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Under scrutiny. Fairy_Nuff, CC BY

British bosses should be paid more, but bonuses are risky

The global market for CEOs is highly competitive. Shareholders may not like it – and the general public might like it less – but that means British companies could and should be increasing the pay of the people at the top to keep pace with competitors, particularly in the US.

The debate over CEO pay packages continues to grab attention, even more so as Thomas Piketty helps to make income inequality a grand political theme. Multinational corporations around the world keep pushing up compensation and risking the ire of their investors. Companies have sought to address this by increasing the proportion of pay which is linked to performance, but it is no simple task. How long do you give a CEO to work their magic? How do you recoup the cash if it all goes wrong down the line? And how can we develop a multilateral model when companies are fighting over the best candidates?

It is a delicate issue which should be considered from all sides. On the face of it, the move towards incentive-based pay should work. It makes sense to reward bosses for delivering share price rises or relative outperformance, but incentives can focus the mind too keenly. Some shareholders, namely those hoping to hold a stock for a long time, are against this increasing trend to pay CEOs in bonuses, stock and stock option awards based on their performance over one or two years.

No smoke without fire

There is another risk too. Revolts at companies over pay deals may still be relatively rare but they do signal to the market that a company may be facing issues of weakness on the board and potential doubts over management succession. That in turn can push down trading in the firm’s shares, making the stock less liquid, piling more pressure on management and potentially reducing investor returns. Clearly then, it’s a tough call for investors to make too public their distaste for the remuneration at the companies they own.

For their part, the boards which set the CEO’s incentive packages face their own tricky balancing act. If you seek to base pay on long-term performance, then adjusting the criteria in contracts every time there is a change in the firm’s fortunes may discourage the CEO from making the best decisions for the company. Such a strategy imposes the wrong kind of risk aversion on the CEO – the risk to their own wallets. It means that incentives should be more resilient to short-term stock price changes, giving CEOs room to take decisions designed to maximise long-term gains, and not punishing them if the strategy involves some short-term pain. In Britain at least, the threat of state intervention hangs over industry if the balance can’t be struck.

However you structure it, there remains an inescapable reality. Chairmen at those companies which face a relatively high level of shareholder discontent defend their decisions with a rather valid point: peer benchmarking and competition. They claim that incentives are matched to benchmarks in their peer groups.

Keeping up with the neighbours

Demand for decent CEOs, and other top executives, is extremely high and the market very competitive. This gives a board little choice but to match the incentives with what their CEO could achieve elsewhere; the assumption being that the CEO would leave and drag the firm into a worse position which harms shareholder value even more.

It can, of course, be argued that boards simply follow the trend around the world. CEO pay at the top 100 firms in the US increased on average by 9% in 2013. That would imply a need for Britain to play catch up. Research from consultant PwC found that the top British firms were showing restraint in 2013, with many freezing pay and bonuses. By another measure, US unions estimated that the worker-to-CEO pay ratio was at 354 times in 2012, compared to 84 times in the UK.

Focusing on the role of incentives in the US, the proportion of incentive pay in total CEO compensation rose by roughly 1% in financial sector and by almost 8% for pharmaceuticals, according to figures from Wharton Research Data Services. The big jump occurred in mining industry. On average, the US mining firms chose to compensate their CEOs in 2013 with an incentive pay package which is 12% more than it was in 2012.

It makes it a tough call for investors. They must allow company boards to keep pace with their US rivals, but they must take care to target their incentives carefully.

Investors expect better performance from companies to justify high pay, but they can’t ignore the rising tide of compensation which has lifted pay globally for pretty much all firms. In order to keep a valuable CEO within the firm, boards and investors need to bite the bullet on improved packages, and make sure they provide the correct motivation for bosses to look further down the line than the next quarterly earnings statement.

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