Transforming Executive Pay

Executive pay is clearly out of touch with executive performance.

In the past 30 years or so, while real growth has been difficult to come by in mature markets, executive performance has become short-term transactional (i.e. through the buying and selling of businesses at inflated prices). These transactions have been executed in order to bolster a company’s share price in the short term. For a long time these transactional results seemed positive, and executive pay correspondingly grew.

But then the edifice crumbled with the financial crisis—companies had been borrowing to afford their purchasing of other companies at inflated prices, and could no longer afford it. The short-term transactions weren’t creating long-term value, and shareholders have started to revolt against high executive pay—Shell provides one recent example.

Now citizens and politicians are starting to expect longer-term sustainable results, and as such, companies need to start linking executive pay to transformational results rather than transactional results. In other words, they are looking for long-term, sustainable performance rather than short-term profit-seeking.

One can look to companies in Scandinavia to see the long-term approach in action. These companies work on different pay structures: their executives are hit by up to 70-75% tax, and they don’t have intense shareholding and bonuses—they just get a small bonus if they do well. Their take-home pay may be negligible compared to top UK or US directors, yet the companies these Scandinavian executives work for have been relatively unscathed in the financial crisis—their sustainable approach has served them well.

Of course other parts of the world couldn’t just copy the Scandinavian model and change overnight—the cultural context needs to be considered. In continental Europe, a professional has a high standing regardless of pay, whereas in the US and UK, high standing comes from one’s amount of compensation—essentially better pay makes you a better expert (or shareholders trust that one is a ‘better expert’ if he/she is paid a large amount).

And so three elements need to be assessed when considering executive pay: the company’s performance (Are company transactions creating profits?), the company’s sustainable approach (Will the brand survive over the long term? Are all stakeholders properly engaged?), and the company’s cultural context (What cultural issues does the company face? Are executives properly paid for their cultural context?). Considering these together can make executive pay difficult to quantify.

Boards need to be more responsible in establishing how much roles are worth, rather than entering into excessive negotiations to get the ‘best person’. The concept of spending a great deal of money to get the best person is seriously flawed, as Shell CEO Jeroen van der Veer recently made clear, saying: “You have to realise: if I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse”.

In determining pay, an analysis has to be done based on the role, not the person. However, current thinking on executive pay is based on the person, not the role. David Bolchover’s recent article in the FT noted that despite the financial crisis, executive pay will continue to be assessed on a comparative basis, using comparative data to find an average salary range. This is nonsense. Just look at Shell—they’re currently facing potential damage to their reputation from allegations of misdoings in Nigeria—a role dealing with that situation would face complex issues; it would be difficult to compensate for such a role based on salary averages. Company boards need to determine what their executive roles are worth, taking into account the role’s challenges (not the position’s comparative median), and have the guts not to negotiate with people beyond a set range of boundaries.

Boards need to have the confidence and courage to enter into more clever ways of assessing executive pay. They might not recognise it now, but the right level of executive pay is imperative for their companies’ long-term sustainability.