June 21, 2016 Executive pay – the unintended consequences
One of the key roles of the executive team may be to ensure that organisational success is delivered through strong governance but can the reward structure actually act against effective delivery of the strategy? That was the question examined by a recent Stanford University research paper and reported in the Harvard Law School Forum on corporate governance and financial regulation.
The paper entitled ‘CEO Pay at Valeant: Does Extreme Compensation Create Extreme Risk?’ looked at the way in which a compensation package which focused on long-term value creation led to an initial rise in the value of shares, followed a few years later by a devaluation of 90%. Using this case study as an example the paper’s authors asked a number of questions including to what extent were the fortunes of the company tied up with the remuneration package and whether a single performance measurement should have been used to judge reward. More particularly, the paper highlighted the importance of striking the right balance between encouraging pay for performance and excessive risk.
The question of executive compensation has moved up the corporate agenda in recent years. The headlines may have been taken by those in the financial services sector, particularly in respect of deferred reward schemes, but the importance of balancing risk and reward packages has moved away from being simply the preserve of remuneration committees and is now very much in the regulator and shareholder arena. Indeed in its recent consultation on succession planning, the FRC highlighted the way in which flawed pay structures can be exacerbated by ineffective succession planning processes and counselled companies and investors to consider the interdependency of succession planning and executive reward.
As the report’s authors commented “The litmus test for an effective compensation program is whether it provides pay for performance” adding that “while the concept of pay for performance is simple, its implementation is not.” Put simply, it is not enough to believe that’ x’ pay package will achieve ‘y’ outcome. For some executives it may well do, but others may see the reward package in terms of a threat and a disincentive to act, whilst others again may act solely with a view to achieving the reward package regardless of the long-term consequences to the company.
So how do companies avoid the unintended consequences of executive pay packages? Firstly, the reward package should be structured not only with the aims and strategies of the organisation in mind, but also bearing in mind the personal leadership approach and attitude of the executive team. It is also particularly important to subject executive remuneration to regular scrutiny and review with the twin aims of ensuring the organisation is on track to deliver the strategy and that there are no unintended consequences which could lead to long-term damage to the company’s reputation, strength or performance.