Chapter 4: Directors' remuneration

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain and evaluate the role and purpose of the following committees in effective corporate governance:
  • remuneration committees
• describe and assess the general principles of remuneration:
  • purposes
  • components
  • links to strategy
  • links to labour market conditions
• explain and assess the effect of various components of remuneration packages on directors' behaviour:
  • basic salary
  • performance related
  • shares and share options
  • loyalty bonuses
  • benefits in kind
• explain and analyse the legal, ethical, competitive and regulatory issues associated with directors' remuneration.

1 Development of corporate governance regarding directors' remuneration

As discussed in chapter 2 the development of corporate governance codes is closely associated with the UK. The Greenbury Report (1995) contributed to the existing code with regards to directors' remuneration.

This committee was formed to investigate shareholder concerns over director's remuneration. The report focused on providing a means of establishing a balance between salary and performance in order to restore shareholder confidence.

2 Remuneration committee

The role of the remuneration committee

The role of the remuneration committee is to have an appropriate reward policy that attracts, retains and motivates directors to achieve the long-term interests of shareholders.

This definition creates a good balance between the opposing viewpoints of stakeholders.

Objectives of the committee

• The committee is, and is seen to be, independent with access to its own external advice or consultants.
• It has a clear policy on remuneration that is well understood and has the support of shareholders.
• Performance packages produced are aligned with long-term shareholder interests and have challenging targets.
• Reporting is clear, concise and gives the reader of the annual report a bird's-eye view of policy payments and the rationale behind them.

The whole area of executive pay is one where trust must be created or restored through good governance and this is exercised through the use of a remuneration committee.

Responsibilities of the remuneration committee

The overall responsibilities of the remuneration committee are to:

• Determine and regularly review the framework, broad policy and specific terms for the remuneration and terms and conditions of employment of the chairman of the board and of executive directors (including design of targets and any bonus scheme payments).
• Recommend and monitor the level and structure of the remuneration of senior managers.
• Establish pension provision policy for all board members.
• Set detailed remuneration for all executive directors and the chairman, including pension rights and any compensation payments.
• Ensure that the executive directors and key management are fairly rewarded for their individual contribution to the overall performance of the company.
• Demonstrate to shareholders that the remuneration of the executive directors and key management is set by individuals with no personal interest in the outcome of the decisions of the committee.
• Agree any compensation for loss of office of any executive director.
• Ensure that provisions regarding disclosure of remuneration, including pensions, as set out in the Directors' Remuneration Report Regulations 2002 and the Code, are fulfilled.

3 Directors' remuneration

Remuneration is defined as payment or compensation received for services or employment and includes base salary, any bonuses and any other economic benefits that an employee or executive receives during employment.

Behavioural impact on directors of remuneration components

Whatever remuneration package is determined, it is essential to ensure that the directors have a stake in doing a good job for the shareholder.

• Each element of a remuneration package should be designed to ensure that the director remains focused on the company and motivated to improve performance.
• A balance must be struck between offering a package:
  • that is too small and hence demotivating and leading to potential underachievement, and
  • that is too easily earned.

The company, following the work of the remuneration committee, should:

• Provide a package needed to attract, retain and motivate executive directors of the quality required, but avoid paying more than is necessary.
• Judge where to position the remuneration package relative to other companies.
• Be aware of what comparable companies are paying and should take account of relative performance.
• Be sensitive to the wider scene, including pay and employment conditions elsewhere in the company (especially when determining annual salary increases).

Remuneration policy and strategy

Strategy

A company's remuneration strategy may consider:

• offering more benefits in kind to compensate for lower basic salary
• non-cash motivators for all or some of the company employees, e.g. childcare vouchers, company car scheme, additional holiday
• availability of company resources, e.g. there may be insufficient cash available to pay an annual bonus, but share options might be an alternative
• encouraging long-term loyalty through share purchase schemes.

The need to develop a remuneration strategy that links reward to performance is the greatest challenge facing the remuneration committee. There is a critical need to ensure the board is:

• motivated to strive to increase performance
• adequately rewarded when performance improvements are achieved
• seen to be paid appropriately for their efforts and success
• not criticised for excessive pay
• retained through market-based pay levels

The remuneration strategy is therefore about creating a link to corporate strategy since corporate strategy is the process through which performance is improved.

• the extent to which the remuneration strategy achieves this link or how close this link is, is a measure of the remuneration strategy's success.

Components of directors' remuneration package

Basic salary

Companies set salary levels according to:

• the job itself
• the skills of the individual doing the job
• the individual's performance in the job
• the individual's overall contribution to company strategy
• market rates for that type of job.

The setting of base salary in relation to peer groups may give some indication of expectation of director performance since upper quartile salaries generally suggest the individual is being paid a premium for a premium effort over the future period.

Performance-related elements of remuneration

Defined as those elements of remuneration dependent on the achievement of some form of performance-measurement criteria.

• Performance-related element should form a significant part of the total remuneration package.

A short-term bonus may be paid to the director at the end of the accounting year. This could be based on any number of accounting measures.

Bases for short-term bonus

Short-term bonuses may be based on any of the following:

(1) Operating profits or pre-tax profits

• Percentage of bonus based on salary in relation to percentage yearly profit increase.
• 2% of salary for each 1% increase in profit.
• Fixed sum for achieving a given profit target.

(2) Earnings per share (EPS)

• This may exclude exceptional charges that affect earnings.

(3) Total shareholder return

• This includes both dividend and capital appreciation over time.

(4) Economic value added (EVA)

• This is the surplus calculated above a charge on all assets used using the weighted average cost of capital (WACC) as a threshold percentage minimum return before a bonus is achieved.

Executive stock options are the most common form of long-term market-orientated incentive scheme.

• Share options are contracts that allow the executive to buy shares at a fixed price or exercise price.
• If the stock rises above this price the executive can sell the shares at a profit.

Executives treat share options as part of their compensation and almost always exercise the option when it becomes available.

• Share options give the executive the incentive to manage the firm in such a way that share prices increase, therefore share options are believed to align the managers' goals with those of the shareholders.
• This alignment should, in theory, overcome the agency problem of the separation between ownership and control since the executive in effect becomes the owner.
• The actual shares or share option incentives should be:
  • approved by shareholders
  • preferably replace any existing schemes or at least form part of a well-considered overall plan, incorporating existing schemes
  • rewarding but should not be excessive.
• Payouts (or grant of options) should be:
  • subject to challenging performance criteria reflecting the company's objectives and performance relative to a group of comparator companies in some key variables such as total shareholder return
  • phased rather than awarded in one large block.

Share options

The company, following the work of the remuneration committee, should:

• consider whether the directors should be eligible for benefits under long-term incentive schemes
• weigh traditional share option schemes against other kinds of long-term incentive scheme
• ensure that executive share options are not offered at a discount
• ensure that shares granted or other forms of deferred remuneration should not vest, and options should not be exercisable, in under three years
• encourage directors to hold their shares for a further period after vesting or exercise, subject to the need to finance any costs of acquisition and associated tax liabilities.

Pension contributions

• In general, only basic salary should be pensionable.
• The remuneration committee should consider the pension consequences and associated costs to the company of basic salary increases and any other changes in pensionable remuneration, especially for directors close to retirement.

Benefits in kind

• Benefits in kind (also referred to as perks) are various non-wage compensations provided to directors and employees in addition to their normal wages or salaries.
• The remuneration committee should provide whatever other ancillary benefits would either be expected with the position of executive director or would increase their loyalty and motivation (examples of these would be a company car, health insurance, etc.).

Illustration 1 – Tesco CEO's remuneration package

The following information is summarised from Tesco plc's 2008 Annual Report.

Other forms of compensation

The guaranteed bonus and 'golden hellos'

• The purpose of a bonus is to adjust pay on the basis of performance. To award a bonus regardless of any particular effort is to make the term meaningless.
• Although not common, guaranteed bonuses are sometimes used to retain CEOs in struggling organisations. The same is true for signing on (turning up) bonuses ('golden hellos').

Loyalty bonuses and retention payments

• As with guaranteed bonuses mentioned above, loyalty bonuses are also used to retain senior executives. For example, in May 2011 Citigroup awarded its chief executive, Vikram Pandit, a $16.7m (£10.3m) retention bonus.   
• However, they have come under criticism for the following reasons:
  • The current preference in Western countries is for rotation of directors to ensure freshness and independence, rather than an emphasis on loyalty
  • Corporate governance codes recommend linking bonuses with performance
  • There have been many cases of directors leaving soon after receiving their loyalty bonus (e.g. easyJet boss Andy Harrison controversially banked a £1.2m retention bonus in 2009 and then left in 2010)

Loans

• Since corporate governance is a global issue there are many countries where loans to directors have not been outlawed as they have in the US under Sarbanes-Oxley (SOX).
• There is little justification in making loans to people who can get loans from any other commercial lending source, especially when these loans are often non-interest bearing and possibly even non-repayable.

Deferred payments and transaction bonuses

• In a down market no one wants to be top of the tree for bonuses. Stock options for future periods become a welcome alternative in these lean times, to be vested when the market recovers.
• Transaction bonuses may be given for successful conclusion to a business deal such as a takeover.

Retirement benefits

• All awards are ultimately given by the shareholders and should be viewed in relation to performance achieved by the director.
• A retirement benefit such as lifetime use of the company plane or a sizeable pension payout could be awarded.

Termination

• Awards may be made on termination of contract simply for services rendered over a number of years.
• Building protection into a contract at the time of employment in order to limit the likelihood of forced termination is one way of reducing the possibility of being asked to leave.

Test your understanding 1

Mr Smith, an executive director of Company XCX, is paid a salary of £100,000. In addition, he receives the use of a company car. He is reimbursed all his travel expenses to and from all the places he has to visit in the course of his work. If the company's share price rises above £5 he is entitled to 10,000 share options at a price of £1 each. He will also receive a bonus of 20% of his salary if company profit before tax rises above £2.5 million. His wife also receives a company car, paid for by the company. He has permanent health insurance paid for by the company and has death-in-service benefits as well.

All of this is contained within his service contract.

What elements in the above paragraph constitute the director's remuneration?

UK Corporate Governance Code (2010)

There is more written in the UK Corporate Governance Code (2010) about the issue of directors' remuneration than anything else. This is probably due to the fact that it is an area where:

• excess needs to be reined in.
• it is too easy to be excessive.
• excess is viewed very dimly by everyone except the excessive.

In addition, Schedule A to the Code provides further guidance on performance-related pay.

• The committee must consider eligibility and upper limits to bonuses.
• The committee must consider eligibility and nature of long term incentive schemes such as share option schemes.
• Long-term schemes should be approved by shareholders and should replace existing schemes where possible.
• Payouts under all schemes must relate to performance criteria.
• Payouts under share option schemes should be phased where possible.
• In general only basic salary should be pensionable.
• The committee must carefully consider pension costs and obligations.

Some of the issues that arise from this are:

• the importance of performance-related pay
• the conflict of interest that may arise in cross-determination of pay between directors
• the variety of pay and the impact of share option schemes.

4 Directors' remuneration: other issues

There are a number of other issues relating to directors' remuneration which a company should consider. These are:

• legal: what are the legal implications of the company/director relationship in terms of remuneration, especially when things go wrong?
• ethical: what ethical considerations should a company have in setting directors' remuneration?
• competitive: how does a company remain competitive and ensure that they attract good quality directors?
• regulatory: what are the regulatory requirements that a company should adhere to in relation to its directors' remuneration?

Other remuneration issues

Legal

A company (with the guidance of the remuneration committee) should:

• carefully consider what compensation commitments (including pension contributions and all other elements) their directors' terms of appointment would entail in the event of early termination
• aim to avoid rewarding poor performance.

Ethical

• The traditional view that ethics and business do not mix is now rarely accepted.
• Increasingly companies are demonstrating a sensitivity to combining ethical issues with commercial success.
• The commercial environment is progressively affected by the very ethical issues that companies are now dealing with.
• The 2006 Companies Act in the UK makes it a legal requirement for directors to act as 'good corporate citizens', in effect, that directors pay attention to the ethical effects of company decisions.
• Public reaction to high profile corporate failures where directors were receiving what was perceived as excessive remuneration in relation to their performance.
• Public perceptions of excessive pay rises in underperforming companies and privatised utilities.
• Recent changes to best practice disclosure requirements on board structure and executive pay have put pressure on companies to change their board policies to be seen to be in line with accepted best practice.
• The following recent developments have resulted in many leading companies incorporating business ethics into their management processes, directors' employment contracts and performance- related pay systems.

Competitive

It is vital that a company has a proficient, motivated board of directors working in the interests of its shareholders and that it can recruit and retain the individuals required for successful performance.

A balance must be struck with regards to the overall remuneration package.

If it is too small:

• unattractive for potential new appointees, hence a failure to recruit required calibre of individual.
• demotivating for existing directors, hence potential underachievement.

If it is too big:

• too easily earned, hence shareholders not getting 'value for money' in terms of performance.

Regulatory

The UK Directors' Remuneration Report Regulations 2002 require that:

• directors submit a remuneration report to members at the annual general meeting (AGM) each year
• the report must provide full details of directors' remuneration
• the report is clear, transparent and understandable to shareholders
• where a company releases an executive director to serve as a NED elsewhere, the remuneration report should include a statement as to whether or not the director will retain such earnings and, if so, what the remuneration is.

There is an increasingly regulatory environment for companies to operate in and this in turn is placing greater demand on directors.

• Remuneration packages in general have risen in the wake of recent high profile corporate scandals and the passage of the Sarbanes-Oxley Act 2002 (SOX).
• This reflects:
  • the additional demands on directors
  • the additional responsibilities of directors
  • the potential liability of those individuals who agree to serve on boards of directors
  • heightened external scrutiny.

5 Non-executive directors' remuneration

To avoid the situation where the remuneration committee (consisting of NEDs) is solely responsible for determining the remuneration of the NEDs, the UK Corporate Governance Code (2010) states that the board and shareholders should determine the NED's remuneration within the limits set out in the company's constitution.

NED remuneration consists of a basic salary – no performance related element is awarded.

6 Chapter summary

Test your understanding answers

Test your understanding 1

All of it apart from the expenses reimbursement.

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