Executive Pay

Executive Pay
Published: 
September 2012

Salaries for corporate bosses have skyrocketed. The question is, are shareholders getting value for their outlay?

Incentives are supposed to change behaviour - that’s the point.

Now that shareholders have the power to remove boards that pay executives too much money, understanding the link between pay and good corporate performance is crucial, says UQ Business School Associate Professor, Dr Julie Walker.

The increasingly contentious issue of executive pay continues amidst further evidence that top Aussie bosses are still ratcheting up salary and bonuses. To the bystander at least, there is little evidence of any link to performance.

That executive pay is excessive is hardly news. There has long been a gap between what corporate boards and shareholders feel is a reasonable reward for top management.
No longer acquiescing to bad company executive pay practices, shareholders are finally fighting back – their disapproval expressed by votes against management on pay. They are combing their top executives’ pay packages for dodgy or badly written bonus plans and scrutinising them to see whether so-called pay-for-performance plans, in fact, reward poor performance.

By emphasising short-term profit in bonus arrangements, institutional fund managers have sometimes been seen as part of the problem, since they have encouraged executives to focus on profit margins at the expense of long-term growth and investment.

What is surprising, then, is that despite the howls of protest from investors about escalating salaries, and greater regulator and investor scrutiny, return on investment for executive pay is not measuring up to any other use of corporate capital.

Obviously, companies need to pay their top people well. But managers must be paid in proportion to the value they add. This can only be assessed by taking into account the capital they employ to create value and the risk that capital is exposed to. Ultimately, in this debate, the question is changed from, ‘are shareholders getting good value from the executives?’ to ‘have compensation schemes had the perverse result of harming shareholders’ interests?’

Dr Julie Walker, Associate Professor in Accounting at UQ Business School, says shareholders are right to check remuneration reports since pay still isn’t matching performance.
Dr Walker has analysed various components of 240 ASX-listed companies between 2001–2009, a period that straddled regulatory change in Australia. She wanted to see how far real pay moved with improved company performance.

For her, the relationship between executive pay and company performance is still very weak: a 10 per cent increase in shareholder value correlates to only about a 1.11% rise in executive pay.

While this level of pay-to-performance is consistent with the US and UK, it is far from okay.

“Since executive pay is usually justified on the basis that managers need relatively high levels of incentive-based remuneration so that they will take necessary risks and boost shareholder wealth, it seems strange to find such low levels of pay-to-performance in evidence,” she says.

“We make a fuss about performance-based pay and yet when we measure it, the performance component is a really small part of total shareholder return and hardly powerful as an incentive. If we say the absolute salaries are too big, then packages contain a big whack of fixed pay.”

After analysing pay packages for both a bull market as well as in the 2008 downturn, Dr Walker concluded that tougher regulations have had a positive affect on the executive pay process. The trouble is, the positive impact should have been more dramatic. Regulators have been slow to act.

It wasn’t until the Corporation Law Reform Act in 1998 that companies were forced to disclose exactly how their executives were paid or incentivised. But even then, the poorly drafted rules weren’t policed.

Add into the mix the numerous instances of egregiously high salaries being paid out on the basis of fictional accounts.
Things improved in 2004, says Dr Walker, following a very prescriptive international accounting standard which demanded corporate bosses be more upfront about disclosing salaries and bonuses.

From where she sits, regulators could do a whole lot more – especially when it comes to disclosing how payouts are determined. “For instance, the calculations on how cash bonuses are tied to performance measures are still too vague.”

Cash bonuses are often payable at the discretion of the board.

“Incentives are supposed change behavior – that’s the point. We need to provide better incentives and tie more of executive pay to the value of the corporation,” she believes.

That view fits with Dean Paatsch, director of proxy firm Ownership Matters Pty Ltd, who rails against the one-size-fits-all mentality when it comes to pay, preferring companies to thoughtfully tailor executive incentives to each business. “Also, they should remove the effect of general market movements – you don’t want to reward someone for being in a rising market when commodity prices are booming.”

According to Paatsch, executives are currently on a mission to de-risk their pay packages by eschewing share incentive schemes and clamoring for cash.
Share incentive schemes which were so attractive in a bull market – because they kept on paying out as share prices continued to climb – are clearly way less desirable in a downturn or in times of uncertainty.

Says Paatsch: “We are seeing a dramatic rise in both the executive cash pay base and cash bonuses.”

He warns that if boards continue to give in to the executive demand for more cash – without it being tied more to performance – then executive productivity will deteriorate just when low labour productivity is coming under fire.

Worse, the sudden and significant cash outlay is starting to hit the bottom line for many
mid-cap companies. “It’s not unusual for salaries being paid to key management personnel to be between five per cent to 10 per cent of corporate profit.”
Transurban chief Chris Lynch’s pay was seven per cent of all employee expenses.

Clearly, any sea-change in compensation structures has to come from shareholders. We’re seeing far more shareholder attention being paid to executive pay policy, partly because of the federal government’s controversial two strikes rule introduced last year.

This empowers disgruntled shareholders to remove the board if 25 per cent of them decide after two years that corporate bosses’ salaries are too high. This can change the outcome on pay tomorrow.

Attracting and keeping talented managers is always hard, and in a tight labour market the challenge becomes enormous. Companies are forced to pay more, putting pressure on margins, which in turn leads boards to demand higher performance, prompting executives to demand even more money.

To John Harte, Australian Institute of Company Directors member and chief executive of Integrity Governance Shareholders, salary disclosure levels (and the cost to the company) are about right.

Company communication stems from uncertain earnings outlook post global financial crisis as well as in high chief executive exit payouts when their stewardship of the company has been unsuccessful.

He worries that the new two strikes rule could present a range of unintended consequences. He says many of the top ASX 100 will find themselves falling foul of this rule if a significant number of proxy votes aren’t counted.

In the US, where shareholders have a ‘say on pay’, the process would have little affect, given the strong culture of the chief executive, who is also chairman of the board. Data analysed by USA TODAY showed chief executives salaries rose two per cent in 2011, following a whopping 27 per cent increase the year before.

Shareholders must involve themselves in the process of renewing boards that are clearly not doing the job properly and prevent rewards for mediocrity or failure. “Disclosure of pay and incentive schemes is giving shareholders the transparency they need to make their case,” says Dr Walker. “Tracking the link between pay and actual company performance is a powerful tool to create accountable boards and executive teams incentivised to generate the returns shareholders require.”