Back to basics is not the way to resolve high pay

EXECUTIVE Pay is out of control – official. That’s the message from last week’s High Pay Commission report, which claims that “excessive top pay is deeply damaging to the UK as a whole, and action is urgently required to address it.” However, on the subject of long-term incentives, in particular, it is just plain wrong. The report says that pay programmes are far too complicated and recommends going “back to basics”. The argument runs that complicated pay programmes are far too difficult for us to understand and so everyone should get a salary plus a discretionary award if performance is good enough.

Apparently we don’t need long-term incentives anymore because “escalating high pay for senior executives is often concealed from shareholders and the public within complex remuneration arrangements, buried in the small print of companies’ annual reports”.

Before everyone decides these supposedly complex programmes get the chop, just consider this: if you invested £100 in Rolls Royce in 2001, it would be worth four times that 10 years later. Sir John Rose, as chief executive, was paid £27m for those 10 years. Of the £2.7m annual average take-home pay, salary made up 26 per cent, annual bonus 20 per cent and long term incentives 54 per cent. Who would begrudge a chief executive the rewards of that kind of success, and isn’t it right that long-term pay drives a man like Rose? Rolls Royce is an example of what the UK is capable of, and focusing on the long-term is a key reason why shareholders derived that kind of value.

If the High Pay Commission had conducted the same analysis for the FTSE 100 over, say, the last five years (chief executives’ total five-year pay compared with the company’s value performance 2007 to 2011) they would have found something very interesting. Total annual bonuses paid to chief executives of companies with total shareholder returns greater than 5 per cent annually (the “winners”) are only 25 per cent more than those paid to chief executives managing companies with returns less than 5 per cent annually (“underperformers”). By contrast, long-term incentive pay for winners was more than five times (500 per cent) that awarded to underperformers.

Long-term incentives are an effective link between pay and performance, whereas large bonuses tied to annual operating targets may serve to obscure rather than clarify that link.

The chief executive of BP received over £8m in bonuses over the last five years despite achieving shareholder returns of less than 5 per cent annually. Of the 55 FTSE companies that did better, only five received bigger bonuses, but 35 received greater long-term payouts.

To put the UK’s concerns into context, US chief executives are paid roughly double that of UK chief executives. In an attempt to address the issue, they opted to introduce a British style “say-on-pay” vote for shareholders. The UK is significantly ahead of the US in terms of disclosure and shareholder communications.

While other countries admire our approach, there is a real danger we will shoot ourselves in the foot over long-term incentives. If the public, the government and shareholders come to the view that all pay is unrelated to performance, it will be a dangerous misjudgement.

Simon Patterson is a partner with Patterson Associates LLP, the independent remuneration consulting firm.