The Institute of Directors in Southern Africa’s (IoDSA) Remuneration Committee Forum has released its fifth position paper, “Value creation and executive pay”, dealing with the practical measures that boards should take in order to link executive pay with the value they create for the company and all its stakeholders.
“Executive pay is one the most visible and criticised aspects of corporate governance,” says Ray Harraway, Director: Remuneration Services at EY and Chair of the Remuneration Committee Forum. “I don’t think anybody really objects to high executive pay so long as it is directly linked to the value that executives create for the company and its stakeholders. However, getting the link between pay and performance right is extremely difficult – and that’s the issue this paper aims to address.”
At the heart of this problem is the difficulty in understanding value creation. Before anything sensible can be said about executive remuneration, boards and their remuneration committees have to understand what, for the organisation, constitutes value – and how the company creates value. Once that is understood, the remuneration committee can begin to establish what the desired outcomes are, and what drivers are important in achieving them.
A major stumbling block is that, according to 2013 research by McKinsey, only 34% of directors surveyed agreed that the boards they served on fully understand their companies’ strategies. Such an understanding is a prerequisite for understanding what value creation looks like and thus, ultimately, how executives should be incentivised.
Overemphasis on outcomes at the expense of drivers is one of the common shortfalls of executive incentive schemes, Harraway says. Outcomes may take years to achieve, so they are an inadequate measure of executive performance over the short term, whereas drivers—those actions that lead to the desired outcome—can be better indicators of progress in the short term.
To be effective, incentive schemes need to be multifaceted. Both outcomes and drivers should play a role in the design of the schemes, as should a balance of short-term financial performance and long-term sustainability.
Thus, for example, while a rise in the annual share price is obviously important, it should not be at the cost of investment in R&D and training, which are vital to the company’s long-term sustainability. And profitability cannot be the sole financial measure used—the return on capital has to form part of the equation when assessing executive performance and how it contributes value creation.
Parmi Natesan, Executive Director at the IoDSA and a member of the King IV drafting team, adds that one of the fundamental shifts in King IV is to make the performance/value creation aspect of governance more explicit.
Harraway says: “Setting remuneration levels is never going to be an easy exercise, and nor will it ever be a simple matching of actions and results, so the remuneration committee will always need a certain amount of business acumen as well as discretion. Nonetheless, if the value-creation levers are well understood, the committee will be better placed to incentivise the right kind of executive behaviour,’ .
“For instance, if there is a conflict between actions that might result in lower profits in the short term but are likely to drive long-term value, the incentives should default in favour of the latter.”