The debate appears to be shifting on executive pay in some jurisdictions. In-House Perspective explores the factors behind how executive pay is calculated and what it means for companies.

Julia Hoggett, Chief Executive Officer (CEO) of the London Stock Exchange, called last year for a ‘big tent’ conversation on the approach to executive compensation in the UK. She argued that UK-listed companies can’t attract and retain talent because proxy agencies and some asset managers vote against UK pay packages while approving similar renumeration in other jurisdictions, notably the US. This inconsistent approach, she argued, means UK companies aren’t competing on a level playing field.

Some UK-listed companies have recently expressed frustration at their perceived inability to compete with US-listed companies on pay. As a result, the tone of the debate on pay in the UK has shifted – there’s signs that investors in UK companies are becoming more open to pay packages influenced by US practices.

Structuring pay

The fundamental elements of executive pay are base salary and both a short-term incentive and a long-term plan. A base salary may include private medical care, pensions, an allowance for a car and life cover.

Annual bonus is part of overall incentive pay and tends to be linked to profitability. In many cases, between 20 and 25 per cent of annual bonus is linked to individual performance targets. These could be financial or qualitative and are linked to the responsibilities of the specific role. In the UK, it’s quite common for a proportion of a bonus to be deferred if it’s above a certain level, usually for three years. The amount is converted into shares and paid out at the end of the deferral period.

The biggest difference between the UK and the US approach to executive pay relates to long-term incentives. Long term incentive plans (LTIPs) are made up of share plans and are usually the largest element of an executive pay package. In the UK, LTIPs have traditionally comprised performance share units (PSUs), which vest after three years subject to continual employment and meeting certain performance targets. The shares are often held for two further years before they can be sold, known as a post-vesting holding period. This approach is favoured by the majority of FTSE 350 companies.

In the US, LTIPs tend to be a combination of PSUs and restricted share or stock units (RSUs), sometimes known as a hybrid plan. RSUs are guaranteed to vest after a set period of time, as long as the executive remains in position. They might include minimal performance criteria, but these wouldn’t be as stretching as in a PSU. Because payment is more certain, the amount that’s offered may be reduced.

RSUs focus on retention and reward loyalty, especially in difficult times. Phil Linnard, a partner at Slaughter and May in London, explains that ‘if you stick around in a difficult environment, you know you might get a degree of additional variable pay’. Hybrid plans also offer comparability of pay between the US and the UK.

Deb Lifshey, a managing director at Pearl Meyer, a US-based executive compensation consultancy, says that in the US, RSUs are used to provide some stability to the overall plan. She says that recently in her country, proxy advisers have driven a focus on PSUs in LTIPs, saying they should constitute more than 50 per cent of the plan. However, this year, one proxy adviser has proposed eliminating that rule and introducing either longer-term RSUs or units with a post-vesting holding period. Lifshey says one downside of PSUs is that they sometimes pay out above target for performance, resulting in outsized payments where a recipient wasn’t exceptional. Or, on the other hand, if a PSU doesn’t pay out at all, companies can struggle to find other ways to compensate an executive.  

Historically, shareholders of UK listed companies have voted against hybrid LTIPs at annual general meetings (AGMs). Paul Norris, Senior Partner at MM&K, a UK-based consultancy offering executive remuneration advice, explains this is partly because they ‘shift the cost base of compensation from the company to its shareholders’. However, the mood in the UK is changing and some hybrid plans proposed by listed companies have recently been approved by their shareholders.

David Tuch, a managing director with the Executive Compensation Services of Alvarez & Marsal’s Tax practice in London, argues the UK has been more influential on the structure of pay than on the amount. He says other countries are adopting similar practices to those used in the UK, such as a two-year post-vesting holding period.

According to Tuch, in Europe, freedom of movement means ‘there really is a European market for senior talent. You can’t pay less in one country if you want to be able to recruit the top talent’. He adds that over the last five to ten years there has been a degree of levelling up on remuneration across Europe.

Retention and other considerations

Many companies say their high-value executive pay packages are important for attracting and retaining the most senior talent. These businesses may need to compete with those from other jurisdictions or, for listed companies, they might want to retain talent attracted by higher rates of pay in private equity, where there’s also less disclosure and therefore reduced scrutiny.

Lifshey says that ‘ultimately, the success of your company depends on the retention of critical staff’. While not advocating for outsized pay, she argues the CEO’s job in particular can be all-consuming and extremely demanding. As such, a company will ‘want to make sure that if [its] shareholders are doing well, [its] CEO is doing well’. In the US, a CEO is often paid significantly more than other senior executives.

According to Bernadette Young, a director at advisers Indigo Independent Governance, a ratchet effect can happen when pay is compared across similar businesses because executives ‘want to be seen as at least as highly valued as their peers’ and therefore want their pay to increase in line with what others are paid. She adds that ‘remuneration committees can be under quite a lot of intense pressure to increase pay and to be more innovative about how they incentivise performance through pay’.

Linnard says the amount of pay needed to attract and retain senior talent depends on what the executive could get elsewhere. He says that’s why institutional investors focus on asking companies to justify their plans based on who they’re hiring and where their market is.

After significant increases in executive pay in the UK between 2000 and 2010, over the last ten years ‘CEO pay in the FTSE100 has not increased at all,’ highlights Tuch. This is partly because investors objected to the practice of increasing CEO base salaries by more than those of the rest of the workforce. Consequently, rises in CEO base salaries were pegged against increases elsewhere in the company. Tuch adds that during the recent period of high inflation, many companies increased executive base pay at a lower rate than for the broader workforce. This reduced the gap between the two levels of pay to an extent, but the difference is still significant.

Young argues that ‘shareholders aren’t giving away value for nothing. They will give away a share of the uplift if they think it’s been earned by outstanding performance’ that creates additional value for them and success for the company. She adds that, in most cases, that value should filter down to other stakeholders, such as employees and suppliers, whose contribution to organisational success should also be recognised.

Tuch says that pay packages don’t always act as a retention tool. When a CEO moves to another company, for example, any outstanding pay awards will probably lapse at the company they’ve left and be replaced by the company they’ve joined.

Karine Audouze, Co-Chair of the IBA Diversity and Equality Law Committee, says higher levels of pay play an important role in attracting executives, ‘but they are not always sufficient to retain them’. Audouze, who's also a partner at Watson Farley & Williams in Paris, believes a well-balanced package is important for retaining executives. That could include performance incentives such as bonus payments, professional development opportunities, a strong corporate culture that fosters transparency, respect and work-life balance, and long-term compensation schemes.

Luke Hildyard is Director of the High Pay Centre in the UK, an independent think tank with a particular interest in top pay. He argues that the senior talent pool doesn’t have to be as limited as companies say it is. Hildyard believes ‘the idea that you have to pay that much to get a capable person is slightly dismissive of the capabilities or potential capabilities of 99 per cent of the population’.

Hildyard says companies could develop a talent pipeline within the business to widen the pool of available senior executives, allowing them to have more control over who they hire and how much they have to pay to attract and retain talent. Hildyard also suggests that if companies were able to pay their top executives slightly less, it may enable them to raise the wages of their lowest paid staff, who are struggling in the current cost of living crisis.

He argues that if the wider workforce were more involved in corporate governance structures, with stronger trade union rights and a voice at board and senior management level, corporate culture would change, and boards would be more conscious of inequality and the financial challenges some of the workforce face. ‘That would incrementally progress us to pay levels that [the public] would consider more reasonable,’ he says.

In the UK, the disparity in pay between the country’s listed companies and those listed in the US has come to dominate discussions about executive remuneration. ‘US senior executives simply get paid more than they do in the UK,’ says Linnard. ‘Their companies are bigger and they can afford to pay more.’ He adds that shareholders in US-listed companies have also been more tolerant over time of larger pay packages.

UK companies whose overall business is in direct competition with peers in America are the most likely to feel they’re at a disadvantage when competing for executive talent. They may generate a large amount of revenue in the US, for example, or some or all of their senior executives may be based there. These companies can make the strongest case for paying their executives in line with US counterparts and have been the focus of the debate over differences in pay. However, not all UK businesses are in this position. Those that don’t compete with US companies for talent may be less able to justify raising executive pay.

Shareholder engagement

For Norris, the amount of pay isn’t the issue, it’s ‘the way it’s structured and the flexibility to deliver it in a way that’s right for the business’. Fundamentally, commentators agree, executive pay practices should be aligned with the overall strategy of the business. Companies and their remuneration committees should feel confident to put forward their case for structuring pay in a particular way, or for paying a certain amount, when they can demonstrate how doing so aligns with the overall strategy and culture of the business, and how it helps to create value for shareholders. This is the approach regulators want to see, according to many commentators.

However, in practice the approach to pay has become standardised. This is largely because companies and their directors can be wary of their investors voting against pay proposals at an AGM. Consequently, it feels safer to take an approach that investors and proxy advisory agencies will probably support. Institutional investors with a stake in UK companies have traditionally resisted innovations in pay practices, for example including more RSUs in LTIPs – making companies hesitant to propose these sorts of structures.

In the UK, taking this approach can run counter to the comply or explain principle that’s the foundation of its corporate governance regime. ‘To make comply or explain work efficiently, effectively, requires a dialogue,’ says Norris, ‘engagement between companies and their investors.’ This dialogue isn’t always as effective as it could be. Resources and time are limited both at companies and for asset managers, and consequently their dependence on the guidance and voting recommendations of proxy advisers has grown. While proxy advisers offer a valuable service, some argue that overreliance on them means companies take a formulaic approach that stifles innovation.

Lifshey says proxy advisers ‘are issuing guidelines that are one size fits all and no two companies are alike, and it really is counter intuitive with respect to company strategy’. She says there have been moves in the US to require more disclosure from proxy advisers to address some of the concerns about the role they play.

The UK’s Investment Association, the trade body and industry voice for UK investment managers, has recently updated its guidelines to emphasise better and more effective consultation by companies with their shareholders on why a certain pay package is appropriate. The new guidelines also include relaxations for remuneration committees to give them more flexibility when devising pay packages – for example, by being able to use more than ten per cent of their issued share capital over a ten-year period for share schemes.

Points of comparison

Both the UK and the US have introduced requirements for listed companies to report the ratio of their CEO’s pay to that of their workforce. UK-listed companies with more than 250 employees are required to report annually on the ratio of their CEO’s pay to the median, lower quartile and upper quartile pay of their UK employees. US public companies are required to disclose the ratio of their CEO’s remuneration to the median pay of the rest of their employees.

While these calculations are perhaps intended to nudge companies to change their practices by highlighting the large discrepancies between what a CEO is paid and what the average worker receives, they’ve had limited effect in the UK and the US. Lifshey says that, in the US, when the regulation first came into force, compliance was expensive and required significant time and resource. She says it was a ‘nonsensical calculation’ that hasn’t had any impact.

Norris doesn’t ‘believe that ratio is terribly helpful’ because it depends on factors such as the sector the business is in, the workers it employs and the types of work they carry out, which would be paid at varying levels. Tuch adds that two companies could be the same except that one sub-contracts its lower-paid workers, which would affect its CEO-to-worker pay ratio.

Audouze says CEO worker ratios should be based on differences in sectors, company sizes and economic context, which can all be an influence. Taking these factors into account, she argues that looking at the ratio between CEO and worker pay can be a useful tool for assessing the fairness and proportionality of executive salaries that provides a framework for transparency and ethical assessment, encourages responsible governance and fosters a climate of trust and social cohesion.

ESG incentives

In some jurisdictions, the pressure to include environmental, social and governance (ESG) targets as incentives in executive payment plans is lessening because these areas can be hard to measure and therefore difficult to pin an incentive to. To work as an incentive, the individual should be able to effect the necessary change to meet the target. That’s not always possible with ESG targets, which can depend on changes in public policy and other areas outside of an individual’s control. If the target is outside the individual’s influence it can begin to act as a disincentive. As Lifshey observes, the trends in this area are driven more by macroeconomic and socioeconomic movements than they are by the performance of the company.

However, this isn’t the case everywhere. Audouze says that in France, ‘more and more companies include sustainable development objectives in their variable compensation packages, such as carbon footprint or diversity indicators’. She adds that it’s common practice for smaller, unlisted companies there to link compensation to ESG criteria.