ENSURING LONG-TERM COMMITMENT

The use of fixed-term service agreements used to be perceived as a benefit as well as a legally required written contract of employment. Such agreements were thought of as status symbols - signs of company commitment to its top executives. There is now concerted pressure to limit the terms of such contracts for 12 months or less; hence it is now necessary to look for other methods of ensuring directors' long-term commitment.

Share options, deferred bonuses or other long-term incentives are the three main ways in which remuneration policy can provide messages on the need for loyalty and commitment to the organization.

Their design  will reflect the different emphasis the company may wish to place on attraction, retention and motivation. Some examples are illustrated below.

Deferred Bonus Schemes

Some companies have adopted deferred bonus schemes under which part of the executive's annual bonus is deferred for, say, two years. The deferred element is converted into shares, each of which is matched with an extra, free share on condition the executive remains employed by the company at the end of the deferral period. Such a scheme is designed to reward: 1) annual (sometimes personal) performance, and 2) loyalty to the company, but does not differentiate on the basis of long-term performance (other than that reflected in the share price).

Share Option Schemes

Some companies have adopted share option schemes under which options are awarded to executives that may be exercised if long-term performance conditions are met. Typical conditions may be that the company's earnings per share (EPS) growth should exceed inflation by a set amount over three years and that the executive remains employed by the company at the exercise date. Such a scheme emphasizes: 1) share price growth (the option has no final value to the executive unless the share price increases), 2) loyalty to the company, 3) real earnings per share growth (which the executive may be able to influence by profit maximization, cost control, etc), and 4) share capital stability or reduction (eg through the buy-back of shares).

Performance Share Schemes

Some companies adopt performance share schemes under which executives are provisionally awarded shares. The release of the shares is subject to the company's performance, typically determined on a sliding scale by reference to the company's total shareholder return (a combination of share price growth and dividend yield) ranking against its chosen peer companies over a three-year period. Release is also conditional on the executive remaining employed by the company at the vesting date. Such a scheme emphasizes: 1) relative share price and dividend performance (hence even if the company's share price falls the scheme can deliver rewards to participants, provided the company's peers have done worse), 2) loyalty to the company, 3) value delivered to shareholders (in the form of share price performance and dividends), but does not link directly to business performance.

Economic Factors

Although share option schemes remain extremely common for a variety of reasons, the historically typical economic 'boombust' cycle means that they periodically fail when stock market values are low. During the last recession, Hay Group found that 70 per cent of companies in the FTSE 100 had executive options in issue that were 'deep underwater' (ie the share price was less than 80 per cent of the option price). During such times the popularity of other arrangements, such as performance share schemes, tends to grow. When the bull market returns, however, options become fashionable again as companies and their executives see the possibility of large option gains returns.

THE BALANCE BETWEEN BASIC SALARY AND INCENTIVES FOR FULL-TIME DIRECTORS

Basic Salary Differentials

Differentials in basic salary exist in the UK between directors in different functions and between the board as a whole and the chief executive. Differences between directors by function are normally market related - based on survey and other evidence of competitive remuneration practice.

To set the basic salary differential between the managing director or chief executive and other directors, survey evidence should also be sought. Evidence from a number of sources suggests that board salaries are, on average, some 60–70 per cent of chief executive's pay. The earnings differential with sales directors may sometimes be lower, or even the reverse (ie higher than the chief executive), where special incentive arrangements exist. It may also be narrower for other directors in response to market forces or where recent recruitment has dictated a higher basic salary that has not, as it often does, yet triggered a general review of boardroom pay.

The majority of major UK employers operate executive incentive schemes and the payments involved continue to grow as a proportion of basic salary. In more aggressive and performance-orientated organizations, incentive payments which exceed 100 per cent of basic salary are being made, sometimes with no 'cap' when profits rise unexpectedly. In good times such payments are, as we have already said, an outward visible sign of company and indeed executive success - the 'applause' given to those who perform well.

The credibility of this approach, however, probably depends in the long term on whether the beneficiaries are prepared to take the decline in payments as inevitable when profits fall, or when the country faces an economic recession from which even they cannot escape. (A recent review of chief executives' bonus payments at the top of the FTSE 100 would suggest this is not happening and that annual bonuses may be being held at high levels to compensate for poor returns from long-term incentives.)

Such considerations inevitably affect the decision on where to set basic, pensionable salary and what to provide as performance reward. If basic salaries are set competitively, there will be less temptation to 'fudge' the incentive payments in lean years because executives have become more dependent than they should on 'risk' payments. Provision of the benefit of independent personal financial counselling, to help directors plan their incentive payments sensibly in 'good' years, is worth considering.

Before a board decides to implement change in its current salary and incentive arrangements, it needs to consider how this will affect salary policy for staff lower down. A particular concern should be the differential within the level of management just below. The basic salary differential should provide for sensible progression and a reasonable jump on promotion to the legal responsibilities of a full-time directorship.

PAY MANAGEMENT PROCESSES IN UK COMPANIES

In broad terms, the UK 'unitary' board typically manages its own pay along the following lines:

§  Responsibility for the pay of the executive directors is delegated to the remuneration committee (to be formed of at least three independent, non-executive directors), which will make its annual recommendations to the board.

§  The pay of the non-executive directors is usually managed by the chairman, perhaps in conjunction with the chief executive, who will also make recommendations to the board (often less frequently than annually).

§  The board as a whole votes on these pay recommendations but no director is able to vote on his or her own pay.

§  Shareholders have the opportunity annually to vote on the acceptability of the remuneration committee's report on boardroom pay in the company's report and accounts and to vote to approve (or otherwise) any new long-term incentive schemes for the board or that involve the issue of new shares or the transfer of treasury shares.

The impact of the annual vote of the remuneration committee's report is purely advisory but most boards seek to achieve high levels of shareholder approval - the disapproval of a small but significant minority of shareholders can be very damaging to the company's reputation and, if not addressed, can jeopardize the remuneration committee chairman's position.

Executive Directors' Pay

The principles (outlined in the Greenbury Report) that should underpin the recommendations of remuneration committees concerning executive directors' pay are that:

§  basic salaries should be maintained at a level that allows the company to compete effectively for good-calibre executives;

§  annual pay increases (if any) should be awarded in relation to performance and an assessment of market competitiveness from one or more reputable sources;

§  the basis, targets and payments from executive incentive schemes should serve the needs of the business and be satisfactory to shareholders in both the short and the longer term;

§  the balance between the elements of pay and benefits should be maintained on a sensible, competitive and defensible basis;

§  relationships between boardroom pay and that of employees at a more junior level should remain consistent and sensible;

§  in addition, directors contracts should be reviewed from time to time to ensure they remain up to date and defensible (eg notice periods should be 12 months or less).

In applying these principles the remuneration committee should seek proper, professional and, where appropriate, independent external advice.

The 2003 Higgs Review suggested that boards should adopt a process whereby the performance of individual directors, as well as the board as a whole, should be assessed each year. The results of this process clearly should be used to support the work of the remuneration committee.

Non-executive Directors' Pay

The pay for non-executive directors (again from Greenbury) should:

§  provide a reasonable recompense for the time and commitment a non-executive director contributes to board meetings (ie reflecting the role undertaken, time commitment required, committee and other responsibilities taken on, the company's size and the individual's unique skills/reputation);

§  not be so large or so structured (eg by participating in any incentive scheme or having a company car) as to jeopardize the non-executive director's independence.

In response to the second condition, many companies pay non-executive directors purely in cash but now some allow or even require their non-executive directors to take some or all of their fees in the form of the company's shares.

In the introduction to his 2003 review, Sir Derek Higgs observed that, 'Too often the governance discussion has been shrill and narrowly focused on executive pay with insufficient attention to the real drivers of corporate success. It would represent progress if this Review were to open a richer seam of discussion, one with board performance and effectiveness at the core.' Although the spotlight seems very unlikely to move away from directors' pay, it does seem that the press and boards themselves increasingly recognize the need for a clear link between pay and performance at board level and that 'payments for failure' (large pay-offs to directors leaving as a result of poor performance) will be much more difficult to make in the future.

CORPORATE GOVERNANCE AND BOARDROOM PAY IN THE UK

Reward management in the UK boardroom is complicated by the way that UK companies are run and has to be set against the backdrop of the many reviews of directors' pay and related corporate governance issues that have taken place here in the past decade or so.

Corporate Governance

In simple terms, a UK company is owned by its shareholders, but the power and responsibility for almost all decisions concerning its business operations are devolved to its board of directors, including most decisions about pay. Public company shareholders in particular are usually far removed from any day-to-day or even strategic decision making. In the UK (as in the USA) the board of directors is a single or 'unitary' structure, responsible for corporate governance as well as business decision making. While some other countries use two-tier board structures that separate the two, the 'unitary' board structure relies on an internal division of responsibility, typically between non-executive (corporate governance) and executive (business decision making) directors.

UK Reviews of Corporate Governance and Directors' Pay

A number of reviews have taken place in the UK into corporate governance processes and directors' pay. They were each undertaken in response to a different set of factors but all included recognition (implicit or explicit) of the potential for conflicts of interest arising as a result of the 'unitary' board structure. The sequence started with the Cadbury Report, was furthered by Greenbury and tied together by Hampel. Subsequently, Turnbull and then Higgs examined how boards work together, including a review of the structures and processes by which directors' rewards are set. The stated objectives of these reviews were various but at their hearts was often the concern of the government of the day that directors' pay might, at best, be out of control and, at worst, include aspects that might be encouraging behaviour contrary to shareholders' interests. 

SETTING THE STYLE OF REMUNERATION POLICY

The principles affecting boardroom pay are generally the same as those described elsewhere in this book for all employees. What is different is the public visibility of pay decisions and the fact that salary policy for directors is usually an indication of corporate culture. Statements in many company annual reports confirm this, especially when an organization decides to change, and usually sharpen, rewards at the top. The press has always reacted badly to major pay hikes - playing on the politics of envy and the so-called 'fat cats' syndrome. More recently, major institutional shareholders have taken considerable interest in the link between executive rewards and corporate success and the press in the UK is alays prepared to make adverse comments on what are perceived to be excessive pay increases for boards, when increases for the rank and file have been kept at a minimum in times of low inflation.

The way in which boards of directors are paid tends to reflect the pay philosophy of the organization as a whole. Boards that have adopted and believe in the value of incentives, for instance, will push the concept of performance-related pay down through the whole organization. Those who choose to reinforce other values such as loyalty and commitment may place more emphasis on these - but they may, of course, offer performance rewards too.

Critical to the success of the remuneration policies for more junior staff is the level at which boardroom pay is set in relation to the competition. Boards, especially in family companies where remuneration does not come from basic salary alone, do not always appreciate that the level of their basic pay sets the ceiling below which all other salaries generally have to fit. Failing to recognize this or allowing for necessary exceptions can create 'headroom' problems, which have an impact on both recruitment and retention.

Also potentially damaging are salary levels which employees perceive as excessive in relation to their own rewards. High boardroom pay can and should be an outward sign of corporate achievement. But the taste can go sour if employees perceive that their pay is 'just a cost to be controlled' and that there is no potential share for them in the organization's success. It is no coincidence that many companies that have gone for generous bonus or incentive schemes or executive share options at the top have also opted to introduce performance-related pay further down, perhaps in addition to some form of all-employee profit sharing or share scheme. Such actions have not just tempered possible accusations of executive greed but have given everyone a potential share in success. They may also reassure shareholders that good and competitive remuneration practice has been introduced at all levels. It is, after all, in the interests of shareholders that the employees and the board are motivated to achieve the same goals and to deliver corporate success.

TAXABLE BENEFITS, TAX AND THE SELF-EMPLOYED

TAXABLE BENEFITS

There are a number of employee benefits offered by companies that are taxable on the employee as a benefit in kind. These include:

§  private medical insurance;

§  payments for expenses that have not been wholly, exclusively and necessarily incurred in the performance of relevant duties of the employee;

§  payment of telephone rental charges and private telephone calls;

§  the cost of luncheon vouchers above 15 pence per day.

We emphasize that the basic principles of benefit taxation are not clear cut and that it is always advisable to get a ruling from the Inland Revenue on any specific new benefit under consideration. In addition, it is important to ensure that employees are fully aware of the tax liabilities on their benefits in kind.

 

TAX AND THE SELF-EMPLOYED

The income tax position for individuals depends largely on whether they are employees and their income is taxable as employment income or whether they are taxable under Schedule D. (Some employees, eg professionals who teach and write for fees but have either a full- or a part-time contract, may be both.) It is now very difficult to have a contract with a 'self-employed person' if he or she works more or less full time for one 'client'. There are a number of tax cases that have debated this point. However, the basis of being self-employed is generally dependent upon a number of factors. Guidance is available from the Inland Revenue to help decide whether an individual is an employee or is self-employed.