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.

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.

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

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.

 

 

 

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. 

 

 

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/

Reward and Rock and Roll

ImageWhat are the similarities between reward and rock and roll?  At first glance not very much.  But the pending publication of Peter Cook’s new book “The music of business” got me thinking.  I first came across Peter when I undertook the creativity and innovation module of my MBA.  He was leading an improvised jam session to demonstrate the application of techniques of innovation and creativity.  I have, and still do, find his approach to business strategy meaningful, impactful and most of all, fun. 

Peter Cook is a polymath.  An unusual man who straddles several different “worlds” and not only brings them together but is able to translate and communicate the lessons from one field in to other fields of his expertise.  He is a gifted musician, educator consultant and social media expert.  A real renaissance man.

What has this to do with the world of reward?  There are many lessons from the world of rock and roll that could be applied in reward (albeit at a somewhat lower volume).  If we take creativity and innovation we see the examples of David Bowie and Kylie Minogue who constantly reinvent their persona to meet current tastes and trends.  We in reward need to constantly reinvent our products, communications and approaches to meet the demands of our challenging client base not to mention the changing agendas of regulators and rule makers.

To me, a large part of reward is the communication of our message.  Rock stars (or perhaps their management) are masters at segmenting their audience and thus their customers by all the normal demographics such as age and country. They then communicate short, impactful messages about the products they have produced to sell to their chosen demographic. We also need to segment our client base so we can provide meaningful products and messages to get the best bang for our buck.  I use the Prato rule – 80% of our impact will come from 20% of our communication.  Getting that 20% right will make the difference in our reward space between success and failure.

Leadership is another key area in which Peter is a specialist.  The lessons in product, strategy and marketing leadership in the face of changing environments, technologies and fashions by the rock industry (look at the move from CD’s to MP3’s)  can be usefully and creativity learned and applied to our own fields.  I have written before on how social media is going to not only change the way we communicate our message but will change the very products that we offer our clients.

I am a strong believer in using creativity in my reward work.  Part of creativity is being willing to move outside our comfort zone, outside our normal models of thinking and open ourselves to the unexpected.  Peter Cook’s new book and his general approach is about exactly that.  It is about moving outside the normal MBA approaches to business and to look to other industries and ways of doing business to allow us to think creativity about both our day to day activities but also about wider issues of strategy formulation – and perhaps to do it in a fun and interesting way.   Now where did I put my Stratocaster?