THE PERFORMANCE PAY RACE - Top UK executives still trail their US counterparts in the salary stakes, but they may soon sample some of the joys of rarefied American-style packages that rely heavily on long-term share incentives, particularly after mergers and acquisitions. Get ready for some astronomical figures, says David Smith.
It all started, perhaps, with Richard Giordano, the American who used to run BOC. Like today's foreign football stars, Giordano did not come cheap. For years he topped the executive pay league, and by some distance, but the reasons were straightforward enough. Operating in the global management marketplace he could always take his talent elsewhere.
As an American, he knew what the global marketplace paid.
While Giordano was the source of much envy, however, he did not produce a great deal of imitation. Even in the days of red-blooded Thatcherism a mood of caution prevailed. Business was emerging timidly from the dark days of the 1970s when private enterprise was seen as public enemy number one, and few people wanted to risk their head above the parapet for fear of reigniting old enmities. Margaret Thatcher herself, while chief torch-bearer for the free market, appeared to find it morally repugnant when those who prospered in that market enjoyed what appeared to be 'excessive' rewards.
When Giordano took his salary philosophy to British Gas, the Tories were still in office, now under John Major, but this did not prevent Cedric Brown - the chief beneficiary of Giordano's philosophy - from facing one of the most vicious campaigns endured by a senior executive in recent years. That has now changed and few could have expected that a Labour government, elected partly in response to the sharp edges of Thatcherism, would not only embrace the free market but actually declare itself comfortable with sky-high levels of executive remuneration - as long as they are justified by performance.
Thus Stephen Byers, the trade and industry secretary, declared in July, 'We need to recognise that in a global economy, world-class performance must be rewarded with world-class pay.' As few companies would ever admit to not aspiring to be world class, Byers has effectively given the Government's blessing to what Labour used to attack as 'fat-cat' excesses. Like his predecessor, Peter Mandelson, Byers is impressed with the American experience using, among others Marjorie Scardino, the US-born chief executive of Pearson, as someone who deserves every penny. 'We accept such an approach in relation to sports stars, so why don't we adopt the same attitude for directors?'
Hot on the heels of Byers' comments came proof that to take advantage of this philosophy you don't have to be American like Giordano, Scardino or 'Lucky' Jim Fifield - who, although he did not make it to chief executive (and received a £12-million handshake for his disappointment) topped the FTSE-100 league of directors' remuneration for running EMI's music division - when Martin Sorrell, chief executive of WPP, announced a five-year incentive plan for himself and fellow directors under which, subject to performance, they would receive £60 million in bonus shares, half of which would go to Sorrell. He insists the plan is, 'a truly entrepreneurial programme in that it is a risk-take', not least because he and his colleagues are committing £12-million of shares to the programme together with some of the shares they were awarded under the previous, and controversial, incentive scheme. For US investors, he says, it would hardly raise an eyebrow, so common are such programmes, it is only conservative UK institutional investors who get picky over such things.
The mood though is changing. Richard Regan, head of investments at the Association of British Insurers, has said: 'The scheme appears to be designed to meet the criterion recently agreed by the ABI and the National Association of Pension Funds (NAPF) which demands exceptional performance for exceptional rewards, and it is unlikely to be resisted by institutional shareholders.' So are the floodgates opening? Is Britain shifting towards US-style executive pay? The answer is probably yes, but it is also true, as shown in a special analysis for Management Today by William M Mercer, that the starting point is one in which UK pay structures are about as different from those in the US as it is possible to be.
Mercer took 10 top UK companies (median turnover £7.2 billion) and compared the remuneration of their chief executives with a comparable top-10 US sample (median turnover £10.2 billion). The comparison was based on three measures - basic salary, total cash compensation (salary, plus bonus) and total direct compensation (salary, plus bonus, plus expected value of options and other long-term incentives awarded during the year).
If we take the latter figure, the differences are striking. In 1998, only one of the top-10 UK executives had a remuneration package worth more than £5 million. But even with a £10 million-plus package, this executive would not have made the US top 10, where the CEO who squeezed into 10th place boasted a total direct compensation of £18.7 million. A normal package for those at the very top in corporate America is more than £20 million a year. This difference, it should be said, has little to do with basic salary, but everything to do with annual bonuses and, more particularly, options and long-term incentive plans (LTIPs). The median UK chief executive's cash compensation (salary and bonus) was only just over 40% of that of his US equivalent, while his total direct compensation, including options and LTIPs, was a mere 12% of the American figure. Put another way, the UK chief executives relied on salary for 31% of total direct compensation, bonuses accounted for 30% and long-term incentives 39%. In the US, salary amounted to just 2% of direct compensation, annual bonus 10% and long-term incentives a massive 88%.
These differences cannot be explained by the parochialism of the British sample. All 10 companies, while UK-based, had extensive worldwide operations.The global market for products is not yet, it appears, a true global market for executives in terms of reward. But change, admittedly from this low base, is happening.
'In the UK we're good at running ourselves down,' said John Rogers, head of investment services at NAPF. 'In the US, share options are part of the normal package, not just related to performance, and we are gradually moving that way. Where the US really scores over us is in long-term incentives. The directors, after all, only really make a killing if the company is going somewhere serious.'
Ironically, corporate enthusiasm for US-style remuneration is coinciding with some soul-searching about whether such packages have harmful long-term economic effects. Such criticism is not confined to the US labour unions, who have pointed out that the ratio of executive to shop-floor pay has risen to more than 300-to-one, compared with 40-to-one in the 1960s. The UK, again, is some way behind. Executive pay is increasing more rapidly than earnings in the economy as a whole, but last year the median level of salary, plus bonus for the chief executives of the top 100 companies, rose by almost 10% to £614,000, compared to just over 4% in average male earnings to nearly £20,000.
So, what happens when the bull market comes to an end? Do CEOs accept the lower value of their long-term incentives, or will they have to be rewarded in another way? In the US, the Financial Accounting Standards Board has suggested companies would need to respond to maintain executive rewards, probably by re-pricing the options to take account of the lower market. So not only are the rewards for those at the top of the corporate ladder in the US enormous, but it appears they also enjoy a significant safety net. To what extent, too, are all these options being issued by US companies diluting their equity, to the point where the interests of outside shareholders are adversely affected? And, most critically, is it true, as some market observers suggest, that directors become obsessed with keeping their share price, and the equity market, on a rising trajectory sometimes by resorting to the issuing of debt to buy back equity?
It is partly because of these criticisms and partly because even New Labour free-market advocate Byers has made it clear that the onus is on institutional shareholders to ensure executive rewards are linked to performance.
In other words, something of a British 'third way' is evolving on executive pay, as institutional investors themselves have made it clear they would not be happy with open-ended remuneration schemes of the US type being imported wholesale into Britain. 'Those schemes look a lot better now than they will in a few years' time,' said one leading manager.
What is causing concern is how closely it is possible to link pay to performance without introducing distortions?
'In the US there are little or no performance measures attached to long-term incentives, whereas in the UK this is very much the emphasis,' says Jacqui Lewis, a senior consultant at William M Mercer. 'If the performance measures are right, they are no bad thing. The risk is that they are badly thought out. The key to performance measures has to be about how good you are at responding to, and outperforming, the competition. It is also terribly important that the people who will benefit from performance measures understand them, which means they should not be over-complicated. You can't expect managers, for example, always to keep a close eye on the 63 different variables that determine Economic Value Added.'
There is another danger. Critics of high levels of executive remuneration argue that British directors want the best of both worlds - high salaries plus generous incentives. 'There is a hybrid developing in which UK compensation is mixed with that of the US,' says Stuart Bell, head of research at Pension Investment Research Consultants (PIRC), a thorn in the side of many a remuneration committee. 'You have high levels of fixed compensation combined with increasing performance-related rewards. The fixed compensation doesn't show any sign of reducing.'
Organisations such as PIRC will be monitoring closely the structure of remuneration packages and how they relate to the companies introducing them. 'We're concerned that companies which don't warrant US-style compensation, and aren't competing in a world market for executives, don't introduce these packages,' says Bell. 'There is a danger that what is acceptable as an exception will come to be the norm. It is not in the shareholders' interests or in the wider interests of the economy that this happens.'
The NAPF's Rogers also suggests that the Government's benign attitude to high levels of executive reward may not last. 'Although most executives believe the Government has given them at least an amber light, the question will be asked, whether pay is being linked to performance,' he says. 'I would expect to see some modification of the present policy.'
For the institutions, the green light for the Sorrell package at WPP may not necessarily mean a smooth passage for other such schemes.
UK attitudes to success, as Prince Edward and others have pointed out, are different from those in the US. So, while US-style executive pay may be coming to Britain, in many cases it will not be without a fight.
TOP-10 EXECUTIVE PAY IN THE UK AND THE US
Salary Total cash Total direct
UK MAXIMUM £950,000 £2,747,000 £10,599,000
UK AVERAGE £649,000 £1,379,000 £3,133,000
US MAXIMUM £1,741,000 £6,219,000 £34,785,000
US AVERAGE £672,000 £3,369,000 £26,205,000
UK AS A PERCENTAGE OF US EXECUTIVE PAY
Salary Total cash Total direct
MAXIMUM 54.6% 44.2% 30.5%
AVERAGE 96.5% 40.9% 12.0%
Source: William M Mercer Ltd. * Dollar remuneration has been converted
to sterling at a rate $1= £0.63. Total cash = 1998 salary,
plus annual bonus. Total direct = total cash compensation plus the
estimated expected value of options and other long-term incentives
granted in the latest financial year.