Executive pay: how big is your bonus?

• United Kingdom

• Employment law
• Financial services

01-06-2021

Introduction: executive pay

Executive pay is no longer a discreetly guarded secret subject to little or no external inquiry. Rather, it is now intensely scrutinised from the point of inception by a firm’s remuneration committee, and closely analysed by external stakeholders, the workforce, the wider public, the media and regulators. Executive pay does not exist in a vacuum; many factors – perhaps most  importantly a firm’s reputation - should be borne in mind. Financial services regulators in particular have for some time called for restraint on variable pay, particularly during the pandemic, and for firms to link financial incentives to wider objectives such as diversity and inclusion. Some have pushed for a re-think on how executive pay should be set and for non-financial metrics to be incorporated into targets for bonuses and long-term incentive plans.

However, despite expectations the government has avoided legislating on the issue. The Queen’s Speech this month contained no employment or corporate governance bills and has left the issue to regulators and trade bodies to encourage best practice, with external stakeholders continuing to apply pressure. Without legislative reform on the horizon, employers are left with little clarity and bodies such as the FRC (in its new incarnation, ARGA) with few enforcement tools. By way of example, at a recent annual meeting of the mining company Rio Tinto, 61% of shareholders opposed a large bonus for the outgoing chief executive who resigned following public outcry about the company’s destruction of sacred Aboriginal rock shelters, while The Times recently reported that the pay report of Hochschild Mining may be rejected by shareholders who wish to reduce the portion of the chief executive’s remuneration which was linked to safety performance of the firm to nil . Despite this opposition, the packages were expected to proceed as the vote was only ‘advisory’.

COVID-19 considerations

During – and emerging from – the pandemic, public sensitivity to executive pay awards has sharpened. The Institutional Shareholders Service published a Q&A document on executive pay in continental Europe during COVID-19, noting:

In the context of the COVID-19 pandemic, above-inflation pay raises or increases in variable pay opportunity are likely to be considered inappropriate and should be supported by a particularly compelling rationale.

Companies that had poor performance, imposed sacrifices on their workforce or required government and/or shareholder support or other funding to face the pandemic are generally expected to pay little if no variable remuneration to their top executives.

In a joint report on executive pay, the Chartered Institute of Personnel and Development (CIPD) and the High Pay Centre (HPC) identified that 36 of FTSE 100 firms cut CEO overall remuneration due to the impact of COVID-19 but the most common action was to cut executive salaries (which typically comprise just one fifth of total CEO earnings) by one fifth. The report urged Remuneration Committees (RemCos) to re-think executive pay and to look at wider workforce issues and organisational cultures’ relationship with CEO pay. The CIPD and HPC are working together to provide guidance for RemCos and have called for listed firms to establish a formal people and culture committee in place of their RemCo, or at least to broaden the remit of RemCos to consider organisational culture, fairness and wider workforce reward policies.

Sensitivity is particularly acute where firms have received government support during the pandemic. The HPC published analysis of the first year of disclosures of CEO pay ratios, highlighting those firms with large pay ratios who have received government support. Recent media reports have also criticised banks which have received furlough support and then disclosed that they are setting aside additional money for bonuses this year. Reputational issues abound.

External stakeholder pressure

Investor pressure on executive pay has hardened. Investors are much keener to see companies follow best practice in pay awards and are quick to speak out where they see bad behaviours being rewarded. The Investment Association has urged RemCo chairs of FTSE 350 companies to exercise restraint in executive pay awards and to consider the wider employee pay context and fairness when setting pay levels. Fidelity International has written to FTSE 350 companies saying that it wants to see ‘a restrained approach to executive pay’ this year and warning that it will vote against bonuses for executives whose companies have used schemes such as furlough without repaying that money.

Shareholder pressure is also being brought to bear, not only on the level of pay in isolation but in response to what shareholders perceive to be bad decisions, such as the Rio Tinto example above. Media reports have highlighted a shareholder rebellion over a lack of board diversity in one major retailer and shareholder opposition to a significant bonus award to the CEO of a bank which suffered heavy losses last year. Barely a week passes without media ‘naming and shaming’ of a company making a large pay award in circumstances that are less than ideal.

CEO pay ratios

Scrutiny of CEO pay has been made easier by the requirement under the Companies (Miscellaneous Reporting) Regulations 2018 for large companies to disclose CEO pay ratios. Analysis of the first pay ratio reports was carried out by the HPC, which followed up with a briefing on how these disclosures could be used to inform Environmental, Social and Governance (ESG) strategies.

Companies obliged to disclose under the regulations should make good use of the opportunity to produce a supporting narrative and explain significant disparities. However, such explanations can easily get lost in press coverage about the sometimes blunt instrument of the particular pay ratio, exposing companies to sometimes unjustified criticism.

The HPC argues that the CEO pay ratio reports provide insights into business models and corporate cultures. Companies associated with low-paid work are at higher risk of reputational problems, industrial disputes and employee engagement issues including higher staff turnover and absenteeism, higher recruitment and training costs and productivity. The pay ratio disclosures could help investors to better identify where these risk factors are highest.

The HPC recommends that investors should monitor pay disclosures, engage with companies whose disclosures provide grounds for concern and vote at AGMs when engagement fails to achieve desired aims.

Links to ESG and governance more widely

According to recent research from BlackRock¹, one in five investors are more interested in sustainable investing because of the pandemic and intend to double their allocation to sustainable and impact investing over the next five years. The revolution in ESG awareness has been extraordinary. External stakeholders – shareholders, clients, customers – want to see businesses that adhere to sustainable and fair practices and there is pressure on companies from all sides to ensure that their working models accord with ESG best practices.

To this end, remuneration, as noted by recent joint FRC/ Portsmouth University research of FTSE 350 companies, is at the heart of governance and the role of a firm’s RemCom is key. We see that companies are now disclosing more information about engagement with stakeholders albeit this does not extend to reporting on engagement with firms’ workforces which remains under-reported. The report urges companies to take account of the wider workforce when considering remuneration for executive directors. Workforce pay and policies and engagement with employees should be reported in more detail, particularly when reporting on company culture and remuneration.

The report also notes risks associated with excessive pay and that there appeared to be little reporting on how companies planned to mitigate such risks. Further, many companies now use non-financial performance indicators in executive pay formulas but do not explain how they are assessed or the link with wider strategy. That said, over half the sample surveyed linked remuneration with ESG objectives and provided detail on this. For example:

• one firm provided details noting that their group performance assessment included ESG metrics and assessed to what extent the committee were satisfied that the bonus structure and resulting outcomes for all employees did not raise any ESG risks by inadvertently motivating irresponsible behaviour
• another firm had their committee consider corporate performance on ESG issues when setting the remuneration of executive directors and in determining whether to exercise its discretion to adjust formulaic outcomes of the annual bonus and long-term incentive plans

Another report by PwC and London Business School² examines the link of executive pay to ESG metrics such as diversity and highlights a shift from ‘old’ (meeting regulatory requirements and managing risks) ESG to ‘new’ (sustainability and social responsibility) ESG. Financial services firms have a high prevalence of ESG metrics in executive pay and a number of financial institutions are now considering climate related goals within pay. 60% of the 20 financial services firms in the FTSE 100 include an ESG measure in executive pay, 50% in the annual bonus and 35% in the LTIP. These are generally risk related measures or relating to diversity and employees.

The report also highlights the downsides of linking ESG to pay where executives deliver strong ESG performance but do not meet the precise targets since the incentive measures the wrong or different factors. Additionally, ESG targets are difficult to measure and assess and can add more complexity to executive pay.

Further considerations

Without input from the government, it is left to the regulators, stakeholders and wider public to ensure that executive pay aligns with good corporate strategy, ESG objectives and healthy values. To some extent, this is already happening and a mind-set shift can be perceived. For example, the Investment Association’s Principles for Remuneration 2021 focuses on the balance between the need to incentivise executive performance whilst ensuring that the executive experience is ‘commensurate with that of shareholders, employees and other shareholders’. The Principles have been updated to be clearer on shareholder expectations on non-financial metrics in variable remuneration.

From a legal standpoint, if executive pay is to be overhauled, employers should first consider whether there is a contractual right to amend the terms of variable pay. There have been calls for a more robust and targeted use of malus and clawback; employers should check what provision they have in their contracts and how widely malus and clawback provisions are drafted. Have any oral assurances been given around pay that may cut across any non-financial metrics that are hard to measure? How do executives deliver against objectives?

Going forward, when designing pay strategy variable pay should be linked to cultural targets such as diversity and inclusion, as repeatedly exhorted by the FCA. Not only is this the right thing to do, it will make executive pay more palatable to the wider workforce, stakeholders and public.

1 https://www.blackrock.com/corporate/about-us/blackrock-sustainability-survey

2 https://www.pwc.co.uk/human-resource-services/assets/pdfs/environmental-social-governance-exec-pay-report.pdf