Keep it simple, stupid

Executive Pay

1 Nov

1 November 2019

Support for simpler executive pay plans is growing - now both companies and investors need to focus on the possibilities not just the risks

Published on November 1, 2019

Back in 2007 when we were building our executive pay practice at PwC we sought to create a point of distinction through insightful analysis. As part of this we did a lot of work exploring the dynamics of relative TSR conditions. We found that while over a single performance period there was, by definition, a strong relationship between relative pay and relative performance when using relative TSR performance conditions, over multiple cycles this very quickly broke down. Looking over ten years, relative TSR conditions could indeed separate the stars from the dogs. But for companies between the 20th and 80th percentiles the correlation between relative pay and relative performance over the decade was close to zero. We replicated this result across a wide range of sectors. Companies delivering the same cumulative TSR could easily have rewards differing by a factor three or more.

We found that relative TSR conditions have strong option-like characteristics, frequently rewarding volatility of performance rather than sustained outperformance. These option-like features are exacerbated by investors’ insistence on no pay below median, which means that companies crashing between the lower and upper quartiles get much higher rewards than those consistently delivering 60th percentile performance (which compounds over time into serious outperformance). We also saw that relative TSR conditions were heavily skewed by issues such as leverage and the specifics of business mix, particularly in banking and commodity driven industries.

We started to promote the (at the time heretical) idea that perhaps performance conditions weren’t all they were cracked up to be. Could they instead be an example of the law of unintended consequences writ large? Our analysis showed that simple awards of restricted shares coupled with high shareholder requirements created a tighter link between relative pay and relative shareholder returns over long periods than was the case with performance conditions.

In the years since, we have supported a number of initiatives to provide insight on the question of optimal executive pay design. Working with the London School of Economics and Political Science, our 2011 study into The Psychology of Incentives cast further doubt on the efficacy of complex incentive plans. As well as delivering unintended consequences in terms of outcomes, their complexity lead to them being severely discounted by executives, who struggle to see how their actions influence reward.

We worked closely with the Investment Association’s Executive Remuneration Working Group when they took the issue on in 2016. Although progress since has been slow, this was an important turning point as, for the first time, the idea of share awards without long-term performance conditions became something that could be discussed in polite company.

My conviction to the cause was reinforced when I was introduced to Professor Alex Edmans at London Business School, one of the leading global authorities on executive pay. Alex and I worked together on The Purposeful Company Executive Remuneration Report. Scanning the best academic evidence on executive pay, we found compelling support for the proposition that simple deferred share plans should be a much more common, even perhaps the most common, approach. I was struck by the consistency with which the academic evidence pointed towards a mix of cash and restricted shares as being the optimal pay model in most cases for listed companies. We’ve seen increasing numbers of shareholders publicly supporting this position. Yet progress in implementation has remained slow.

Change does at last seem to be in the air. At The Purposeful Company we have just completed a comprehensive study into the state of the market in relation to simpler deferred share alternatives to LTIPs.

Our research shows that investors and companies both believe that simple deferred share plans should be used in place of LTIPs in around 5x as many companies as we currently see. We also found that investors in particular were overwhelmingly positive about the potential behavioural benefits of simpler, longer term plans, which is a position largely supported by the academic evidence. There are barriers of course. Companies find that the trade-offs demanded by investors for support can be too austere – particularly the reduction in maximum award level. Navigating diverse investor views is a challenge for companies and for proxy advisors. As a result, proxy advisor attitudes can be seen as a barrier. Too often simpler plans are only accepted if it can be proven that nothing else works.

We made detailed recommendations in two areas to bring about change:

Process changes to encourage innovation and adoption. As well as positive signaling from investors, we need changes to how companies, investors and proxy advisers engage on and evaluate the implementation of deferred share plans.
Design changes to address concerns from investors about payment for mediocrity and company concerns about performance incentives and the attractiveness of the package to executives.

The Investment Association, in its recent letter to Remuneration Committee chairs, has used the study as a catalyst to re-energise the debate pay structures with the aim of encouraging wider adoption of simpler plans. Having supported this cause for the last 12 years of my career I’ve become used to false dawns. But this feels different. One positive sign is the mirror-image discussion going on in the US, where the influential Council for Institutional Investors recently updated its guidelines to encourage use of long-dated deferred shares in place of LTIPs. The UK is no longer flying solo on this topic. I’m genuinely optimistic that productive dialogue could lead to significant progress.

For the debate to move into practice, the right intent is needed from both sides:

Investors need to focus on the benefits that deferred shares can offer in terms of a simpler and more transparent system that incentivises better long-term performance and alignment with investor interests. The focus needs to be on this prize: if investors only focus on using deferred shares as a way of bringing down pay levels then they won’t get the change they want.
Companies likewise need to focus on the strategic and performance benefits rather than simply turning to deferred shares when LTIPs aren’t paying out. There is also a need for bolder thinking, looking beyond simple reconfiguration of the LTIP box to a wider package restructuring that involves bonuses too. This can help square the circle between making packages that are attractive to executives while ensuring the long-term performance variability that shareholders want to see.

Enabling an environment where companies can choose simpler deferred share plans in place of LTIPs where it’s right for them is a cause I’ve been pursuing now for over a decade. It does at last seem as though we’re making progress. I hope so.