Client Affairs

UK Executive Remuneration: Size Matters

Cliff Weight IRS Director 16 May 2005

UK Executive Remuneration: Size Matters

Total remuneration is crucial, when reviewing directors’ pay. In 2004, for companies with over £1 billion ($1.84 billion) turnover, the medi...

Total remuneration is crucial, when reviewing directors’ pay. In 2004, for companies with over £1 billion ($1.84 billion) turnover, the median increase in CEO total remuneration was 16 per cent, whilst salaries rose only 7 per cent. For smaller companies, those with less than £300 million turnover, the median increases were 7 per cent and 5 per cent. Since 1998, average FTSE100 CEO’s salaries have risen by 58 per cent, whilst total remuneration zoomed up by 208 per cent. In the same period average UK earnings went up 33 per cent and retail prices by 15 per cent, whilst the FTSE100 fell 13%. The growth of the non-salary parts of the package means that salaries now make up less than one quarter of total remuneration for the average FTSE100 CEO. There is a wide variety of practice. Smaller companies still focus on salaries, which can be 80 per cent of the total. Other companies adopt low salaries, with big incentives. Yet others use defined benefit pension plans to provide large parts of the reward for loyal, long service directors. Looking at salaries by themselves is no longer good enough. LTIPs are more popular and options less so. Most large companies now have two or even three long term incentive plans. The proportion of long term incentives awarded in the form of LTIPs has grown substantially in the £100 million to £3 billion turnover companies and are now at a similar level to the largest companies. EPS (Earnings Per Share) performance targets for long term incentives are easy to achieve. In most cases they are well below analyst expectations. Actual payouts from LTIPs, deferred bonus matching plans and the exercise of options were modest in 2004. Executives “received” much less than the “fair value” of long term incentive awards. The bear markets of 2001 and 2002 meant many options were underwater. Executives at larger companies have done relatively better as LTIPs were more prevalent at larger companies and more likely to pay out than options in this period. Most executive directors of small companies were only awarded options and received no long term incentive payouts in 2003 and 2004. Median total remuneration for CEOs of companies with over £1 billion turnover was £1.7 million, made up of £636,000 salary, £40,000 benefits, £395,000 bonus and £683,000 from the expected value of options and share schemes. Salaries The median increase was for CEOs of companies with over £1 billion turnover was 7 per cent with one quarter giving more than 11 per cent and one quarter less than 4 per cent. Salary rises were lower in smaller companies, at around 5 per cent. This compares to RPI of 3 per cent. Bonuses In companies with over £1 billion turnover the average CEO bonus was 67 per cent of salary, 17 per cent higher than the previous year. EPS rose by 17 per cent. The FTSE100 share index rose by 10 per cent and the mid-250 companies index by 14 per cent, so this growth in bonus payout was matched by performance. There was a wide spread of bonuses with one quarter of CEOs paid less than 30 per cent and one quarter more than 106 per cent of salary. One quarter were paid less than 11 per cent of their maximum and one quarter more than 84 per cent of their maximum. The median bonus maximum went up from 60 per cent to 100 per cent of salary in the £31–100 million turnover category and from 50 per cent to 88 per cent in the below £30 million turnover categories. Smaller companies paid out much smaller bonuses than larger companies. In 2004 grant values increased significantly. For companies with over £1 billion turnover , the median increase was 15 per cent, with one quarter getting over 57 per cent more. The swing towards share based LTIPs, and away from options, has continued except in the largest companies. The median award comprises 60 per cent in LTIPs and 40 per cent in options. However one quarter of companies only awarded LTIPs. For smaller companies, options remain the most popular form of long term incentive. EPS performance targets for options and LTIPs have toughened marginally, but in many cases are miles below analysts’ estimates of future growth. They are often window dressing, to meet a corporate governance requirement. There is little disclosure of the definition of EPS and how exceptional items are treated and how much discretion the remuneration committee can apply. It is difficult to see how tough the targets will be in practice. In most cases the option is unlikely to be in the money if the performance target has not been achieved, so the impact of the EPS performance condition is marginal at best and at worst merely adds confusion and complexity. Since the share option is meant to reward and incent share price growth over a ten year period, we don’t see the logic in having tough EPS performance conditions at year 3. For Total Shareholder Return performance targets the norm of no payment below median is almost universal. Maximum payout at upper quartile is increasingly common. The ABI and NAPF have been vigorous in opposing the retesting of performance conditions and nearly all companies have now stopped this practice. IFRS2 has been cited as a reason to switch away from options. The intellectual rigour of such arguments is dubious as studies have shown that the impact of options has already been priced into most shares as the information to value options is already available in most accounts. In terms of pay, size matters. Bigger companies have bigger salaries, bigger bonuses, much bigger long term incentives and bigger pensions. Added together this gives them much bigger total remuneration. Remuneration increases in line with the logarithm of turnover or market capitalisation. For smaller companies this is a straight line relationship. For larger companies, executive directors are on a curve to infinity. Long-Term Trends Total remuneration has grown fastest in the largest companies. The biggest growth has been in long term incentive awards, with many companies now using two or sometimes three plans, e.g. options, LTIPs and bonus matching plans. Bonus opportunities and payouts have also increased significantly. Factors influencing pay trends: · Globalisation led to executive demands to be paid closer to US norms; · Acquisitions of US businesses came with US executives on US style pay packages. In order to retain US executives, everyone’s pay tended to average up to US levels; · Private equity offered much larger rewards, often for running simpler businesses. Executives demanded bigger incentives; · Many lawyers, accountants, consultants, investment bankers and fund managers are paid more than the executive directors of trading companies; This led to remuneration inflation. There was little to restrain it: · Institutional investors set overall dilution limits for share schemes. They focussed on excessive rewards for failure and argued for reduced contract lengths. They also focussed on increasing the proportion of performance related pay. They tried to set individual limits as percentage salary for share schemes but were ignored by many companies who argued theirs was a special case. Until recently institutions ignored salary and pension issues. · Government action was intended to increase transparency and increase accountability through the annual advisory vote on the remuneration report. This failed as there was no requirement to disclose the total remuneration, so companies spread the data over many pages of the annual report. Pay was transparent only to the very few experts who could decipher what was hidden in the 16 or so pages of the remuneration committee report. · Many consultants suffered from a conflict of interest . They worked too closely with management - their recommendations favoured executives rather than the company and its shareholders. The consultants’ fees were large. They also sold other consulting assignments to their clients. They were unwilling to make recommendations that might upset the CEOs and other buyers of their services. If they kept the CEO happy, there was a better chance of selling other work. In some cases the Group auditors were also the remuneration consultants. Many people believe that such remuneration consultants ratchet up pay. Bigger companies led the way in increasing pay. GlaxoSmithKline, Vodafone and BP were the bellwethers. Other companies followed in their footsteps. Predictions More of the same! We predict double digit rises in total remuneration for some years yet. Remuneration will drop off the front pages of newspapers. Rewards for failure have mainly been stopped. Companies have adapted their policies to be compliant with most investor guidelines. Directors’ pay is a complex issue not easily explained. It is a small cost for large companies. Consequently pay will not be a priority for politicians, nor for investors. Salary drift will continue. Pensions will be maxed out under the new regime and cost neutral substitutes will be put in place. Bonuses will grow, driven by the need to catch up with others. The piecemeal approach will continue, so there will be more deferred bonuses and more combinations of LTIPs and options. The moderation by the very largest UK companies is temporary –the US dollar dropped 12 per cent last year taking UK pay closer to US levels. Smaller companies will increase total remuneration levels in a bid to catch up with median sized companies who will try to catch up with the largest companies. Remuneration reports will continue to be complex and confusing. The Combined Code requires Remuneration Reports to be “clear, transparent and readily understandable by shareholders”. This requirement will not be met.

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