Robert Knox, Associate, Mercer Human Resource Consulting
In 2001, we provided a number of insights into the changes occurring in CEO and senior executive reward in our article titled 'CEO/Senior executive reward, performance and benefits: what's happening?' Since then, many of the changes we outlined have evolved further both due to conditions that had already been identified in the market in 2001 and to some significant events witnessed in the past 12 months. Here we draw on some of the observations made in that article and assess the changes that have occurred.
Executive pay has been drawn firmly into the public arena in the past 12 to 18 months following a number of events in Australia and overseas. These events have included:
- the collapse of corporate giants Enron and
WorldCom;
- the revelations of mismanagement at the executive
level emerging from the HIH Royal Commission;
- the review of executive
option plans by some high profile organisations;
- the injection of executive pay levels and practices into the political arena.
The collective effect of these and other events has been to generate considerable public debate about the nature and quantum of executive pay. In much the same way as consumers seek value for money in the goods and services they purchase, the debate surrounding executive pay has been about value for money and not simply the size or nature of remuneration.
Executive pay in a soft economy
A range of variables can influence trends in pay practice at both the executive and non-executive level. Many of these variables are external to individual organisations. Macroeconomic conditions, the socio-political climate and technology are all key external variables that could potentially influence trends in pay practice, particularly at the executive end.
Following a decade of sustained global economic growth, we have experienced economic contraction over the past two years. This contraction has been accompanied by corporate failures and reduced profits for many organisations. How has this change in economic conditions influenced executive pay in Australia? The diagram below shows GDP movements for the past five years plotted against executive salary movements for the same period. The point worth emphasising is that at the median of the market movements in executive salaries for fixed pay have tracked in a narrow range of between 4% and 5%, seemingly independent of GDP movement. At the 75th percentile of the market, however, the executive salary movements for fixed pay appear to be more sensitive to changes in GDP movement.
Executive salary (fixed pay) and GDP movements (1997-2002)
The socio-political climate both here and overseas has also shifted in the past 12 to 18 months. The response to the events of September 2001 and the speculation surrounding war in the Middle East has increased global uncertainty and this has been reflected in fluctuating stock markets across the globe. This situation is also inclined to heighten, rather than diminish, the likelihood of government intervention in a whole range of politically sensitive issues, and executive pay is one such issue. This is even more likely when corporate governance in many organisations has been found wanting and where corporate excess has been revealed, such as in the case of Tyco.
We can expect further debate about whether governments here and overseas should introduce legislation as a means of intervening in the nature and quantum of executive pay. The mere threat of legislation could bring about subtle changes in pay practice as organisations, or the market more generally, attempt to anticipate government moves in this area. One aspect of executive pay already under scrutiny is stock options. The Commonwealth Bank has recently signalled its intention to replace their stock option program. Over the coming twelve months it would not be surprising to learn that other organisations have made similar moves to that of the Commonwealth Bank.
And what of technology? The fact that information such as share prices and exchange rates can be aggregated, analysed and distributed in 'real time' to a wide audience means that shareholders, and the public in general, can take a more active role in placing pressure on boards over matters such as executive pay. When share prices fall and this coincides with shareholders hearing of generous incentive payments to executives, supposedly performance-based, questions are asked.
With this in mind, it is worth determining whether executive reward plans that were designed during prosperous times are still aligned with current conditions.
Last year we introduced the concept of calibrating pay to performance in relation to executive pay. The diagram below serves as a reminder of this model. The 'Market value measure', on the 'X' axis could include shareholder value, revenue growth or other suitable metrics of business performance. The key to the model is ensuring the measures being selected are pertinent, so that the right set of behaviours are being encouraged. To simply say that a particular executive is a high performer may not only be a sweeping generalisation, it may also be in reference to measures that are not currently important to the organisation.
Executive pay: calibrating pay to performance
The relationship between fixed and variable pay in 2002
In 2001 we reported that CEO pay structures among major corporates were comprised of 52% fixed pay, 17% STI and 31% LTI. How has this picture changed in the ensuing 12 months? Given the uncertainty in the economy it is not surprising that the change in this pay mix has been marginal. One of Mercer's recent executive pay studies nevertheless reinforces the trend that the 'at risk' component of executive pay (i.e. the long-term and short-term incentives) is anticipated to grow in relation to fixed pay.
When asked if the 'at risk' component of executive pay has increased, decreased or remained steady, almost 60% indicated this component had remained steady, about 33% indicated it had increased and the remainder indicated the 'at risk' component had either decreased or they were uncertain.
CEO survey: movements in 'at risk' pay (STI & LTI) for 2001-2002
Recent movements in executive pay levels
Does pay move backwards? It can in some instances.
And certainly components of pay can be reduced. Many executives are familiar
with the international model of executive pay. This model is composed
of three core elements:
- Base pay
- Annual incentives (also known as short-term incentives)
- Long-term incentives
In a dynamic marketplace, it would not be surprising to learn that individual elements can increase or decrease at the same time that the total reward is increasing. The diagram below reveals what can happen to an individual's remuneration package between one year and the next. In this example, the fixed pay component is unchanged while the short-term component increases marginally and the long-term incentive component increases noticeably.
Changes in executive pay structure
Over the past 12 to 18 months there has been a slowdown in the rate of increase of executive salaries. This has particularly affected the fixed pay component as shown by the market median percentages (refer to 'Executive salary (fixed pay) and GDP movements' above.
Although individual pay cuts are far more often the exception than the rule, when we look at the overall market in times of economic slowdown, the salary level for a given role in the market can drop. For example, in tough times the first people that organisations will seek to terminate are employees who are regarded as overpaid and under-performing such as those who might be aligned to the bottom left quadrant of the diagram, 'Executive pay: calibrating pay to performance', above. If this happens across a number of organisations, the effect is to remove a number of relatively highly paid individuals from the organisation's survey group. Similarly, when there is a surplus of people for these roles, there is generally no need to pay a premium to fill vacant positions. In fact, under these circumstances, people can often be brought into an organisation at a pay level below the market median.
The chart below illustrates what can happen to a survey sample between one survey period and the next, particularly in times of soft economic conditions. On the surface, individuals appear to receive plausible increases, but because of the change in survey composition between the two periods, including individuals entering and leaving the sample, the effect is an overall drop in the market rates for the position except for the top 25% of the sample.
New entrants receive below median pay: a hypothetical sample
This chart shows the potential impact of changes to a hypothetical remuneration survey sample for a senior role. The chart shows fixed pay for individuals for two survey cycles. Those that remain in the sample receive an increase and new survey entrants are paid below the median of the market. The overall result is a drop in pay levels for all but those in the upper quartile (Q3).
Reduced pay levels have been observed across a number of executive and non-executive roles over the past 12 to 18 months. Recognising this will be important when benchmarking salaries for the coming year.
Evidence also shows that the levels of short-term incentive payments for executives have dropped in the past 12 to 18 months. This can be linked to declining profits among Australian businesses and in the case of multinational companies, may be linked to global head office decisions. Data collected over the next six months or so should confirm the extent of this decline.
The interest in executive pay is likely to remain strong in the coming months, particularly if overall business performance remains subdued. Because of this, executive salary movements for fixed pay are likely to be restrained (less than 5% at the median). Where more aggressive increases are provided, there will be an expectation that there is a demonstrable link between reward and organisation performance.
We will continue to see the trend of an increasing 'at risk' component of executive pay. This will include both increasing the proportion of remuneration 'at risk' in annual incentive plans and increased use of long-term incentive plans. While there is current controversy regarding the use of options plans, other long-term incentive plan designs (e.g. performance shares, cash) will be given more consideration.
A recent study undertaken by Mercer, Executive Incentive Plans, suggests we are likely to see an increase in targets for short-term incentives but a reduction in the caps being applied to these incentives. Based on current evidence, actual short-term incentive payments will probably remain below targets given the challenging business environment.
Increased attention is being given to the relatively short tenure of many senior executives, particularly CEOs. Not only do businesses need to ensure that they have appropriate retention and succession plans in place, they also need to ensure that the reward levels and structures offered to their senior executives account for this situation.
