What a performance!

Performance related pay for senior executives rarely seems to achieve the
returns that it promises, reports Stephen Overell

One of the many useful functions of work is that it provides a way for
society to allocate its resources.

Because of their occupations, a baker is worth so much, a nursery nurse a
bit less, a management consultant much more and Sir Christopher Gent of
Vodafone £5.1m in salary and bonuses and £9.3m in share options. Hopefully,
even the great man himself, flushed as he must be with his shareholders’
largesse, might agree that the values placed on certain jobs are really very
arbitrary.

As time goes by it often seems that such awards are becoming even more
arbitrary. With Sir Christopher at the helm, Vodafone lost £13.5bn in the year
to March 2002. From a share price peak of 399p, they now languish at around
97p. Of course, the glumness of the telecoms sector is beyond his control. But
it still feels like an affront to common sense to learn that 80 per cent of this
voluptuous remuneration package was performance-related.

Yes, indeed. According to Vodafone’s 2002 accounts, the performance element
in senior management packages sits at 80 per cent of the total amount. The
rules that determine executive pay are entirely geared towards growth, with
such inscrutable measures as one year cash flow, one year Ebitda, one-year ARPU
and so on.

As any rational fellow would do, Sir Christopher seeks to maximise his
income within the rules set by his remuneration committee. If it wants growth,
it gives its managers incentives and viewed historically that is what they have
delivered. Value is another matter. It is a question of what companies choose
to reward that matters.

Expressed like this, Vodafone’s pay policy seems entirely logical in a
Kafkaesque sort of way – the shareholders are happy. But to the rest of the
world it looks like fumbling in the greasy till by another name.

Over recent years, researchers have been at a loss to find a clear link
between pay and performance – as most people would understand it – in executive
remuneration.

The directors of FTSE 100 companies, for instance, received an average pay
rise of 28 per cent in 2000 – five times as much as the increase in the UK’s
average wage, according to pay consultants Inbucon1. Overall, 2000 was a good
year for the economy – maybe not 28 per cent better than the previous one, but
good nevertheless. Most of the increase received by Britain’s highest paid
executives came from performance-related schemes and share options, as one
would expect.

Yet Inbucon found that even when the effect of bonus schemes and long-term
incentive plans was removed, base salaries rose by 22 per cent. And who did the
best? Step forward 2000’s winner: Sir Christopher Gent with a 400 per cent pay
rise.

If asked for an intuitive definition of what ‘performance’ should mean, many
people might say profitability. Yet it is on this very point that the
pay-performance link seems most opaque. When the research group Incomes Data
Services looked at the salaries, bonus payments, incentive plans and benefits
packages of the UK’s 350 largest companies, alas, think-of-a-number culture was
most in evidence. The researchers could find "no statistical relationship
between total cash movements and changes in corporate profitability", its
report said2.

The problem has been taken to absurd levels in the US, where even those who
bring about the collapse of their companies emerge from the rubble with a tidy
fortune. A recent investigation into the remuneration practices of the 25
biggest corporate failures since January 2001 by the Financial Times found that
the executives who brought about bankruptcies walked away with $3.3bn (£2.1bn)
in payouts and share sales. In the good times, contracts are drawn up promising
wild compensation and then the unstoppable gravy train cannot be halted.

Organisations such as the Institute of Directors often point out that by
global standards Britain’s bosses are not basking in richesse. To attract the
best in an alleged (though highly debatable) ‘global market’, pay must be
competitive. Yet the idea of ‘competitive’ remuneration depends on comparison.

Those who want to see British salaries levelled up tend to draw comparisons
with the US. There, the average chief executive earns just under £100,000,
against £550,000 for UK chief executives. Indeed, compared with the rest of the
European Union, Britain’s bosses are also doing well. In France, the average
chief executive earns £383,000, while the Germans pay the least at just under
£300,0003. As has always been the case in pay negotiations, ‘fair pay’ is a
question of who compares themselves with whom. From the point of view of chief
executives, it is a good thing those lower down the scale don’t choose to
employ the same logic as their bosses have to feather their nests. The wages of
manufacturing workers in the US are a third higher than those in the UK.

Despite the shortcomings of performance-related schemes, the ideal of paying
for performance remains a beguiling one – far superior to paying people for
getting older, which is what used to happen. Yet it is unclear at the moment
how far organisations recognise and are seeking to tackle the embarrassments it
throws up.

IRS, the research body, says that while performance-related pay (PRP)
continues to be the most common type of reward in UK companies, it has been
falling for three years (54 per cent of them use it). Part of the reason is
that there is "mounting evidence that it doesn’t do what its advocates
claim". In its place, organisations are adopting some complicated systems
that honour both outputs (targets, defined objectives) and inputs
(competencies, skills, contribution and behaviour)4.

However, Mark Edelstein, a consultant with Mercer Human Resource Consulting,
argues it is "an absolute myth" that PRP is declining. Ninety-nine
per cent of organisations want incentive pay schemes, he says, and go to great
lengths to ensure their rigour.

"The results can look peculiar and there is sometimes a big reality gap
between what looks fair now and how it will appear several years in the future.
But I would dispute the claim that performance is unrelated to pay," he
said.

It all depends what you mean by ‘performance’. The suspicion is that what
senior executives mean is as remote from popular understanding as the corporate
aristocracy is from the rest of the workforce.

1 Inbucon executive remuneration survey, August 2001; www.inbucon.co.uk

2 Incomes Data Services, salary survey, October, 1999

3 Study by Management Today, July 2001

4 Paying for Performance, IRS Management Review, Issue 20, 2001; www.xperthr.co.uk

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