Executive Remuneration: an investor’s guide
- Is the pay of senior executives really out of control or have CEOs received a raw deal from the headline writers?
- What do CEOs in the UK really earn and how does this compare with their international competitors?
- How has the structure of pay changed over time and what is current “best practice”?
- How can I become better informed about the structure and level of executive pay?
Help is now at hand in the form of this concise, non-technical review of the key research findings generated by academics and compensation consultants on all aspects of executive pay. Whether your aim is to assess the suitability of compensation arrangements at firms in your investment portfolio, learn more about international pay practices, or simply get an independent, informed view of the current debate on executive pay, you’ll find the necessary information here to get you started.
Find out about the Manifest Total Remuneration Survey
While we have concentrated on presenting often complex research findings accessible and understandable to non-specialists, we realise that there may be circumstances when something more than just a brief summary of the main results is required. As a result, where possible we have also sought to provide direct links to the source material that enable you to download and study the actual research documents in more detail if you wish.
How are CEOs paid? How important are options versus other forms long-term compensation? Is a typical UK CEO paid in the same way as their US counterpart? What are LTIPs?
How much are CEOs paid in total? Has this increased (in real terms) over time? How is this split between the various components of pay? Are UK CEOs under or over paid in international terms? Is pay linked to performance?
What are the internal mechanisms by which pay is set? Do Remuneration Committee help to constrain executive pay? Do Remuneration Committees help to improve the link between pay and performance? Does combining the roles of chairman and CEO result in higher pay and weaker pay-performance links?
Is there a relevant section you are particularly interested in? Please click on a subject below.
Executive Summary | The Structure of Effective Pay Contracts | International Comparison | The Components of Executive Pay | Performance Standards | Academic Articles
Executive Summary
Most senior executive pay packages are made up of four basic components: salary, annual bonuses, share options and Long Term Incentive Plans (LTIPs)
The relative mix of these four components in the total package varies across different countries: US and UK CEOs receive a higher portion of their compensation in the form of options
Average CEO pay in the largest 500 companies is almost £600,000 (sum of salaries, bonuses, benefits, other cash pay, grant date values of options, and grant date value of LTIP shares)
The use of options is on the decline among UK firms while increasing among many international competitor firms (particularly those in the US, Japan and Germany)
Options are commonly linked to the achievement of certain performance criteria in the UK. In contrast, US firms rarely link option exercise to performance
CEO Cash compensation has been growing at about 10% per annum over the last decade: up from £158,000 in 1989 to £340,000 in 1997
UK CEOs earn close to the international average
The top earners are US CEOs who receive more than twice as much as their UK counterparts. Put differently, CEOs of FTSE-100 firms earn about the same as US CEOs in the S&P Small-Cap index
CEO pay varies across industries and positively links to company size
The link between cash compensation (salary & bonus) and firm performance is very weak: in the UK a £1000 change in shareholder wealth results in around a 3 pence change in CEO cash receipts
Even after taking into account the share-based component, executive pay still remains relatively insensitive to changes in a firm’s value: UK CEOs receive about 0.25% of any change in shareholder wealth.
For example, estimates for the US show that resisting a hostile takeover attempt promising a $500 million premium to shareholders will personally cost the average CEO about one year’s pay.
However, there is little hard evidence that tying executive pay more closely to firm performance actually helps to improve overall firm performance
The increased use of Remuneration Committees appears to have had relatively little effect on either the level or the sensitivity of executive pay
The increasing globalisation of business means that pay levels and structures may start to converge towards those prevailing in the major economies
Links to Relevant Sites
Towers Perrin: A US consulting firm specialising in executive pay
http://www.towers.com/towers
AFL-CIO: A US union tracking executive pay practices
http://www.aflcio.org
Articles from the US business press
http://www.businessweek.com/1999/99_16/b3625001.htm
http://interactive.wsj.com/public/current/summaries/expay99.htm
The Structure of Executive Pay Contracts
Current UK Practices
Senior executive pay contracts tend to differ from those of mid- and junior-level managers
Top executives are increasingly negotiating formal contracts that typically last 3-5 years and that specify minimum base salaries, target bonus payments, severance arrangements, etc.
In contrast, mid-level management typically operate under “employment at will” contracts
Most senior executive pay packages contain four basic elements:
- Base Salary
- Annual Bonus
- Share Options
- Long Term Incentive Plans
Additional components of pay can include:
- Restricted Stock
- Retirement Plans
The average pay package for a UK CEO in 1997 could be broken down as follows:
| Base Salary | 59% |
| Bonuses | 18% |
| Options | 10% |
| LTIPs | 9% |
| Other | 4% |
Option grants among UK firms increased dramatically in the mid-80s and early-90s: by 1986 nearly 100% of firms were offering their CEOs options
However, the use of share options in the UK has been declining in recent years following recommendations in the Greenbury Report and by shareholder groups such as the National Association of Pension Funds (now the PLSA) and the Association of British Insurers (now the Investment Association). By 1997 only 68% of firms were offering options to their top executives.
Following recommendations in the Greenbury Report, share options now typically vest only upon the attainment of some performance criteria (often based on EPS growth)
However, the typical performance criteria employed tend to be relatively undemanding: EPS of 2-3% in any 3 years of the option’s term
In 1997, the majority of firms in the UK achieved real EPS growth in excess of 3%
Key References
Conyon & Murphy (2000) The Prince and the Pauper? CEO Pay in the US and UK.
A working paper version is available for downloading at the following website:
http://papers.ssrn.com/paper.taf?ABSTRACT_ID=163914
International Comparisons
Substantial differences also exist between the way UK and US CEOs are paid:
- US CEOs receive a lower proportion of their total pay in the form of base salary: 32% compared to 59% in the UK
- During the early 1990s in the US, share options began to replace base salaries as the single largest component of pay in S&P 500 firms
- US CEOs are more likely to receive an option grant: 72% of US CEOs were granted options in 1997 compared to 50% of UK CEOs
- In addition, the size of the grant tends to be much larger: the median for the US is £736,000 compared with only £69,000 for the UK
- US there is little variation in firms’ granting practices: most options expire in 10 years and are granted with exercise prices equal to the fair market value of the share on the date of grant.
- In contrast to the UK, performance triggered options (where options are forfeited unless share price reaches a pre-determined hurdle and/or performance exceeds a benchmark level measured over a specified period) are rarely used
- Overall, share option grants comprise a much larger percentage of total pay for the average US CEO (36%) than for the average UK CEOs (10%)
- US CEOs are less likely to receive an LTIP grant. However, when a grant is made, the value tends to be much higher: £325,000 compared to £161,000 in the UK
- These differences are particularly pronounced for larger firms
- Compared to other countries, CEOs in the UK and US receive a relatively high proportion of their compensation in the form of options. The increasing use of options in the US over the last 10 years has been linked to the relative bullish conditions prevailing in the US stock market
- The S&P 500 index increased by 300% during the 90s while the FTSE index increased by only 150% over the same period
- Systematic differences exist between the two countries in terms of their LTIP plans
- LTIPs in the UK are typically grants of shares conditional on the attainment of certain performance criteria
- LTIPs in the US typically take the form of either (a) restricted share grants that vest with the passage of time (but which are not tied to performance) or (b) multi-year bonus plans
- The use of options is less common in Germany
- In 1997, only 10% of DAX-listed firms offered option-type packages to their CEOs
- But the situation is changing fast, with more than one in three firms now including an option component in their CEO’s pay package
- The increasing globalisation of business means that pay levels and structures may start to converge towards those prevailing in the major economies
- Canadian and Mexican companies routinely include US firms in the peer groups used to determine pay levels
- US companies routinely export pay practices to executives of foreign subsidiaries
- Foreign companies acquiring US subsidiaries face significant internal pay inequities, often resolved by increasing home-country executive pay
- Legal restrictions on the granting of share options in Japan were lifted in April 1997, leading to an increase in US- and UK-style compensation
Key References
Murphy (1999) Executive Compensation. In Handbook of Labor Economics
(eds. Ashenfelter & Card) Vol. 3. North Holland
The Components of Executive Pay
Base Salary
For senior executives, base salary is usually determined through “competitive benchmarking” based on general industry salary surveys supplemented by detailed analyses of selected industry or market peers
Comparisons typically adjust for company size, thereby reinforcing the well-documented link between executive pay and firm size
Because salaries below the 50th percentile and often labelled “below market” while those between the 50th and 75th percentile are considered “competitive”, compensation surveys have tended to “ratchet up” base salaries
CEOs base salaries typically do not reflect dimensions such as age, experience, education, performance, job complexity and span of control
Executives pay particular attention to the determination of base salaries because (a) they comprise a substantial part of total compensation and (b) they represent the fixed component of compensation and risk averse executives will prefer a £1 increase in the fixed component of compensation to a £1 increase in the variable component
Annual Bonuses Tied To Performance
Typically bonuses are paid annually based on a single year’s performance
Bonus plans can be categorised in terms of three basic components:
- Performance Measures
- Performance Standards
- Pay & Performance Structures
Accounting numbers are widely used in bonus plans because they are verifiable, widely understood and managers know how their day-to-day actions affect year-end profits
However, accounting numbers are associated with two fundamental problems:
(a) they are backward looking and short term;
(b) they can be manipulated. Research shows that managers use creative accounting techniques to maximise the value of their bonuses over time
Share Options
Contracts giving the recipient the right to buy the firm’s share at a pre-specified price (the exercise price) for a pre-specified period of time
They are non-tradable and are often forfeited if the executive leaves the firm before they become exercisable
In many countries, the use of options has increased substantially since the beginning of the 1980s
Restrictions in the UK limit the granting of options
- Inland Revenue rules plus best practice guidelines from the Association of British Insurers (ABI) and the National Association of Pension Funds (NAPF) effective limit the value of awards to the greater of £100,000 or fours times current pay
- Limits also exist in relation to the exercise of options: no sooner than three years and no later than ten years
- Prior to Greenbury, many firms took advantage of the ability to issue options at a discount to the market price (up to 15%). This practice has now stopped.
- Often options only award share price appreciation rather than Total Shareholder Return (i.e., inclusive of dividends)
- This can create incentives to reduce dividend payments and increase share repurchases
- Some firms are now attempting to build in dividend protection for their executives
- Although options provide a direct link between managerial rewards and share price appreciation, the incentives from options do not mimic perfectly the incentives from share ownership
- Since they typically only reward share price appreciation, they provide incentives to undertake share repurchases and avoid paying dividends
- Since the value of options increases with share price volatility, they can create incentives to engage in more risky investments
Options lose their incentive value once the share price falls sufficiently below the exercise price that the chance of exercising becomes very low
Options “cost” more to shareholders to grant than they are worth to executive recipients. The “opportunity cost” to the firm of an option grant is measured as the amount an outsider would pay for the option. The problem is that executives place a lower value on the option because:
Outsiders can trade the option and take actions to hedge away the associated risk while executives can do neither
Outsiders are relatively well-diversified while company executives are not
As a result, options should only be granted if the “incentive effect” (i.e., the increased performance resulting from their use) exceeds the difference between the company’s cost and the executive’s value
The most widely used method of calculating the company’s cost of granting an option is the Black-Scholes (BS) formula. However, there are many drawbacks to using this valuation formula:
- The model assumes constant stock price volatilities and dividend yields
- Since executive options are typically subject to forfeiture, this reduces the costs of the option to the firm
- BS tends to overvalue options
The model assumes that options can only be exercised at the expiration date, whereas executive options can be exercised before the end of the option’s term
Options are essentially “free” from an accounting perspective since the company incurs no expense when the option is granted
However, outstanding options will lower the company’s EPS figure when computed on a fully diluted basis
Long-Term Incentive Plans (LTIPs)
- Designed to encourage and reward longer term performance.
- In the UK, LTIPs typically take the form a grants of shares that become transferable to the executive (vest) only upon the attainment of certain performance objectives
- In the US, LTIPs take one of two forms: (a) restricted stock grants that vest with the passage of time (but are not linked to performance criteria) and (b) multi-year bonus plans based on rolling three- or five-year accounting performance
- The typical performance measures used in UK LTIPs are EPS and TSR
- Performance is often measured relative to a fixed standard (e.g., EPS growth of 6% or EPS growth equal to the RPI plus x%)
Restricted Shares
- Grants of shares that are “restricted” in the sense that the shares are subject to forfeiture under certain conditions (usually related to employee longevity with the firm)
- More commonly used in the US
- Used to help reduce the likelihood that key executives will leave the firm
- Particularly well-suited to knowledge-based industries where human capital represents one of the main assets
- Consistent with this, research indicates that restricted stock plans are more common in R&D intensive firms than non-R&D intensive firms
Retirement Plans
- Top executives routinely participate in supplementary retirement plans in addition to the standard company-wide pension plan
- Typically the information disclosed in the annual report and accounts is insufficient to calculate the value of such plans, leading to the concerns that executive retirement plans may represent a significant form of “invisible compensation”
Bonus Plans
Bonus Plans can be categorised in terms of three basic components
Performance Measures
The criteria against which performance is assessed
- Many large companies use two or more performance measures rather than relying on a single measure (e.g., net income and sales growth)
- Of the basic types of performance measure, most companies rely on some version of accounting profits (either £-value, measured on a per share basis, as a margin or return, or as a growth rate)
- Many firms supplement financial performance measures with non-financial measures (e.g., performance measured relative to pre-established objectives and subjective assessments of individuals performance)
- Other non-financial measures include customer satisfaction, operational and strategic objectives, and plant safety
- The types of performance measure vary across industries: e.g., financial institutions are less likely to use non-financial measures
Performance Standards
How the level of performance necessary to achieve the bonus is determined
The main standards against which performance is assessed are:
- Budget Standards: Performance measured against the company’s annual budget goals
- Prior-Year Standards: Performance measured as year-to-year growth or improvement (e.g., growth in sales or EPS)
- Discretionary Standards: Plans where the performance targets are set subjectively by the board of directors following a review of the company’s business plan, prior-year performance, etc.
- Peer Group Standards: Performance measured relative to other companies in the industry or market
- Timeless Standards: Performance relative to a fixed standard (e.g., 10% return on assets, where 10% is constant across years or moves in a pre-determined way independent of performance)
- Cost Of Capital Standards: Performance relative to the company’s cost of capital (e.g., EVA)
Pay-Performance Structures
How bonus pay-outs are determined
- Plans tend to have both a lower threshold and an upper cap on the level of bonus that can be paid
- A common payout method is the 80/120 plan, where no bonus is paid unless performance exceeds 80% of the performance standard and bonuses are capped once performance exceeds 120% of the performance standard
- The use of caps and thresholds in bonus plans can lead to dysfunctional behaviour such as creative accounting. Research shows that managers seek to increase (decrease0 income when they are between (outside) the lower and upper bounds
- Formula based payout methods are also used, in which the plan defines a bonus pool which is allocated to individuals based on a combination of target bonuses and individual performance
- Discretionary payout methods are less common, whereby the board meets at the end of the year to assess subjectively the firm’s performance based on a variety of criteria, and determines the magnitude of the bonus pool
- Performance standards can cause problems whenever the individual being assessed can influence the standard setting process (e.g., budgets and prior year performance)
- In contrast, timeless standards and those based on peer groups are not as easily influenced by members of the plan
The Level of Executive Pay & its Association Performance
How Much Do UK CEOs Earn?
- CEO pay levels rose by 18% in 1997 (compared with raises for employees in the public sector of less than 3%)
- Cash compensation has been growing at about 10% per annum over the last decade: up from £158,000 in 1989 to £340,000 in 1997
- In aggregate, CEOs of the 500 largest UK companies made £330 million in 1997, including £74 million from exercising options
- The highest paid UK CEO in 1997 was Sam Chisolm (British Sky Broadcasting PLC) who received a £6.8 million pay-package
- Average CEO pay in the largest 500 companies is £589,000 (sum of salaries, bonuses, benefits, other cash pay, grant date values of options, and grant date value of LTIP shares)
- Company size is an important determinant of pay:
- Median total pay for CEOs of firms with revenues in excess of £1500 million is £811,000 while total pay for CEOs of firms with revenues less than £200 million is £287,000
- Estimates show that doubling firm size increase cash pay by about 20% and total pay by 22%
- This holds for most sectors
- Pay varies across industries
- Despite recent headlines in the business press, pay levels are typically lower in the utilities sector
- About 50% of CEOs receive option grants while 32% receive LTIP grants
- CEO incentives from share ownership
- The median share holding for UK CEOs is 0.05% of the firm’s total shares outstanding
- Share ownership for the median UK CEOs is worth about £460,000.
- In the largest UK firms, CEOs hold shares worth roughly 3.4 million
- The value of shares held by the CEO declines with firm size
International Pay Comparisons
- US CEOs significantly out-earn their UK counterparts
- Median base salary in the US is £317,000, compared to £240,000 in the UK: a premium of 30%
- While about the same proportion of CEOs receive a bonus in both countries (about 82%), US bonus payments tend to be much larger: the median bonus for the US is £270,000 compared to £91,000 for the UK
- Overall, US CEOs receive 44% more in cash pay (salary and bonus)
- Cash compensation in the largest UK firms is roughly on a par with that in Small-Cap US firms, even though Small-Cap firms are substantially smaller in terms of market capitalisation
- US CEOs receive 163% more in total pay (including share options and LTIP awards)
- These results hold even after controlling for firm-specific factors such as firm size, industry, growth opportunities, CEO human capital, etc.
- Median total pay for US CEOs is £1.3 million
- The US premium is especially big for large firms and for firms in the financial services sector
- In the Germany, the typical CEO of a blue-chip company like Siemens earns around £340,000 in salary and bonuses
- US evidence indicates that pay levels vary across industry
- CEOs in electric utilities earn below average levels of compensation
- CEOs in financial services earn above average levels of compensation
- Top executive pay in the US has increased over time
- Average cash compensation (salary plus bonus) paid to CEOs in the S&P 500 has more than doubled over the period 1970-1996, adjusted for inflation
- Average total realised compensation (salary, bonuses, options and LTIPs) for the same group has more than quadrupled over the corresponding period
- Cash compensation has been growing at similar rate in both countries over the last decade. However, Total compensation has been growing faster in the US due to the dramatic increase in the use of share options
- CEO pay practices vary across different countries
- US CEOs are paid more than their international counterparts and almost twice as much as comparable UK CEOs
- However, evidence indicates that the “US premium” is largely confined to the CEO: there is no observable difference between US and international pay practices for lower level executives and production workers
- UK CEOs are paid close to the international average
- US CEOs are paid differently: they receive a larger fraction of their pay in the form of options and a lower fraction of their pay in the form of base salary
- Relative to their European counterparts, UK CEOs receive a relatively high proportion of their salary in the form of options
- While firm size is an important determinant of pay in both countries, the rewards for scale are more pronounced in the US
- Doubling firm size increases total pay for US CEOs by 41% compared to only 22% for UK CEOs.
- Share ownership patterns differ for UK and US CEOs:
- The median share holding for US CEOs is 0.29%, compared to only 0.05% for UK CEOs
- The median effective ownership (including options and LTIP awards) is even greater: 1.48% for US CEOs compared to 0.25% for their UK counterparts
- Share ownership among US CEOs is higher across all firm size categories and industry groups
- The median value of share holdings for US CEOs is £3.3 million. The equivalent figure for UK CEOs is less than £0.5 million
- In contrast to the UK, the value of shares held by US CEOs increase with firm size
Key References
Conyon & Murphy (2000) The Prince and the Pauper? CEO Pay in the US and UK, The Economic Journal forthcoming
Murphy (1999) Executive Compensation. In Handbook of Labor Economics (eds. Ashenfelter & Card) Vol. 3. North Holland
Is Pay Linked to Performance?
- An executive’s wealth is implicitly linked to firm value through accounting-based bonuses and through year-to-year adjustments in salary levels, target bonuses and option grant sizes
- In addition, an executive’s wealth is explicitly (and mechanically) tied to firm value through holdings of shares, restricted shares and share options
- The relationship between cash compensation and firm performance: the implicit link
- Evidence suggests that the link between CEO pay and changes in firm value is typically very weak
- In the UK, a 10% increase in shareholder return corresponds to a 1% increase in cash compensation (about £3,500 for the average CEO)
- Similar results hold for the US: estimates show that current cash compensation changed by about $0.03 for every $1000 change in firm value over the period 1975-1996, while lifetime CEO wealth rose by $0.3
- In other words, a 10% increase in shareholder wealth in the US corresponds to about a 3% increase in cash compensation
- However, while evidence suggests that the sensitivity of cash compensation to firm value in the US has been increasing over time, research indicates that UK sensitivities may be on the decline
- Research shows that virtually all of the sensitivity of executive pay to company performance comes from the explicit part of the contract.
- Estimates from both the UK and US indicate that around 95% of the estimated pay-performance sensitivity in 1996 was the result of share options (64%) and share ownership (31%)
- Estimated sensitivities in US for pay measured inclusive of options and share ownership indicates that a $1000 change in shareholder wealth results in a $3.25 increase in the lifetime wealth of the CEO: significantly more than that associated with cash compensation but still very low
- Even lower sensitivities prevail in the UK
- Total pay-performance sensitivities have been found to vary substantially across different industries, with utilities ranked bottom and the non-financial services industry ranked top
- Total pay-performance sensitivities tend to be smaller in larger firms (primarily because wealth-constrained CEOs of large firms can only own a tiny proportion of the firm’s shares)
- The increasing use of share options has led to a substantial increase in the sensitivity of total pay to firm performance
- However, despite the increase in total pay-performance sensitivities over time, they remain low in absolute terms. For example, total pay-performance sensitivities in 1996 for large US firms were about 0.6%
- In other words, every $10 million of perk consumption costs the typical CEO only $60,000
- Alternatively, resisting a hostile takeover attempt promising a $500 million premium to shareholders will personally cost the average CEO about $3 million (approximately one year’s pay)
- Despite international differences in pay levels, many similarities still exist
- The sensitivity of cash compensation to company firm is constant across countries
- The sensitivity of CEO cash compensation to share price performance is similar for the US, UK and Germany
- It is important to recognise, however, that despite repeated calls for increases in pay-performance sensitivities in both the academic and policy domains, there exists almost no evidence to support the view that higher pay-performance sensitivities lead to higher share prices. In other words, while there exists a strong desire to have CEOs pay tied closely to measures of corporate success, there is very little evidence that doing so actually helps to improve overall firm performance
Jensen & Murphy (1990) Performance pay and top management incentives, Journal of Political Economy Vol. 98(2): 225-64.
Buck (1996) Total company remuneration and company performance, The Economic Journal Vol. 106(November): 1627-44.