How to reform pay in the boardroom

Allister Heath
SOME CEOs are paid too much compared with the value they add; others, however, are worth every penny. Rather than waiting to be lectured by the likes of Ed Miliband, as happened yesterday, the City must tackle the issue head on. The issue is technical, not ideological: how does one design the best remuneration system for bosses to maximise value for shareholders?

UK Plc faces a principal-agent problem: if a company is not managed by its owners, the paid hands brought in usually put their own interest first, and that means big salaries, big offices, prestige projects, empire-building and value-reducing acquisitions – subject, of course, to growing profits sufficiently to entice shareholders to turn a blind eye. Such corporate capitalism works pretty well – infinitely better than socialism – but it is sub-optimal and leads to an excessively cosseted managerial class. Private equity firms, where owners are hands on, are better at making bosses focus on value – they reward stars even more than quoted firms but with less wastage thanks to their ability to weed out dud executives, implement controls and incentivise correctly.

So what should listed firms do? Performance related pay works, but only if structured properly; many such schemes are excuses for ever-higher compensation regardless of outcomes. A proper measure of value creation must be agreed – for example, risk adjusted return on capital over a certain period of time, compared with the overall market. Governance bodies could usefully come up with suggestions to prevent boards from rigging the system to make it too easy.

Crucially, pay must fall when performance is bad and rise when it is good. A variant on the theme of the bonus/malus scheme implemented by some banks is the way forward. Performance-related pay is an especially powerful motivator when income actually drops; people respond to sticks as well as carrots.

Bosses of Plcs should face four possible outcomes: the sack with no payoff if they fail; a low compensation in a bad year; a high but not excessively high comp in a decent, on-target year; and potentially massive rewards for excellent performances. Rather than a package comprising of a base and a likely bonus, CEO candidates should be presented with a range of possible outcomes – eg zero if realistic targets are missed too much, £200,000 if they are missed; £500,000 if they are reached; and a sliding scale to untold millions if they are smashed. The very concept of an ex-ante salary must become obsolete. Every year, a board’s remuneration committee should decide which of the outcomes has materialised, the pay for that year and next year’s targets. All decisions should have to be ratified in a vote by shareholders – and the committee sacked if it failed to win majority support, perhaps because of lenient targets. Ideally, specialist remuneration directors would begin to emerge; firms that wanted to signal they are serious about value-creation would appoint them to hold executives to account. Roll on the revolution.

Kudos to Boris for backing our campaign to allow the redevelopment of Broadgate Estate. Jeremy Hunt, the culture secretary, must now veto English Heritage’s silly bid to list the complex. We can no longer afford eccentric, job-destroying decisions from anti-growth bureaucracies.
Follow me on Twitter: @allisterheath