Restructuring Executive Pay

Over the past months, shareholders have rebelled against company executives at annual meetings, forcing the reevaluation and restructuring of payment strategies.  On top of this, many banks are planning to claw back bonuses. HSBC, for instance, will rescind bonuses to pay fines associated with money laundering. JP Morgan will take away bonus payments from the London Whale to make up for trading losses.  

Compensation methodologies are currently being reformed. Ideally, the altered compensation strategies will ensure proper motivation for top executives; ensure a long-term perspective for investment/innovation/risk-taking; not adopt a simplistic view of how people will respond to financial incentives; and be simple enough for outsiders to understand.

Remuneration typically has three parts, a fixed salary, a cash bonus based on the year’s performance and a component based on long-term performance and incentives. In its current form, the annual bonus of FTSE 350 companies is typically around 200% of base pay salary. Bonuses are normally paid if certain benchmarks are met. Bonuses of this nature have also been criticized for encouraging risky behaviour in the short term, in order to meet or exceed benchmarks.

There are several strategies being considered to alter remuneration methodologies. 

1. The Kay review, a paper examining short-terminism in asset management, suggests that annual cash bonuses be abolished. Instead, companies should provide long term performance incentives and base pay only. Long term incentives should be given when leaving the company.
2. The European Commission has proposed limiting the bonus pay to 100% of base pay. 
3. Publish a single figure encompassing all forms of pay. 
4. Making shareholder votes more binding, such that shareholders must be consulted if a majority votes against the pay policy  

The problem with number one is that will likely lead to higher base pay.  If annual bonuses are 200%, base pay would be tripled in order to substitute what is lost. Yet, this option would at least increase transparency. Shareholders would vote on base salary and long-term incentives only.  By deferring long-term bonuses, companies would also align payouts with the overall results of a bank, rather than a single person’s track record (ideally).

The European Commission’s suggestion would likely have similar repercussions; base pay would increase to make up for the bonus limitation. It is also possible that companies paying out a bonus less than 100% of base pay would increase the bonus amount, as it would act as a form of anchoring.

Option three, which would increase transparency, could potentially hide the nuances associated with remuneration, and make it more difficult to determine the reasonableness of the pay. Yet, shareholders would have more power, which could be beneficial long term.

None of these options seems to be perfect. Perhaps the best option is a combination of the various strategies. For instance, a binding vote on policy, together with increasing transparency by requiring companies to publish bonus-to-salary pay ratios, while eliminating short-term bonuses for the sake of long-term compensation, is worthy of consideration. It would increase transparency and shareholder power and help eliminate short-term incentives. 

The psychology of executive remuneration

Executive pay across industries is facing criticism surrounding high salaries. This condemnation is especially true in the financial services, both in wake of the financial crisis and in light of an increase in their share of the wage bill. Indeed, the pay gap in the UK has widened significantly over the past thirty years. Someone in the 90th percentile in 1979 earned 2.5 times more than someone in the 10th percentile, now he earns 3.7 times more. 60% of the increase among the top 10% of earners is accrued to those working in the financial sector.

Much of this increase takes the form of a bonus. Originally, bonuses (performance pay) were designed to align the incentives of the executive with that of shareholders. It was meant to eliminate the principal-agent problem by aligning executive incentives to increasing company value. By reaching a certain benchmark, executives were given additional remuneration. This bonus was often given in the form of stock options or shares, which was meant to further goal alignment. Yet, this has not necessarily worked as meant. Performance pay has led executives to take unnecessary risks. Bonuses have been continuously paid even when institutions are failing. Salaries became a way for executives to judge themselves against their peers, rather than used as a judgment of company performance. 

There are two main problems with this theory, however. One stems from an incorrect view of human motivation. The second problem is associated with payment relativity.

Money is not the only motivation for workers. While bonuses have long been used to incentivize performance, large bonuses when performing cognitive tasks are actually counter-productive to performance. Research has shown that while financial incentives can motivate people to work, very large bonuses can hinder performance by causing stress involved in attaining it, the fear of not receiving the bonus and focusing attention on the bonus rather than the job at hand. 

The problem of compensation relativity is two fold. First of all, executives judge themselves against one another, and compete for highest salary. This leads to higher compensation demands, without the performance to back it up; meaning there is sometimes inconsistency between economic value added and pay. Payment relativity is also problematic when peer group comparisons are used to determine pay. Pay groupings are meant to provide information on appropriate salaries, providing boards with benchmarks, but often result in the inflation of executive compensation when peer groups with higher salaries are chosen. 

A third issue surrounding performance surrounds the idea of crowding out. Monetary incentives have been found to impact the intrinsic motivation of people, as motivation now comes from something external. As a result, people perform less well after monetary incentives are given. This is true regardless of the form of the remuneration (base pay versus bonus).

The regulation of executive compensation is an area currently being considered by regulators, central bankers and more. While regulators are focusing on the structure of pay packages from an economic perspective, they must also be careful to consider the psychology and utility of remuneration before altering the structure of executive payment.