Executive remuneration in high definition Article two a high definition approach to benchmarking Our latest series of papers turns a high definition lens to different aspects of executive reward. This second article examines the use of benchmarking. What is executive remuneration in high definition? Sensible remuneration strategy is often undone by poor execution. When looking at the remuneration policies of new or potential clients, we often find that an apparently sensible remuneration strategy is undone by poor execution. This usually has its roots in low definition thinking too many remuneration committees are satisfied with a set of fine sounding policy statements without realising that these are being undermined by the reality of how they are applied. The good news is that these problems are not difficult to fix. The solution is to dig a little deeper, to ask the why? question and to prod and poke the policy to see if it is robust: in other words to look at executive remuneration in high definition. This article is the second in a series turning a high definition lens on a particular area of executive reward. Please email katharine.nurse@haygroup.com for a copy of the previous edition which was focused on relative TSR. 2010 Hay Group. All rights reserved
Executive remuneration in high definition It s important that the market data used is fit for purpose. Benchmarking does it really matter? Our new map for executive reward argues that many remuneration committees focus too much effort on benchmarking at the expense of developing pay arrangements that reflect the organisation s business strategy and approach to talent management. Yet we find that those same remuneration committees often rely on low resolution data that at best paints a very approximate picture of the competitive position and at worst may systematically over or understate the level of competitiveness. And even if you accept Hay Group s new map approach to executive reward with market data of less importance than organisation strategy in determining reward it s still important that the market data used is fit for purpose. Why so fuzzy? Most UK remuneration committees have a median policy and most remuneration reports are very clear about this. And remuneration committee members normally have a reasonable understanding of the comparator group(s) used and the definition(s) of remuneration (base salary, annual compensation, total compensation etc) under consideration. However, there are some other key questions which non-executive directors have not (at least historically) been encouraged to consider. If our policy is to use a broad comparator group of companies of similar size, how should these companies be selected? If our policy is to pay at the median, what does this mean if we are one of the larger or smaller companies in the comparator group? Even if our on-target total compensation is at median, how does our remuneration compare if we perform particularly well or particularly poorly? In the rest of this paper, we consider the answers to these questions and others and set out how benchmarking in high definition can work. Choosing comparator groups introduction Today, comprehensive disclosure in annual reports means that anyone with a computer can produce market comparisons. This means that comparisons are no longer limited to a consultant s own clients, transparency is much greater and competition has driven costs down. However, the downside of this new world has been a reduction in definition with a tendency to over-simplify comparisons and / or to ignore potential flaws in the comparisons made. Happily these problems are easy to solve. It just requires remuneration committees to remind themselves of some essential truths that they already know. 2010 Hay Group. All rights reserved
Comprehensive disclosure in annual reports means that anyone with a computer can produce market comparisons. Choosing comparator groups Broad peer groups A common approach is to use market capitalisation as a measure of organisation scale. Market value is an extremely transparent measure of an organisation s scale and it also reflects the organisation s index (FTSE 100, Mid 250 etc.). However, it is not a perfect measure of scale for the following reasons. Market capitalisation can be volatile and any changes in market capitalisation will be impacted by the Beta of the firm s shares. Market capitalisation is aligned to (expected) profitability rather than scale. It can therefore understate comparisons for companies in low margin sectors and arguably inflate salary and annual incentive benchmarks for speculative enterprises such as oil exploration or biotechnology. Similarly market capitalisation depends on PE ratio. And whilst a high PE ratio may result partly from the market taking a positive view of the management team s ability, there are many other possible explanations which should not have an impact on pay. Finally, the relationship between business scale and market capitalisation can be significantly distorted by gearing. As a result, businesses of otherwise similar scale may have very different levels of market capitalisation. In light of the above, a high definition approach suggests considering whether any broad comparator group based on market-cap needs to be amended to exclude businesses of very different operational scale. There may also be a case for looking at enterprise value (market cap plus debt). The obvious alternative to market cap in most sectors is turnover. Turnover is nearly as transparent as market cap but is more representative of business scale. That said, even turnover has its problems when comparators are drawn from diverse sectors. Common sense tells us that running a global business that designs, manufactures and distributes a wide range of products is more challenging than running a business of similar scale that focuses on one part of the value chain, has a simple product range and is primarily focused on the UK. For this reason, even with a turnover-based comparator group, a high definition approach would involve excluding obviously different sectors. The most high definition approach would be to use job size / grading or possibly a multivariate analysis which also allows for employee numbers, internationality and so on. This is the best way of capturing the scale and complexity of a business whilst still using a wide set of comparators and is thus the ultimate high definition approach. The downside is a loss of transparency. Whether this level of sophistication is necessary will depend on the organisation s circumstances; in our experience these approaches make most sense: for organisations which are at the top or bottom of a comparator group for injecting some rigour in the process of assessing the appropriate impact of an organisation change on pay levels for comparing roles below main board level where job title matching alone can be extremely imprecise, particularly in today s complex matrix structures where roles with the same title often have very different responsibilities. For example the Head of Asia-Pacific could be a role in an entirely autonomous business unit; a role in a business unit which although operationally autonomous has its support functions managed from head-office; or a role in a business unit with little control over investment decisions or policy.
Choosing comparator groups sector peer groups The challenges with smaller peer groups are different. Here, the key questions for the remuneration Committee to consider are as follows. Where do we fit in the peer group? This means looking at the scale (and perhaps complexity) of our business and seeing our ranking. Operating a median policy does not necessarily mean targeting the literal median of the peer group. If we are one of the larger (smaller) companies in the sector then a median policy stance perhaps implies focusing on the upper (lower) quartile of the group. Should we necessarily job match like-for-like? When looking at a sector peer group the obvious approach is to compare CEO to other CEOs, CFO to other CFOs etc. However, for a comparator that is much larger there may be a case for comparing their COO or CFO to our CEO. Similarly for a comparator that is much smaller, we might compare our CFO to their CEO. In our experience this approach can be quite effective in the UK but does not work well in territories where the CEO premium over other roles is larger for example the US. Are there any contextual factors to consider? For a small peer group the benchmarking should identify any factors that might distort comparisons. For example the background of the comparators CEO might be relevant if: he/she owns a large chunk of the business; has moved from another sector; previously worked in another country or is newly promoted. This intelligence doesn t necessarily change the comparison but is important context to consider when interpreting the data. The final point to note is that remuneration committee members should not be afraid to rely on their own judgement (or that of their advisers) in making comparisons. After all, data is only data it s not the infallible truth. International comparisons What are the implications of using international data? In some sectors it is important to consider international practice as there is a genuine international market for talent. However, this too requires a high definition approach, as follows. What are the currency effects? Any international comparison requires a currency conversion and therefore the answer will vary from time to time. Should we allow for taxes and cost of living? This may be a step too far. However, there is no doubt that taxes and cost of living have at least an implicit influence on pay differentials between countries. What definitions of remuneration are we considering? Some countries have packages of very different shape to the UK. For example annual bonus payments are higher in Germany and LTIs are higher in North America. This implies a need to look at total compensation and also the individual remuneration elements in isolation. Remuneration committee members should not be afraid to rely on their own judgement in making comparisons.
Taking account of pay shape One of the most low definition aspects of much benchmarking is the tendency to rely on a single point estimate of pay. Having median total compensation for on-target performance is no guarantee of having appropriate competitiveness in other performance scenarios. For example, we recently prepared a report for a company that had median total pay and an above-average proportion of pay in the form of long-term incentive. One might therefore assume that this company would pay more than most of its peer group if share price performance was good. In reality, because of the way its plans were designed, this wasn t actually the case. If the remuneration committee is serious about offering median pay for target performance and upper quartile pay for outstanding performance then it needs to look at pay in a variety of scenarios. This adds definition to the benchmarking but more importantly it feeds into the pay strategy and incentive design processes and allows the remuneration committee to develop a total pay package that is the right shape as well as the right size. The appropriate shape of remuneration and how it should compare to remuneration shape elsewhere will vary depending on the nature of the company its risk appetite, its volatility, its cyclical exposure, the proportion of costs that goes on people etc. Again, how remuneration shape compares to the market needs to be right for the business rather than tied to the market. Market data will always have a role to play in setting senior pay. How else can non-executive directors ensure that pay is sufficient without squandering shareholder funds? However, the approach to benchmarking needs to be fit-for-purpose. This means selecting the right comparators, taking the context into account and looking at competitiveness in various performance scenarios. Hay Group has 60 years experience in this field and would be glad to demonstrate a high definition approach to you. Peter Boreham UK director executive reward T 020 7856 7146 E peter.boreham@haygroup.com 2010 Hay Group. All rights reserved
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