Perspectives. What makes remuneration committees effective?

Transcription

1 Perspectives What makes remuneration committees effective?

2 2 What makes Remuneration Committees effective?

3 What makes remuneration committees effective? Vince Cable has been direct in his views about the effectiveness of remuneration committees. In June, in his speech to the ABI, he said: To be frank, I don t see much evidence that remuneration committees have been living up to their responsibilities, or that major shareholders have been holding them to account. Is he right about this? What are the facts about how remuneration committees work and what makes them effective? Towers Watson has, for several years, worked with Professor Brian Main of the Edinburgh University Business School to review in some detail how remuneration committees operate. In recent months, we have conducted a series of interviews with remuneration committee chairmen to update our understanding of how remuneration committees operate and make decisions. This work builds on research that we published in 2008, and supplements Towers Watson s many years of advising and supporting remuneration committees. Currently we have two types of advisors, one to management and one to the remuneration committee. This can create tension or it can create a strange dynamic if the two advisors are different. The chairmen we interviewed represent UK-listed companies in a wide range of circumstances (in terms of industry, company size, and so forth). The characteristics of our sample are summarised below. 15 chairmen of remuneration committees were interviewed between May and July 2011 Their average age was 60 and ranged from 52 to 70 The directors collectively sat on 28 boards (including 13 FTSE 100 and seven FTSE mid- 250) and 23 remuneration committees (including 11 FTSE 100 and six FTSE mid-250) Among them all they chaired 17 remuneration committees (including ten FTSE 100 and three FTSE mid-250) What is working well? On the whole, remuneration committees approach decision making around executive pay in a systematic and nuanced fashion. Most remuneration committees have a clear annual timetable and the supporting processes are well-established. Members are independent and objective with broad-based experience and backgrounds. Members are willing to devote time to decision making and stakeholder management. Remuneration committees and their members are acutely aware of the need to balance internal and external interests and priorities. Key findings Looking further into the details, some interesting findings emerge from our interviews. Views were mixed on the extent to which pay drives behaviour. A total of seven remuneration committee chairmen said that it does. One said: Long-term incentive schemes very much incentivise behaviour a badly designed scheme can lead to perverse outcomes as a result. But three remuneration committee chairmen were of the opinion that it did not, and the rest were equivocal. Pay determination is often less motivational and more about retention: People won t take their foot off the throttle if they re not paid. They ll perform, it is more about retaining people. Among the chairmen who were more ambivalent, one said: It s a complex set of motives. If there is a problem with pay there s usually something else wrong. Pay is not about quantum, it s about relativities. Technical knowledge of pay is not a prerequisite for sitting on a remuneration committee. Remuneration committee chairmen are experienced business leaders who build up detailed expertise through training, advice, and experience. The remuneration committee s role in the executive pay setting process varies from board to board some are more active than others in driving pay decisions. Reviews of executive remuneration are generally infrequent and tend not to follow a fixed timetable. What makes remuneration committees effective? 1

4 The roles and responsibilities of internal and external advisors are often not clear. Remuneration committees may not have the market/business information to allow them to place executive directors pay into context. What has been earned from executive pay in prior years is generally seen as being of little value for decision making. Originality can be stifled by shareholder guidelines and what others are doing. Who advises whom? The flow of information (or market data on pay) to the stakeholders involved in the executive pay setting process follows different paths in different companies. The data can flow directly to the remuneration committee, which may then share it with the HR team and management. Alternatively, HR may receive the information and channel it to both the remuneration committee and management. It is also possible that the committee and management receive their own separate data, even having one advisor for the committee and one for management. One director said: Currently we have two types of advisors, one to management and one to the remuneration committee. This can create tension or it can create a strange dynamic if the two advisors are different. Another said: The remuneration committee has a strong view that there is one advisor who provides all the advice and thus it is not a confrontational process with advisors scoring points from each other. The CEO, however, has asked for input from other advisors they can provide input but it is important that they are fully informed and briefed by our own advisors. There were clear cases of remuneration committees seeking their own sources of market intelligence independently of other stakeholders in the pay-setting process. One chairman said: The committee has received advice during the year from independent remuneration consultants who were appointed by the committee. They attended committee meetings when major remuneration issues were discussed and also provided the company with consultancy services on general human resources (HR) and pension issues. The committee regularly consults the Chief Executive, the Group HR Director, the Director of Rewards and Employee Relations, and the Company Secretary. The sharing of this information is seen as important. One said: Boards should be run like an open book, not a state secret and there might be appropriate healthy tension between the board and executive directors, and between the remuneration committee and executive directors. The advice should be fully visible to all sides. Another said: The advisor should be recruited by the remuneration committee chairman and the committee. They should work with the executive team. Decisions on the design of remuneration arrangements Remuneration arrangements often start out as management initiatives, although sometimes the initiative originates from the remuneration committee. Seldom, however, it is at the advisor s initiative. The support of the HR director and the pay team is clearly important, but the descriptions that remuneration committee chairmen gave of how the process of pay setting worked perhaps indicate that closer engagement between the HR function and the committee could improve pay decision making further. Here are some of the comments we heard in this area: The remuneration committee would not initiate the design of a bonus plan but might challenge and pose questions on design. Management makes a proposal to the remuneration committee and the committee then makes a decision. Management proposes and the committee reviews. There is a negotiation and executives have considerable initiative in the process. The executives are where the ideas come from but I would not use the word negotiation we would expect to discuss and debate with the CEO and the finance director to get their perspective. Targets for bonuses are proposed by the finance director with supporting logic and debated in the remuneration committee. With annual salary increases I am keen to have the CEO propose the change for his reports, to get his logic, and then set his in the context of that....we would expect to discuss and debate with the CEO and the finance director to get their perspective. 2 What makes remuneration committees effective?

5 Seeking legitimacy Our research shows that remuneration committees place great reliance on what other remuneration committees of other boards are doing. This is the case not only in terms of levels of pay but also in terms of design and structure. This can lead to an element of mimicry or copy cat policy making. Given the prominent role of remuneration guidelines in shaping this common approach, shareholders however unwittingly may have encouraged conformity rather than innovation. We discuss around the table what our other remuneration committees are doing. There is a danger of being sheep, but sometimes it is quite helpful. The remuneration committee is quite sensitive to what other remuneration committees are doing as the members all have experience either in their own companies or in other remuneration committees. We have created conformity driven by the corporate governance guidelines. When we want to create something new, for example, profit share, or private equity style plans, it can make it very difficult. Executives are cynical about performance conditions but investors want stretching targets this means that we have conformed to a certain type and the question is do they really incentivise and influence behaviours, or are they just expected? Remuneration in the UK feels strait-jacketed. The tick box culture means you do what other people do, but it doesn t make sense for us. The application of discretion All but two respondents indicated that the remuneration committee did, on occasion, exercise discretion generally both upwards and downwards. What hinders (-) What helps (+) Aggression/emotional behaviour/ self-interest Chairman of remuneration committee who is not engaged Lack of data/poor data Too much shareholder involvement Pursuit of best practice as opposed to a business-led approach Maturity We generally do exercise discretion particularly for LTI target levels which are very difficult to set and we need to incentivise. Ranges, particularly for the EPS ranges, are small. Therefore, if we take a view that the company has done well then we might change these. We sometimes refer to ourselves as the goalpost moving committee and it s a regular topic at remuneration committees. One of those who ruled out discretion explained as follows: If you do a good job designing the scheme, then there should be no need to intervene. The shareholders have to go with the rough and smooth, and so should the executives. If they are in it for the long term, they ll be all right. In particular, discretion was used when designing or altering arrangements with the aim of retaining particular key executives who may be on the point of leaving the company: Retention payment we are involved with lots of one-off discretionary plans. Strong and trusting relationships between management, the remuneration committee and the wider board Good (and timely) data Appropriate shareholder involvement/engagement An active and respected company chairman and remuneration committee chairman, plus time and preparation What makes remuneration committees effective? 3

6 Key success factors 1. What makes a successful remuneration committee? Our research shows that the basis of an effective remuneration committee lies in the following: Establishing a professional but non-adversarial relationship with the CEO Ensuring a good mix of backgrounds and experience on the committee A supportive and independently minded HR function whose role vis-à-vis the remuneration committee is clear Effective, well-deployed external advisors Establishing protocols on where recommendations spring from. In half of the companies observed, management proposes to the remuneration committee An effective chairman of the remuneration committee 2. What makes an effective remuneration committee chairman? Our analysis indicates that the following characteristics are associated with the effective performance of the role of remuneration committee chairman: High emotional intelligence Preparation and time spent outside meetings Leadership and listening skills A good relationship with the CEO and the senior management team The ability to take soundings combined with toughness and resolve Credibility and confidence Experience in managing investor relations Contacts For further information, please contact Katharine Turner on ( katharine.turner@), or Richard Belfield on ( richard.belfield@), or your usual Towers Watson consultant. 3. Is your remuneration committee effective? We have used our research to identify the following priorities for action: Establish clear roles and responsibilities for all stakeholders Assess the impact of your current remuneration policies Ensure a shared view of what you are paying for and what you should pay for Assess both the emotional and the rational factors Assess the risk inherent in your pay arrangements Ensure that key stakeholders have a sound technical understanding of pay (and solicit support if not) Avoid the danger of copy cat behaviour rather than innovative pay design by careful assessment of what is right for your company Key facts The remuneration committees typically had four members; the range was three to six On average the remuneration committees met six times a year. Directors generally underestimated the number of meetings that had taken place Meetings generally last between one and a half two hours The average time spent on formal remuneration committee meetings was 11 hours a year and the range ran from two hours to almost 20 hours Most remuneration committees set the pay of executive directors and those executives at the level below Three of our 15 interview subjects had a formal background in remuneration In half of the remuneration committees, the chairman of the board was a member of the committee 4 What makes Remuneration Committees effective?

7 What makes remuneration committees effective? 5

8 About Towers Watson Towers Watson is a leading global professional services company that helps organisations improve performance through effective people, financial and risk management. With 14,000 associates around the world, we offer solutions in the areas of employee benefit programmes, talent and reward programmes, and risk and capital management. Towers Watson Limited, Towers Watson UK Limited and Towers Watson Capital Markets Limited are authorised and regulated by the Financial Services Authority. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. Copyright 2011 Towers Watson. All rights reserved. TW-EU September 2011.