my boss would turn round and say – “but Ian, you said it was going to be 2.4%, you’re fired”.  If asked the same question now, I respond with an answer; “there is a 50% probability that it will be 2.4%; but there is as 10% probability it could be 4%, so we should factor that in to our budget.”

My new reward podcast give a wide view over the reward landscape as well as a fascinating conversation with innovation guru and author Peter Cook.

http://www.idavidson.podbean.com

If you would like a guest blog post or to guest blog post on this influential reward blog please get in touch.

blog@mauritius.demon.co.uk

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July 2, 2013

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Executive Reward, Pay Regulation, Reward, Reward Strategy

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UK Government’s own goal pay farce

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Introduction

It is reported today that UK politicians are seeking to block a pay rise for themselves recommended by an independent body.  The IPSA, an independent body that acts as a policeman on MP’s pay and allowances is alleged to be recommending a pay increase of £10,000 per year for UK Members of Parliament.  The politicians are rumoured to be very concerned about how the public would view such a rise in the context of UK standards of living decreasing over the last ten years with average pay increases being well below the rate of inflation

Caught in the pay paradox

Politicians are facing exactly the same paradox as remuneration committees.  The expert, independent advice is that the CEO or CFO are underpaid against the market; but the remuneration committee knows that to give a large increase to the CEO to bring her up to market rates would be unacceptable.  Caught in the pay paradox. 

Not carrying out the recommendations risks MP’s falling further behind the market (is there a market for MP’s?), but granting the statistically justified increase would bring large amounts of unpopularity with the (voting) public.  I hear echoes in the Great Hall of Westminster of “We are all in this together” dying an unpleasant and messy death.

A touch of real life

It is just possible that politicians will begin to appreciate the very real challenges of remuneration committees as they struggle to balance the demands of a thriving market in executive talent with the environment created by the politicians and the media that consider any pay increase for executives as some form of inherent evil.

Endgame

How will this end up.  I would guess that some messy compromise will be reached that will further distort the “earnings” of UK politicians; which will please no one and still result in a further dilution of public trust in the institution of parliament.

Conclusion

The pay paradox has been recognised for some time.  There is no easy answer, if any answer at all.  Politicians have designed and built a rod for their own backs.  Remuneration Committees have the same issues before them in the current environment.  Although I think it is unlikely, let us hope that UK politicians get a better understanding of the pay paradox as a result of this unfortunate farce.
What do you think?

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June 18, 2013

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Banking pay, Executive Reward, HR, Reward, Reward communication, Reward Strategy

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Balance of power – Executive pay and shareholders

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Introduction

There is considerable controversy over levels of executive pay.  There are a multitude of stakeholders or would be stakeholders pugnaciously striving for influence.  Remuneration committees are supposed to control executive remuneration.  However, as the MM&K recent survey shows, FTSE CEO Remuneration increased, on average, by 10% in 2012.  Why are shareholders allowing this to happen?

Balance of power argument

I had a fascinating discussion with the executive pay guru Cliff Weight on the subject of the balance of power argument (although the discussion below is entirely mine) when looking at executive pay. 

The Executive’s power

Most of the time the executives hold the balance of power because:

  • Changes in executive board members, unless well managed, tends to lead to a fall in share price
  • Changes in senior management generally signals a failure of strategy or strategic uncertainties – which lead to a fall in share price
  • A lack of good succession planning by the Board so there is no immediate, obvious internal or external replacement.
  • A shortage of good candidates with the relevant experience and willingness to take high profile roles.  This tends to mean organisations can be without a CEO or Finance Director for six to nine months; which leads to a fall in share price.

No Board or Remuneration Committee wants to be seen to be acting in a way that damages shareholder returns. 

The Stephen Hester debacle

A good example of how NOT to carry out changes in senior management is shown by the apparent decision of the UK Treasury to replace Stephen Hester, the CEO of RBS.  The announcement seemed to take the markets by surprise – leading at one point to a 7% drop in RBS share price.  Further, the lack of any successor or allegedly any succession planning by HM Treasury means there is something of a leadership vacuum in RBS (even with their excellent senior management team) that causes great uncertainty to both investors and employees.  This, just at the point when RBS had turned around and had a clear and compelling vision of its mission and future.

The Shareholder’s power

Shareholders have limited power over executives; they have the upper hand mainly when:

  • There are downside earnings surprises
  • Takeover or mergers are under discussion
  • There is a strategy dislocation – a disruptive technology or social trend; look at Smartphones impact on the traditional phone manufactures
  • The market loses confidence in the management of an organisation

These tend to be seminal points in an organisation’s existence that hopefully do not occur too often.

Important issues for Remuneration Committees and Executive management

Both parties to pay discussions need to think about the balance of power issues and how they influence the reward dynamic.  Strategy needs to be owned and driven by the entire executive team; hopefully mitigating the effect of the departure of any executive.

Good management of shareholder relations and open communication will help reduce any share price “shocks” when changes do take place.  Good financial PR will again mitigate both the shock and share price impact.

The paradox of succession planning

One of the potential failings of Boards when considering the balance of power argument is succession planning.  In an ideal world a replacement for the CEO would have been identified and prepared for the new role well in advance of the change.  Unfortunately there is a paradox here.  A CEO could perceive that work by the Board to identify her successor was a signal of their imminent departure.  As invariably such issues leak, so the market would view it in much the same way.  Dammed if you do and dammed if you don’t.  There is also the issue that the heir apparent may become impatient with the wait and either go elsewhere or worse actively seek to undermine the existing CEO with the Board.

There is no easy or obvious answer to the succession paradox; but clearly it is an issue that must be taken on board in the balance of power debates.

Conclusion

The balance of power approach is a useful framework to view trends in executive pay.  I can see no immediate answer to how or even if, the balance of power should be more equally distributed.  Like any good explanatory framework, the balance of power debate asks more questions than it answers.

 

 

 

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May 30, 2013

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Strong analytics

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Introduction

The UK’s CIPD has published its annual reward survey. The CIPD reward survey; http://www.cipd.co.uk/hr-resources/survey-reports/reward-management-2013.aspx  

“Our findings show organisations responding to multiple contextual factors in their reward management choices.  Economic conditions continue to drive pay decisions for many. In the private sector, market competition and employee value are also key drivers, while in the public sector
more traditional forms of reward management prevail.”

The drivers of reward continue to be to attract talent and reward productive behavior.  I would argue that retention is less important that it used to be due to the lose labour market. The survey also looks at employee benefits; these can both support the social culture of a business and provide valuable, cost effective non cash engagement tools.

One key aspect that Charles Cotton, the CIPD Reward and Performance advisor, notes is that the reward profession is not particularly advanced in analyzing information in a way that is useful for the business.  Cotton goes on to note that

 

“Few employers are able to calculate the cost of their compensation and benefit programs, let alone be able to express this as a proportion of revenue, profit or economic value added.”
   

 

 

 

 

Strong Analytics

Reward and HR professionals have a number of tools to add value to the business case:

  • Strong analytics
  • Employee segmentation
  • Data visualisation

Our colleagues in Finance use KPI’s and key ratios to illustrate financial outcomes and we must do the same in reward. We must understand:

  • Key business segments and drivers
  • The timeframe – immediate, medium or long term, for the business strategies in those key segments
  • Key performers in those segments and responsible for those drivers

This information can drive our reward strategy.  By presenting appropriate strong analytics through data visualisation on the basis of appropriate segmentation gives a very powerful tool kit for us to work with and make recommendations to line management.

Asking the right questions

Any good analytical work and modelling starts with asking the right questions.  There is no point providing large amounts of statistical data and analysis without have a clear view of the questions we are using the data to answer.  This is a big issue with big data.  We have the data; but what do we use it to prove or disprove? 

Reward interventions must “do” something; be it reduce turnover, encourage managers to align with the interests of shareholders, or produce specific results.  Reward professionals must be able to show the outcomes of their products and programs.   For example, we must be able to show the relationship between our variable pay spend and the revenue generation, the return on capital employer (RoCE) and other key financial indicators.

Disclosure requirements

The “Say on Pay” requirements in the US and the regulations in the UK require the production of charts showing, for example, growth in relative total shareholder return against executive compensation.  We must extent this type of analysis through the organisation to show the stakeholders in the business; be they employees, executives, shareholders and regulators, that our reward program is progressive, does not reward failure and, as far as is possible, is “fair”.

I have argued in other blog posts that we are seeing the erosion of privacy around pay.  Within five years we will be reporting, as a minimum, on employees by bands of pay and more likely very detailed pay statistics on every employee in our organisation in the interests of “fairness” and transparency.

Strong Analytics II

There is little excuse for not providing strong analytics with appropriate data visualisation. Microsoft Excel provides some very good analytical and graphing tools and using the PowerPivot addin allows for the analysis of very large data sets and even the development of simple data cubes.  That is before we get in to many of the off-the-shelf compensation management tools and packages.

Here is an example of strong analytics presented through visualisation I produced from some sample data:

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The use of Microsoft Excel’s conditional formatting provides some intuitive “at a glance” analysis of bonus levels by department.  I thought about the type of questions the CEO might want to ask about the data and provided the answers in graphical and colour formats.

This second example shows a very simple graph of correlation between TSR and total remuneration for a FTSE 100 Executive.  It immediately shows the linkage between pay and performance; although TSR needs to be measured over a much longer time period, or alternatively normalised to remove the effects of the economic cycle, to provide a better analytic.

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Conclusion

As the CIPD survey noted, reward is, as always, becoming more complicated.  At the same time we are seeing far more scrutiny of pay by the largely uninformed politicians, regulators, shareholder advocacy groups and the media.  We must arm ourselves for this intrusion by preparing our toolkit of strong analytics to defend our positions and explain our philosophy.

 

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March 6, 2013

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More pay regulation – Doh!

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Photo copyright Ian Davidson Police and protesters outside the Bank of England

Introduction

I am spending a lot of time at the moment reviewing the various global approaches on remuneration regulation.  It suddenly struck me, in a Homer Simpson moment, to ask a basic question.  Does more remuneration regulation lead to better reward outcomes?  It turns out not.  In fact, regulation is a poor solution to a low level problem that will throw up more issues than it resolves.  The real reasons behind the regulatory assault appears to be more to do with political expediency and an easy target rather than resolving issues of market failure.

Few would argue that shareholders and remuneration committees are closer to the issues of executive remuneration than regulators and shareholder advocacy groups taking a generic tick box approach could ever be.  The regulations not only fail to discourage the behaviour that they believe, incorrectly, led to the financial crisis   but they are storing up problems for organisations over the next few years just when the focus should be on economic and organisational recovery.

Does regulation solve the problem?

Professor Ian Tonks of Bath University argues persuasively that statistically, pay performance sensitivity in banks is actually no higher than other sectors and overall is quite low.  The relatively small performance-related element of executive pay means that there is little evidence that executive compensation in the banking sector is dependent on short term financial performance.  He notes that as Conhon et at (2010) shows that the role of compensation in promoting excessive risk taking prior to the crisis was dwarfed by the roles of lose monetary policy, social housing policies and financial innovation – which of course falls largely under the very politicians and regulators that now endeavour to regulate on pay.      As Weight (2012) notes the key determinate of levels of executive pay is organisational size. 

So the evidence points to the fact that executive pay in banking had very little to do with market failure and thus regulating it will have a very limited, if any, impact on the probability of further market issues – as if the current LIBOR issues did not prove that fact with greater eloquence that this commentator could hope to achieve.

Does it work?

So does the regulation of pay work?  The answer is not really.  The CIPD submission to the UK Government’s banking inquiry showed that the issue is mostly around culture; a view greatly supported by the actions of the new CEO of Barclays who is attempting a massive transformation of the Bank’s culture in response to its multiple failings.  Reward is but one small part of a much bigger issue.  But the FSA in the UK, the FCIC in the US and the EU capital requirements directive all link remuneration structures to market failure; with surprisingly little robust evidence to support this assumption. 

In general the approach is to defer large parts of the bonus payment in to the future and also that a large part of the deferred portion must be paid in equity or similar instruments. The deferred part of the bonus is subject to malus and claw back.  What is worse is the EU proposal that bonuses be no more than one times base salary.

Potential outcomes

 

It is all downside for the employer

The most interesting and critical part of this analysis is what will the results of these limitations?  First of all the approach to limit bonus payments to one times salary.  At its most simple level it is going to mean large hikes in base salary.  We have already seen this occurring in response to regulators demands for a greater balance between fixed and variable remuneration.  For employers increasing fixed salary has a very large down side.  It massively increases fixed costs at the same time as the same regulators are demanding greater capital holdings – doh!  The benefit of having a flexible bonus system is that you can pay out when times are good and not pay when cash is tight.  In addition salary payments are not performance driven or risk adjusted; so you are undermining the very strategy on which the assumption of market failure is based.

This leads on to a second issue for employers that are closely linked to the first point.  If you defer large parts of the bonus over multiple years you are forcing employers to pay cash out when they may have much better uses for this resource – including building capital reserves or returning cash to shareholders.  Thus the regulations on pay are hampering the very important role of management in managing the cash resources of their business.  Oh, of course shareholder advocacy groups say do not dilute share capital – the regulators say pay bonuses in equity instruments – doh!

It is largely (but not completely) downside for the employee

The regulators seem to be ignoring two very important financial concepts when introducing regulations on pay; as are shareholder advocacy groups such as ISS when making similar demands on executive pay.  These are the time value of money and the fact that the risker the financial vehicle the more return it has to generate. (Although this is a double edged sword as we will see later).  A cash bonus of £500 today is worth more than £500 paid next year or the year after.  To give the equivalent in today’s money of £500 in two years’ time would mean paying out perhaps £535  – and that is using quite a modest discount rate.  You then say to your employee I promise to pay you £535 in two years’ time; BUT if we do not perform well, or if someone in the organisation misbehaves and we lose money we reserve the right to reduce or not to pay the bonus.  An intelligent employee will look at her organisation and what is happening in other organisations and say “well, I think there is a 10% chance each year over the next three years that I will lose my bonus”.  So the deferred bonus is not worth £500 to me in three years’ time; it is worth   £432.  So the employee can either accept a lower value, uncertain payment in the future or look to her employer to increase the bonus to make up the lower future value.  Not an ideal employee engagement scenario.

The double edged sword of equity

Regulators and shareholder advocacy groups are insisting that a large percentage of deferred bonuses are paid in equity or similar instruments such as cocos. (Broadly, conditional bonds).  For the employee this is a double edged sword.  On one side, equity levels can produce very good results.  For example, Goldman Sachs share price has had an annual increase of around 23% over the last three years.  So if your bonus was deferred in to stock it would have doubled over three and a half years with little or no effort by you.  For the regulators and the politicians this means that stock based bonus pay-outs have the possibility of being very much higher than originally forecast.  Not exactly the policy outcome that was hoped for.  The other side of the sword for employees is the uncertainty factor.  Goldman Sachs shares may have increased; but many organisations share prices will not have risen; or given share price volatility have a high probability of being at a lower level at the very point of vesting.  Uncertainty, as noted above, reduces value.  In the eyes of a rational employee a bonus deferred in to stock over say three years must be discounted to a much lower level that the actual value awarded. (Although the concept of “actual value” here is quite nebulous).  Some traders that I know have discounted future equity based deferred bonuses to close to zero due to the risk (and perhaps their own financial time horizons).   Thus the deferred bonus in to equity ceases to be a retention tool unless you have to be one of the lucky Goldman Sachs employees – but then you do not know if you are going to be in a job in three years….doh!

The other arguable point about deferring bonuses in to equity is that it actually increases risky behaviour.     Why?  A deferred bonus in equity cannot drop in value below zero for the employee so there is a limited downside.  However, if taking a business risk increases the probability of equity upside then there is no rational reason for an employee or a director for that matter, not to take that risk.  So, instead of regulators and politicians providing policy that reduces financial risk the current approach appears to increase the risk, reduce flexibility and increase fixed costs; not an ideal policy outcome with no clear winners and the potential for everyone to lose – doh!

Conclusion

The evidence points to the efforts by regulators to provide prescriptive regulation on pay and bonuses; particularly in the banking sector, to be deeply flawed.  They are trying to solve a problem which played only a small part in the near global market failure.   They would be better to focus on the more important issues of lose monetary policy, culture and poor financial regulation of complex financial instruments.  The pay regulations are counterproductive and have a high probability of not delivering the desired policy outcomes but making the situation worse and more risky than it was before – doh!

I believe the time is right for evidence based, principled regulation around high pay.  Not for any reasons to do with market failure but because we must at least start to take heed of the arguments around social justice while appreciating that in a demand driven market economy the concept of “fair pay” is, like Plato’s table, something of an unobtainable but delightful concept. 

 

 

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January 30, 2013

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Emerging Markets, Executive pay in emerging markets, Executive Reward, HR, Reward, Risk

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Executive Labour markets – the emerging markets story

Introduction

Many people will have been surprised by recent research that showed that executive pay in some areas of emerging markets are at or above the level of mature markets such as the USA and UK.  A study by the global management consultancy Hay Group shows, for example, that in 2011 the average total cash level for senior management was $154,847 in the USA compared with just over $150,000 in South Africa and $204,421 in the UAE.  While appreciating that emerging markets are not a homogenous group of countries; there is a clear trend of rapidly rising executive pay.  The drivers for these increases have been identified as high growth, high inflation and high demand.

This high growth in cost is accompanied by very high levels of geopolitical uncertainty that both adds upward pressure on packages but also means that careful consideration needs to be given to the nature and quantum of investments in a number of emerging market areas.  In more mature markets there are often unspoken assumptions about robust legal systems and continuing political legitimacy (although that is starting to be questionable).  Those are assumptions that need to be examined in the light of current events in a number of emerging market territories.    

It’s a humpty dumpty world

The changes in levels of reward in emerging markets turn traditional assumptions on pay on their heads.  We are seeing increasingly that higher pay is required in some emerging market countries than say the USA or France.  In addition to base pay many EM countries have a structure of large cash allowances for housing, cars, education and so on leading to a very rich cash package before LTIPS, options and the like are taken in to account.

In a phrase, the executive markets in emerging markets are hot.  This is similar to the conditions seen in the mature markets a few years ago.  As an example, senior executives moving jobs in China are likely to generate a salary premium of more than 30%.

New thinking is required.  It is no longer enough to treat EM remuneration as a subsidiary consideration to the parent market.  EM labour markets have their own dynamic which is much faster moving and fluid than we have seen in the west for many years.

The fuel on the executive race track

Most commentators such as Hay Group and CT Partners agree that there are three factors fuelling the explosion in remuneration:

  • High demand for executives in high growth countries and sectors
  • High inflation in some emerging markets together with stronger currencies
  • High growth in both sectors and countries in emerging markets

There is a high demand for senior executives in a number of emerging markets.  Asia Pac is a key example where for some time now demand has considerably outstripped supply.  Given that economic growth rates continue to look very healthy (and certainly when compared with very weak growth in a number of western economies). It is likely that pay levels will outstrip mature markets if that has not already happened.

Inflation adds to the fuel.  EmergingMarkets.org quote pay inflation in Venezuela at 29% and in Argentina at 24.5%.  Brazil and Mexico are likely to rises in excess of 5% – and that is just to stand still – not taking account of the high demand for experienced senior management in these areas. 

Concentrate on tactics rather than strategy

The fast moving and fluid nature of a number of emerging market labour segments means that it may not be possible to have a prescriptive approach.  Nimbleness is the order of the day; reacting slowly or inappropriately will simply mean losing talent to competitors, be they local start-ups seeking a piece of the pie or established national or international players.

CT Partners have suggested that it may be appropriate to treat some EM markets as start-ups and structure remuneration accordingly.  This will mean some innovative thinking.  Larger equity grants (perhaps using local equity market listings) or higher gearing than we are seeing in mature markets.  Yes, this will create internal equity issues – but, to mix a metaphor, if you want flesh in the game you are going to have to gamble the pot.

Differentiated approach

My view is that to compete in the hot markets a highly differentiated approach is required.  The focus must be on individual country and sector labour markets both in terms of the quantum of reward and in terms of the total reward framework reflecting the innovations and retention products of that particular market.

Retention is very important and, given “transfer” premium costs, much more economic than recruitment.  I return once again to the concept of treating some emerging market countries as “start-up” territories.  This may mean offering equity or equity like vehicles with a mixture of time and performance vesting; weighted towards time vesting with steep steps at each annual anniversary.

Affordability

A cost benefit analysis should show that the potential revenue from emerging markets, with their relatively rapid growth in GDP and the expansion of a consumer orientated middle class should provide the revenue to fund the higher levels of executive remuneration that emerging markets are now demanding.  However, there is a fly in the ointment – the risks.

Risks

As Doctor Robert Davis the leading global strategy advisor notes, “We are on the edge of a major revolution in how the world is organised.”  This applies very much to the world of emerging markets.  The Arab spring, it may be argued, it just the start of fundamental change in the region. (Pun intended)  Also of note is the continuing rise of nationalism in certain EM countries that will also lead to a new understanding of geopolitics not just in Asia but across the globe.     Dr Davis goes on to note some major geopolitical risks:

• Social cohesion in Europe
• Rising nationalism in Asia
• Conflict (1), not in military terms, but in terms of the emergence of economic imperialism
• Conflict (2), in military terms, as the hypothesis that the world is becoming a safer place needs to be tested. The South China Sea and Iran head up the list
• the impact of NATO’s scheduled withdrawal from Afghanistan
• Emerging indications of a rejection of consumerism
• Unfolding events in the Middle East particularly pathways to or away from democracy, the robustness of current geographic borders and the emergence of theocracy.

Executive labour markets are going to be impacted strongly by these issues so we have to contend not only with high demand but high uncertainty.  This means HR and reward in particular are going to have to develop a competency in the analysis of geopolitical structures, risks and themes if we are to protect our organizations from unexpected shocks and Black Swans.  This will mean a different approach to termination clauses as well as considerations within EM packages of security and evacuation – as recent events in Mali have demonstrated.  This uncertainty and current events can only lead to further upwards pressures on packages as well as the factors identified above.

Conclusion

The rapidly increasing costs of employing senior executives in emerging markets are a vital consideration when undertaking business in these areas.  It is important to be both nimble and innovative to stand a chance of competing.  Competitive advantage is possible but difficult.  The changes in these labour markets must lead to a challenge on existing assumptions of what is “fair” and appropriate in a rapid changing and fluid environment.  Taking account of what is happening in each country and sector; both in terms of quantum and design is essential; albeit leading to the possibility of highly contextualised and fragmented approaches rather than a centrally driven strategy.

The other side of the coin for executive employment in emerging markets is the very high level of risk and uncertainty.  The interaction and correlation between the factors noted by Dr Davis above are likely to bring many downside surprises over the next twelve months.  This reinforces the need for nimbleness as well as having appropriate exit strategies (both in a physical and organisational sense) as well as robust business continuity arrangements.

One could use the simile of the old Wild West frontier; there are many risks and dangers but the potential for high rewards means that not being in this game is, in itself, a major business risk.  You pays your money (mostly to senior executives) and you takes your choice.

There is a supporting info graphic for this blog at http://prezi.com/_iiuwhlufol1/executive-labour-markets-the-emerging-market-story/

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January 23, 2013

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Visualisation of reward risks – the appetite for risk

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Introduction

The profile of reward and the risks it runs can hardly be higher.  Just in the last few days we have seen media headlines about alleged million pound plus salary overpayments in an NHS trust to further issues around votes on remuneration reports, for example the report in the Telegraph of Imperial Tobacco facing investor revolt over its bonus revamp.

These risks include operational reward risks (an often overlooked area) such as making sure that payrolls are run accurately with appropriate tax accounting and payments through to communications between remuneration committees and the shareholder advocacy groups such as, in the UK, the ABI or in the US ISS.

Risk is part of business operations.  What is important, if not essential, is to measure and manage those risks in a systematic framework.    This allows us reward professionals to discuss risk issues confidently with the business, our colleagues in external and internal audit as well as the regulators.  A systematic process allows us to define and agree our risk appetite with our organisations and reduces (although will never abolish) surprises from our reward activity.  I am a great believer in two philosophic approaches.  One is that we always underestimate the frequency and impact of random events.  The recent best seller “Thinking fast and slow” by Kahbneman is a fascinating book on these issues. Likewise, we will always be subject to “black swans” the disruptive large scale random event that no one was expecting.

An overall approach to reward risk

Rosario Longo has published a very good blog “Risk and Reward Risk Management” which gives an excellent overview and structure for looking at reward management risk.   He identifies the key stages and stakeholders in the analysis of risk – mostly from an operational reward risk perspective but the approach is also applicable to the wider questions of strategy, executive remuneration and so on.

His approach on risk measurement and evaluation is very similar to an approach I developed that allows the use of a relatively simple Microsoft Excel spread sheet to generate a visualisation of risk scores in an organisation.  Rosario makes the excellent point that risk scores and measurements are not absolute numbers but an expression of relativity in relation to the known reward risks that organisations may face.

The visualisation approach

It must be recognised that my approach is essentially a sub-set of the type of systematic approach that Rosario has suggested.  Much of the data feeding in to my spread sheet will have been collected by the methods and collaborations suggested by him.  I would add that much of the generation of indicators in my approach are a result of the implicit knowledge of the person drawing up the risks and metrics.  An experienced reward professional will know where the key choke points in reward operations lie and what issues tend to occur during bonus planning and reward processes.

First step: the listing of reward risks

There are a number of approaches to listing the risks in reward.  I like to use a systematic approach by looking at the individual reward processes and then considering the risks attached to each process.  When I last carried out a process like this I came out with a list of over 300 risks.  Here are some examples of reward risks:

Lack of   understanding by senior management of the reward process

Issues   with Regulators over reward

Levels   of base salary insufficient to recruit

US   Benefit structure not appropriate for culture

Vendor   costs not being controlled

Communications   with employees insufficient

Remco has insufficient market data

Table 1 Examples of reward risks

It would be good practice to collaborate on the list with stakeholders such as Remco, HR business partners, the Finance and Audit departments etc to get their views on what they see as reward risks.

The list of reward risks is not static; it will change with time and such issues as changes in legislation, tax, reporting requirements, code changes and so on. A quarterly review of the list would be a good starting point. 

Some organisations run risk databases; such as Operational Risk departments – or may even have access to external risk databases.  All of these are good sources of intelligence on risk in reward.

Once we have a list of risks we more on to the next stage of probability.

Second step: listing probabilities

This is the most difficult stage of the process.  In the vast majority of cases we look to our (and other) organisational history to see what has “gone wrong” or “needs improvement” in the past.  In addition we must also scan events to look for issues that have occurred in other organisations, either in our sector or elsewhere.  Again, access to an external risk databases is a good way of keeping up with risk issues.  Advisors can also be a good source of advice around incipient risks.

At the end of the day risk is largely down to individual judgement.  Unless you have risks with a high frequency which allows mathematical modelling such as Monte Carlo simulations then you have to make an informed judgement call on the probability of risk based on history.  However, as investment advisors are keen to point out, past performance is no predictor for future results”.  Also any risk listing will be specific to the organisation to which it relates – it is all about context.

My model uses a risk weighting of 1 to 10.  Where a rating of one is highly improbable and ten is certain.    Once again, the rating is not static.  Risk probabilities change over time, so the probabilities must be reviewed frequently to ensure we are capturing as many of the issues as possible with their shifting probabilities. 

I am sure that statisticians or actuaries would have much more sophisticated approaches to this process; but I have designed the approach so that HR and reward professionals have a basic framework to start their risk mapping, if you have access to more sophisticated approaches then do use them.

It is important, from a methodological standpoint, not to read false accuracy in to the risk probability approach.  At the end of the process we are looking at the relative levels of risk in our organisation to give some focus as to where we should concentrate resources; not a forecasting tool.

 Third step: listing impact

This is perhaps easier than listing probabilities.  Again we use a simple 1-10 scale where one indicates no impact to ten – the end of life as we know it.  What we are looking at here is what impact would the risk have on our organisation?  For example, would incorrect tax payments on employee remuneration lead to reputational and financial damage?  Would not paying our R&D staff insufficiently result in them leaving with long term damage to our research effort?   Again, we are looking at an estimate of impact, ranging from some minor inconvenience to putting the existence of the organisation at risk.  As an example of this we have seen some companies run in to very serious financial problems in the UK as they had not fully considered the risks they were taking with their final salary pension schemes and the funding requirements nearly bankrupted them.

Another story around impact and probability.  When working in the City I was advised to carry an emergency gas mask.  I questioned the advice.  It was pointed out to me that the probability of a terrorist gas attack in the City was small (although perhaps higher now than in the past), the probability of being on an over ground or underground train catching fire and filling with smoke was considerably higher – but still low.  However, the impact of either of these events was a ten.  So while I hope I never have to use the mask, it only takes one occurrence of the above and me to have the mask to save my life.  We do tend to underestimate low probability, high impact events; as a former scout leader, “be prepared” it a good motto for reward risk as well as scouting.

At this stage we have a list of risks, a listing of probability against each risk and a score for the potential impact of the risk.

Forth step: Risk correlation multiplier

My initial model of risk in reward did not contain a risk correlation multiplier.  However, I have come to the conclusion that difficult as it is, consideration has to be given to this issue.  What is a risk correlation multiplier?  Simply put, if a risk occurs how likely is it that the risk will cause an increase in another risk factor.  Taking a simple example of payroll.  The risk is that we are not paying our employees correctly.  There is a correlation (and I am not strictly talking of statistical correlation here) between not paying employees correctly and not paying the correct statutory deductions in the relevant country.  What I have done is added a correlation multiplier to the score for the risk of not paying employees correctly to reflect it will increase risk in other areas.  If you pay employees in different countries, perhaps on split contracts, the issue of where payment is made, where, and how much tax is due and the implications of getting it wrong, impact on a number of other risks and pose a real operational threat.

Once again we are in the world of estimates.  The more statistically aware will see I am multiplying estimates by estimates by estimates; giving a number which arguably has no real meaning.  However, as noted above we are not looking for an arithmetical answer but relativities of risk in our organisation to allow us to focus resources in the most effective way possible.

We are nearly at the end of the process…

Fifth step: Generate the risk score

This is simply the product of the probability, impact and risk correlation multiplier.  The risk score is a single number that allows us to rank our scores and see where the highest risks in our environment appear to exist.  

Final step: mapping the risk

As figure one above shows, it is possible to produce a useful graphic that shows where are key risks are concentrated.  This is really beneficial when talking to stakeholders, who may not need the detail of the process, but allows them to focus in on the key risk factors. 

Clearly if you have 300 risks, mapping them like this will not work.  In that case it is easy to return to our original process map of reward and use this approach to map risk against each process with an overall map showing a cumulative risk for each process in our reward product stable.  Once again individual circumstances and trial and error will lead us to a process that is optimal for us and our organisation.

Managing the risks

Once we have the information on the likely risks in our reward environment we need to consider how to manage them.  In my model I use a column called “mitigation”.  That is what we can do to reduce the risk.  It may be, for example, that we review the risk with an external advisor or with our Finance department to see how the risk can be reduced.  Linked to this is the next column which I have called “Controls”.  So, for example, if we are concerned about inappropriate payments being made from payroll we can have four eyes, or even six eyes sign off on non-regular payments.  Or, perhaps mandate a random sampling and checking of the payroll.  Again, our colleagues in external and internal audit can be of great help in designing controls on our key risk areas. 

Having appropriate key performance indicators is one approach to managing risk matrix issues.  We need to know and measure before we can attempt to control.   It is not possible to attach KPI’s to every reward process; but there are many that we can.  For example, we can look at attrition statistics, together with leaver interviews to deduct if pay levels are an issue and track this over time.  Payroll and pension payment errors are easy to use for KPI’s.

Many years ago when I worked for Ford Motor Company, everyone in the business, over a certain level or employed in certain key areas were required to undertake a course in statistical process control (SPC).  I suspect this may be a little old fashioned these days; but I found it a very useful way to look at error occurrences and decide if they were random issues or there was an underlying systematic problem that needed to be addressed.  KPI’s and SPC taken together are very powerful tools for spotting issues before they become (or as they become) problems.  Every organisation will have their way of managing risk, but having an organised systematic approach, from the very simple to the very sophisticated is a very good way to start on the risk management journey.

For me, the final part of the risk management mapping is identifying the risk owner.  Who has responsibility for the process in which there are risks?  This helps focus our attention on the whom as well as the what of stakeholder risk management.

Risk appetite

One of the other important outputs from risk mapping is to agree with management the risk appetite of an organisation.  What risks within the matrix are acceptable and which are unacceptable.  Risk is part of business and the costs of mistakes are again part of the cost of business.  The question arises as to how much cost (including indirect cost such as reputational damage) is an organisation prepared to “allow”?  What risks are completely unacceptable and need to be completely removed if that is possible or a willingness to spend more or less on mitigation of risk.  This is an area where a risk mapping in reward can add real value to a business.

Conclusion

The mapping of risk in reward is a key process.  It gives some comfort to management, auditors and regulators that we are aware of the risks of our activities and the steps we have taken to measure, control and mitigate as appropriate. 

The two frameworks, from Rosario Longo and my spread sheet based approach provide a very useful toolkit for a systematic approach to risk in reward and at least forms the basis for a comprehensive risk structure.

Risk mapping adds value to our activities and processes for the business as it both prevents unnecessary costs and contributes in a very positive way to the governance of our organisation.

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January 9, 2013

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Book Review: “Directors’ Remuneration Handbook” by Cliff Weight

Directors’ pay is a highly complex area with a multitude of rules, regulations and codes of practice; and that is only in the UK.  “Directors’ Remuneration Handbook” is an outstanding reference book and guide to this area.  It deals in concise terms with issues such as reward theory and practice, strategy, design and the host of issues including stakeholders,  pay paradoxes, topical discussions, relevant codes and statutory regulations around the subject.

It is a weighty book with 52 chapters and the same number of tables. The book index runs to nearly thirty pages.  While it is aimed very much at the UK market it has some very useful commentary on US and other jurisdiction’s’ practice.  Cliff Weight is very aware of his target audience of reward specialists, Non-Executive directors, company secretaries, academics and those with a detailed interest in this topical subject.  He moves from the general to detailed technical discussion, such as issues around using Monte Carlo simulations for share option pricing, in an easy to follow way, without being dry and dusty.

The chapter layout is clear and logical allowing readers to dip in and out of the topics that are of interest.  The executive summary at the beginning of the book is, in my view, a “must read” for anyone who wants to get an understanding of the paradoxes and issues within the world of executive pay.  It discusses, among other things, the Principal Agent problem in a very clear way, the issues caused by the differences in time horizons between CEO’s who have a median service of four years; and the vastly different perspectives of long-term shareholders and other key considerations.  The summary also includes seven suggested remuneration strategies depending on where the company is in its lifecycle.

There is a fascinating discussion on the difficulty of measuring short term company performance for executives – particularly when looking at share price movement.  Weight points out the difficulty of using TSR as a pay performance measure over the short-term.  He also touches on tax issues; an important consideration given all the tinkering with the tax system we have seen over the last few years.  He wisely points out that we should not allow director’s pay strategy to be driven by tax considerations.

The bulk of the book focuses on all the issues that impact Director’s remuneration including some useful checklists.  He also discusses in detail the different shareholder approaches to pay and my own personal area of concern, the influence of shareholder advocacy groups.  One of the strong themes in the book is the importance of good communication with and between stakeholders, including management, REMCO, advisors, shareholder advocates, regulators and so on.

The book also contains a wealth of data on the UK directors’ remuneration landscape.  There are many helpful tables in the book; although some are a little unclear – at least without a magnifying glass – but this should not detract from this book being a key reference work and probably the definitive volume on the subject.

This is not a cheap book retailing at over seventy pounds.  However, as a private buyer and compensation and benefits specialist I thought it was worth every penny, my copy is already well-thumbed and notated.

I would highly recommend this book to anyone who has a professional or serious interest in the subject of Directors’ remuneration.

The book is published by Bloomsbury Professional and is available from Amazon (for example) at £70.74.  ISBN 978-1-84766-888-2.