If creating shareholder value is the criterion, why are top executives still paid above-average for below-average results?
Plato would have either bumped off today's fat cats or banished them from his state altogether. The Greek philosopher believed that any lust for wealth was unhealthy, and that it could only lead to eventual destruction. So in his Laws he designed what is probably the first ever pay package linked to only the most modest incentives. Each man, he said, should have a basic unit of wealth - which in those times was land. But Plato's egalitarianism was tempered by a pragmatic view of man's competitive spirit, and he reluctantly permitted individuals to earn four times that basic amount.
Quite what he would have thought of the huge multiples being paid to the top executives in business today compared to its lowest workers hardly bears thinking about. The trends all indicate that the total pay of our most senior company directors is growing faster than ever before, and at a higher rate than lower management levels.
All UK quoted companies operate some form of share option scheme. But there is no doubt that the combined weight of those corporate governance gurus - Cadbury, Greenbury and Hampel - is forcing companies to adopt longer-term incentive plans (LTIPs) linked to future performance over a three-to five-year period.
On the surface this move appears to be a far more effective way of aligning the interests of executives with those of their investors and their workers.
Indeed, since many of these schemes have been in operation, the headline basic pay of executives has gone down by about 14%.
A recent survey by the Monks Partnership consultancy reports that 17 of the FTSE-100 companies use share options as the sole long-term incentive, and a further eight intend to use options as the main incentive. Earnings per share (EPS) growth remains the most popular performance measure, with the most usual hurdle being that EPS growth should exceed inflation by 2% per share, or 6% over three years. Some 22 FTSE companies use an EPS inflation target, while another nine use total shareholder return. Nearly all are phasing out option grants. The survey, based on 1996/97 annual reports, also showsthat the average salary for a FTSE chief executive and chairman is still about £500,000, while other board directors can expect to earn about half as much.
Overall, though, research shows that those running top companies will on average receive a remuneration package of around £1 million a year.
The earnings of senior executives below board level are mixed - from £80,000 upwards - although they too are increasingly linked into longer-term plans which usually give the director up to two times salary in options.
What is happening though is that companies are gearing themselves up to pay out huge bonus packages in three to five years' time. Experts say that more than £100 million will be paid out in LTIPs to top executives by 2000 even if they produce only a modest performance for investors.
So for all the talk of openness, these new schemes can often hide the true amount being paid out unless there are parallel requirements that every detail of a director's package is spelled out in the annual report.
Early reports from president of the board of trade Margaret Beckett suggest that she will want the very fullest disclosure possible. There are two alternatives which Beckett is understood to be looking at. One is to require remuneration committees to report to investors on the overall pay schemes.
A tougher alternative is that all details of directors' pay packages should be put to shareholders at annual meetings for a vote.
Ex-ICI chairman Sir Ronnie Hampel, who undertook the most recent corporate governance report, predictably concluded that behaviour should be guided by principle rather than by regulation. However, Beckett's cynicism about the City's ability to follow a voluntary code of practice suggests that she may decide on the latter option and that legislation is not far away.
But even without regulation it does seem that City investors and fund managers are taking a far more active part in setting pay standards than before. Only recently several larger funds were sounded out on a rather juicy and potentially controversial package for Cable & Wireless' American chief executive, Dick Brown. When C&W decided to double his share bonus package and raise his salary by a third, the first move it made was to write to leading investors to gauge their reaction.
Brown had been approached by rival group AT&T and went to his board for a spot of negotiation. He came away with a three-year deal that took his salary up to £650,000 and doubled the possible share bonus award under its LTIP from 60% to 120% of salary.
This increase could see him awarded C&W shares worth up to £780,000 this year. For the maximum bonus, C&W's shares have to grow at 15% above inflation over a three-year period. Under an existing scheme Brown is also entitled to an annual cash bonus, worth up to 40% of salary, which could give him another £260,000. If Brown makes the top performance criteria, he could earn £1.69 million this year. Overall, investors are happy with the package but there have been questions over the soft target for the minimum share bonus. Earnings only have to grow at 2.5% above inflation over the three-year period for Brown to receive a £520,000 share bonus.
Brown's case also highlights the difficulties of comparing pay scales on an international level. In this case it is justifiable to use US pay levels as a benchmark for setting Brown's package because the telecommunications industry is both global and one of the fastest growing. But John Viney of headhunters Heidrick & Struggles says it is a myth that most British managers are operating at a global level other than in media, drugs, IT and engineering. Those markets apart, most business is still essentially domestic. He does point out, however, the dangers of the domino effect. Brown's salary, for example, may be seen as a new benchmark and could be used to try and push up pay for everybody in big companies irrespective of whether they are global or domestic.
In March last year Whitbread took the step of introducing more stringent performance criteria to match market practice. The brewer said that unless it achieves a minimum total shareholder return ranking of 60th out of the FTSE-100 - it was previously 75th - over the three-year period, the executives participating in its scheme will not be entitled to receive any shares and their rights will lapse. If it achieves its ranking, though, they will be entitled to 30% of the award and if it is ranked 25th or above, they will receive the maximum number of shares to which they are eligible.
Supermarket group Asda, which helped make its chairman Archie Norman extremely rich, has adopted a particularly tough plan using EPS measures which requires all employees to invest in order to participate. In essence, managers can earn up to 75% of salary each year in a special long-term bonus which is paid out as share options. After three years the employees are paid a bonus divided by the Asda share price at the date of issue of options. But these will not be exercisable unless EPS targets are achieved over a three-year period. Then 10% EPS growth is required for options to be exercised and the proportion is increased pro rata up to 15% per year EPS growth, at which point the maximum entitlement is available. If participants hold their options until the seventh year there is a loyalty bonus of 10% per annum.
Most of the larger FTSE-100 companies do appear to be making big efforts to match the mood of the times. However, what often tends to be overlooked in the pay debate is the most fundamental issue of all: are the executives actually worth what they are paid? Numerous studies have failed to measure this relationship accurately or adequately, but the latest report from Price Waterhouse, Boardroom Pay and Operating Performance, gives a modicum of hope. It found that the number of directors who are paid above the average - despite below-average performance - appears to have fallen.
However 40% of FTSE-100 companies are still paying above-average rewards for poor-performing executives. PW's head of shareholder value services, Ian Coleman, says the results show that companies should find more challenging objectives that support shareholder value creation.
Tougher criteria are essential, so are long-term incentive schemes designed to trickle down to as many staff as possible. That other Greek philosopher, Aristotle, would have agreed.
His great worry was that those who had wealth despised those that had little.
Sharing the risk with the investors
'City investors are amazed at our salaries. They think we are completely mad,' says KS Biomedix's finance director, Martin Myerscough. 'Some of their wives spend more on their credit cards than we do on our salaries.'
Myerscough and his colleagues run their AIM-listed biotechnology company by the strictest of rules. He and chief executive Kim Tan pay themselves a salary of £42,000 a year each. The Guildford-based company of 12 has no secretaries and none of the executives or staff has a pension, car or heathcare benefits. They do allow themselves mobile phones and share options.
When KS Biomedix listed on AIM, Myerscough and Tan paid themselves a bonus - £10,000 each - for successfully raising the £3.6 milion. This is chicken feed compared with most hi-tech growth stocks.
Today the company is worth about £49 million but has as yet to make a profit because all its work is still at the clinical stage. It is the only company in the world researching the use of sheep monoclonal antibodies, an invention developed by Tan who founded the group. There are two potential drugs on clinical trial, one which it is hoped will reverse rheumatoid arthritis, and another which treats osteoarthritis.
For this reason Myerscough believes it would be utterly wrong to pay themselves the kind of salary packages which some directors greedily take out of companies which have made neither product nor profit.
'This is particularly true in biotechnology companies where the risks are extremely high. But time and time again directors float the company on high expectations, pay themselves a fortune and then sell their shares even when they haven't even made any money for investors,' he says.
'Our philosophy,' he adds, 'is that we are in a risk business so the employees should share in that risk along with the investors. Once we have fully developed a product then we can all share in the profits through our shares.'
Tan has 70% of Biomedix, Myerscough has options on 100,000 shares, 20% is owned by 600 private investors (including Burford's Nigel Wray), and 10% is held by City investors.