In an interview with Chris Legge, Gerrit Aronson – an independent adviser on pay strategy to boards of large global corporations – discusses the challenges faced by remuneration committees when dealing with executive reward and how his ‘4M’ methodology can help to overcome them
Executive pay levels have always met with controversy – either internally with shareholders and employees, or externally with regulators and the public. A year after the banking crisis and the consequent recession, executive pay and bonuses remain a key headline in newspaper columns, and a chief political issue which spans continents, as evidenced by the measures being considered by US, UK and European leaders and governments. Recently, US President Barack Obama announced that executives working for American companies, which were bailed out by US taxpayers, are to have their salaries cut by up to 90 per cent, in a bid to crack down on the fat-cat culture of big business. Although the UK treasury is not planning to follow suit, it insists that “tougher measures have already been put in place to tackle the massive pay-outs that contributed to the banking crisis, and that in the future it will align remuneration with performance.”
So going forward, remuneration committees will continue to be in the spotlight, and a robust method for determining fairer executive pay must be sought. In our interview with Gerrit Aronson, a former non-executive director of ER Consultants who advises international boards on remuneration and related people issues, we explore the common issues and insurmountable problems faced by remuneration committees when dealing with executive reward. We also reveal how his ‘4M’ methodology provides a simple template to help determine the right type and level of remuneration for global CEOs and executives.
Q: Why’s it all so difficult and controversial?
A: The world isn’t fair. American CEOs typically make a lot more money than European or Asian CEOs for the same job. The difference between CEO pay and ‘average worker’ pay is large and getting larger. There seems to be no way to satisfactorily explain such differences with science, or fact. It’s about judgements, and there are a lot of different and often conflicting perspectives that impact people’s perception of what is fair and right. There are a lot of stakeholders involved. Top executives operate in a competitive market that requires certain ‘competitive’ pay levels to employ and engage them – just as plumbers, accountants, football players, etc. Investors seek value in their investment and want to balance great leadership with ‘not paying more than you have to’. The public is informed by media often more focused on the sensational and exceptional than on the normal and somewhat boring. Governments have different tax laws and legal codes that affect what pay approach is prudent. So setting an effective pay strategy for top executives in global companies, particularly if there are a mix nationalities and countries of operation, is complex and likely to remain controversial.
Q: What exactly is the ‘4M’ model?
A: “It’s really a pragmatic template to assist in determining appropriate pay strategy for top executives in global companies. The 4M approach evolved in response to the ongoing issues in executive pay and performance, with the method focusing on the key principal areas for determining levels and type of remuneration, namely:
- Markets – with whom do you compare and why?
- Mix – how do you slice the pie between base, short, medium and long term variable elements, and pension?
- Measures – what will you base the variable pay on?
- Morals – what’s fair, justifiable and defendable?
Q: Can you briefly expand on these four areas?
A: Markets – Competitive compared to who?
Relevant and robust market data is a key start point. Market data should not determine overall pay but it should inform the decision. Investors often worry that the benchmarking process results in ratcheting up of total pay and there is a such risk. But to ignore market realities is equally dangerous. Choosing appropriate companies to compare to, determining how different national norms should reflect the profile of your business and executive team, and assessing data rigorously and independently are all key for a remuneration committee. Remuneration committees should be thinking of total compensation and the choice is often down to, what are the relevant markets and the structure or composition of the board?
Mix – How do you slice the pie?
Addressing the mix necessitates consideration of total compensation (fixed and variable) including pension provisions. It must fit with the nature and strategy of the business in question. The design of the mix should reflect business timescales, investment strategies and cycles, product development and market dynamics – something that is often over-simplified when compiling a reward portfolio. So companies with very long business cycles, such as the energy sector, may well have a higher proportion of long-term pay than those with shorter cycles, such as FMCG. Similarly, companies whose performance can actually vary considerably may have a higher and more leveraged variable element than those who have stable performance. Whilst there are currently government and shareholder attacks on short-term bonuses apparently rewarding high risk, bonus/reward mechanisms in banks probably fit the business dynamics rather well. Attention is now turning to how to balance this with long-term deferral and claw-back mechanisms to ensure short-term performance is not at the expense of long-term sustainability.
Measures – What’s performance mean for this company?
While the concept of variable pay finds favour with executives, investors and other stakeholders, putting it into operation seems to be difficult. The biggest issue is often one that on the face of it should be easy – defining what drives shareholder value, focusing key performance measures and setting targets that appropriately set out what constitutes expected and exceptional performance. This is almost always a difficult task for remuneration committees requiring sound insight, balanced judgement and strength of conviction. There are, of course, many well-known pitfalls in setting measures and targets ranging from the blatant sandbagging of targets, to focusing on the wrong measures for long-term shareholder value creation, to creating all or nothing plans that executives treat as lotteries. One issue that receives too little attention is the narrowness of performance ranges. Investor preoccupation with ‘no payment below median’ and executive demand that the ‘maximum must be attainable’, often results in a very narrow band of performance within which pay actually varies. It often results in all-or-nothing outcomes and encourages capricious behaviour to ‘hit the zone’ or ‘bank ’til next year’. Broad ranges are good because they actually make variable pay variable.
Morals – What’s fair?
After all the benchmarking, performance assessment, factual review and independent challenge, there is inevitably (and thankfully), a large judgement element required by remuneration committees. This is as influenced by the experience and values of committee members as by hard data and analysis. In the current economic turmoil there is of course considerable focus on the public outrage stemming from the perceived egregious pay of individuals and organisations that have failed. Without minimising either the scale or significance of these situations, it is fair to say that remuneration committees have equal and legitimate concerns about fairness to executives (even if this may not be a publicly popular role). And so the discussion on what is fair becomes a difficult one with sometimes opposing stakeholders and a broad set of constituents that are interested, opinionated, and affected by the outcome. How to ensure such discussions of these ‘difficult to deal with’ issues are both legitimised and effective is an important governance issue. It suggests that remuneration committees made of individuals with a broad range of experience – both personal and professional – have the most likelihood of debating truly diverse views and arriving at healthy decisions. It also suggests that recent trends to see more ‘internal equity’ analysis as an additional way of deciding and justifying pay at the top in terms of how it relates to pay lower down will become more prevalent. One thing for sure – the moral question never goes away.
Q: What’s the reason behind the success of the method?
A: It provides focus and separation of issues. Very often when people raise issues they are really a combination of issues. So for example they mix up issues around markets (what's the right quantum) with issues about mix (we need more bonus). Separating them and dealing with them in a focused way allows better resolution.
Q: Should other companies be following suit?
A: Well there is definitely benefit in having some systematic approach to determining pay for top executives. Increased transparency is being sought by shareholders and investors alongside broad justification for the size and complexity of such arrangements. Top executives remain in short supply and need pay mechanisms that engage them and support the business strategy. In the current recessionary climate, levels of scrutiny will be on the increase, and this 4M approach provides a logical and defensible framework to work within, benefiting executives and corporate bodies.
Q: How easy is it for other companies to adopt/adapt?
A: Whilst the concept is relatively easy, it is experience and knowledge that really provides the basis upon which design, evidence and challenge can be suitably directed to remuneration committees and as a consequence, a total package constructed. External help can be invaluable in such situations, not just in respect of governance arrangements, but strategically, economically and culturally too [see below].
Q: Growing evidence suggests that increased scrutiny of executive remuneration packages is uppermost in the current climate. What is the way forward?
A: For all the heat on remuneration committees, they are still the best tool to make the decisions on top executive pay. Diverse membership, clear charters, independent support and transparency are important components to make them work. Then it’s down to open discussion and strength of character.
Tailored to Your Needs
As outlined above, International/global remuneration is complex. However, as Gerrit Aronson illustrates, there are logical steps to consider when formulating the right package for your organisation. If your executive pay issues are closer to home, ER Consultants can help you review and develop your existing total reward package.
For more information contact Chris.Legge@erconsultants.co.uk
