EQ And Mercer: Exploring Challenges and Trends In UK Executive Remuneration

EQ: From what you’re experiencing, what are the challenges facing current expectations on UK executive remuneration?

NS: Right now, it feels as though executive remuneration is the subject of more public debate than has been the case for a while, and we may shortly see some significant changes in governance. Pressures have been building for a number of years and companies and investors have begun an open discussion about how to respond to these.

1. UK competitiveness: As businesses have become increasingly global and complex, they have found themselves competing more often with peers based outside of their home location for top talent. While UK pay levels are generally competitive globally, they can be dwarfed by the pay offered by US peers, particularly within certain sectors like Tech, where companies typically grant much higher levels of equity-based pay to their executives. There may also be fewer shareholder-imposed constraints on the design of pay and, as a result, pay packages can appear much simpler.

2. Growth in private capital: Historically, a stock market listing was generally the preferred choice for companies wishing to grow and attract new capital. This is no longer automatically the case, with some investors preferring to invest in private equity-backed businesses. As greater capital has flowed into private equity (“PE”), working for a PE-backed business has become more attractive for some executives. Private companies attract less scrutiny, and the views of shareholders may be more long-term.

Many of the corporate governance requirements applicable to listed companies also don’t apply and (so long as capital gains are taxed at a more favourable rate than income) they may end up paying less tax on their equity incentives than if they were employed by a listed company where equity incentives are typically taxed as income.

3. Prescriptive regulation: Along with the US, the UK has for many decades been at the forefront of developments in pay related corporate governance and you used to see other jurisdictions follow where the UK led. You only have to look at the Shareholder Rights Directive (“SRD”) in Europe to see how the UK’s regime for reporting and obtaining shareholder approval for executive pay policies have influenced corporate governance on the continent, as the fundamentals of SRD as the same as the requirements set out in the UK Companies Act. However, other countries have stopped adopting some of the more recent UK developments. I think this is a warning that the UK may have taken some things too far. In particular, no other country has introduced post-employment share ownership requirements which require executives to retain part of their holding in the company after they have left, even if it is to join a competitor.

   While the intention behind post-employment share ownership requirements is worthy, it is worth remembering that UK executive incentives are already subject to malus and clawback for two to three years after payment, as well as bonus deferral, and post-vesting holding requirements that also result in exposure to the risk of a share price fall or downturn in performance after employment has ended.

Looked at in isolation each of these features of UK executive remuneration is fundamentally logical but taken as a whole they make executive directors’ packages overly complex and disengaging, undermining the ability of reward to incentivise executives. It’s no surprise then that some may look outside of the UK or outside of the listed market and feel that the grass might be greener.

4. Volatility and uncertainty: One of the toughest parts of the job of being a Remuneration Committee member is setting incentive plan performance targets to make sure that they are stretching yet realistically achievable and uncertainty volatility makes doing this far harder. We have been through an extraordinary couple of decades starting with the global financial crash in 2008, followed by twelve years of weak growth, which was followed by severe disruption to the global economy caused by the pandemic, and now conflict in Europe and the middle east and ever more visible effects of climate change.

   We may also be about to see major technological shifts as advances in AI and quantum computing which have the potential to create huge changes in our economy, businesses and the way we work. The pace of change seemingly keeps accelerating and the world has become less predictable, and shocks are more sudden. This affects businesses in all sorts of ways and as companies evolve their operating models and strategies, executive pay needs to support that process, and an inflexible approach to the design of remuneration or to target setting can be unhelpful when so much can change from year to year.

5. Societal changes: Not surprisingly given everything we have been through over the last fifteen or sixteen years, society’s values are also shifting. The role of companies in wider society, ESG and DEI have all risen up the agenda and we discuss issues connected to them more openly than before; although this can arouse strong passions when we do. Indeed, some of these debates in the US have started to become unhelpfully partisan. However, it is hard to deny that the demands of customers, employees and investors are changing in response, and they expect companies to reflect their core beliefs and values. Businesses cannot ignore wider society and increasingly ESG and DEI strategies are becoming a core element in the design of reward.

Executive pay does not exist in a vacuum. When making decisions about the pay of Executive Directors, listed company Remuneration Committees need to strike a careful balance between rewarding executive performance, aligning pay with long-term value creation, and addressing wider societal concerns. It also requires companies to engage with shareholders, stakeholders, and the wider public to build trust and ensure that executive remuneration is seen as reasonable and justified. For executive remuneration advisors, our role is shifting to help bring together these different perspectives and help the Remuneration Committee to navigate these shifting sands.

Finally, government too may have a voice in this space. Most recent political interventions on executive pay globally have focused on disclosure and voting, but this could change if companies fail to take adequate note of key societal priorities and trends.

EQ: Given the current debates on stimulating UK listed market competitiveness, what is your hope for the role executive remuneration can play?

NS: Put simply, the role of executive remuneration is to help drive company performance and increase value for shareholders by attracting and retaining executives with the right level of skills and experience and rewarding them for achieving the company’s goals. Ensuring that executive remuneration is sufficiently attractive and drives the right performance will enable the UK companies to fulfil their potential. However, it also requires acceptance by wider society. For executives, given the extent to which they can individually influence company performance, as well as the smaller pool of individuals that have the required skills and experience, it is inevitable that the market will price their roles more highly than those of other kinds of employees. There is sometimes a mismatch in general public perception about executive pay (most members of the public if asked would probably say it is too high) versus the reality that, while executive pay is indeed much higher than that of other employees, it is also much more regulated and scrutinised than the pay of other employees and (in relative terms) UK executive pay levels are not outstanding compared to pay in some other places such as the US or to other highly paid UK-based roles in the commercial world where pay is not subject to disclosure.

Perceptions can be very hard to change, however, in order to ensure social acceptance, it will be important to ensure that:

1. Pay remains proportionate and fair: As with any other employee, executive pay should reflect the scale and complexity of the role and the skills required, taking into account relevant market practices. Companies need to be able to justify why pay is reasonable given their specific circumstances, be transparent about the pay setting process, and be prepared to back this up with robust evidence.

2. Incentive metrics focus on the right behaviours and outcomes: Incentives should be based on performance metrics that reflect the company’s strategic goals and focus executives on things that will genuinely make a difference to company performance. A well-designed incentive should help remove barriers to making the right decisions for the company that enhance operational efficiency, innovation, and long-term value.

3. The overall package encourages a long-term perspective: Businesses often need to balance short-term priorities with delivery of their longer-term goals and ambitions. Having the right balance between fixed and variable pay, and short- (i.e. annual) and long-term incentives, as well as encouraging executives to build up holdings of company shares can help prevent executives making decisions that put too much weight on near-term considerations. This can also ensure that they remain focussed on sustainable longer-term objectives that may not yield results until further into the future.

4. Executives (and other employees) are aligned with shareholders: It may sound obvious but the simplest way to create alignment between executives and shareholders is for them to become shareholders in their own right. These shareholdings should be earned through performance, which is why equity incentives are such an important part of executive remuneration.  However, it’s also important for the wider workforce to have the opportunity to participate in equity plans as encouraging employees to become shareholders, either through HMRC approved share plans or other types of equity incentive can be a key driver of employee engagement.

EQ: Finally, with the new 2023 UK QCA Code recommending that the remuneration policy and remuneration report be put to a shareholder vote, can we expect many more UK companies to be engaging remuneration consultants to help them design appropriate reward structures?

NS: Many AIM companies already engage remuneration consultants although those that are putting a remuneration policy or remuneration report to a shareholder vote for the first time may want them to support them in new ways. It will be important to ensure that the policy is explained clearly and succinctly and to avoid unintended consequences; e.g. to avoid unintentionally drafting the policy in a way that limits flexibility in ways that were not considered when it was written. 

AIM companies will also want to avoid their reports becoming excessively long; something that unfortunately has happened to the reports of companies on the main list; or containing boilerplate disclosures that add little if any value. This extent of change to reporting and disclosure can be a significant task and, in addition to being able to provide advice to companies on the content of any new disclosures, the company’s remuneration consultants can provide valuable additional resource to help with project management, report design and actual drafting.

Putting a remuneration policy to a vote for the first time may also be a natural point for the company to review its current approach to executive remuneration.  Formalising the policy has the potential to result in the loss of some flexibility for the Remuneration Committee and there is likely to be an expectation that whatever policy shareholders are asked to approve will remain broadly unchanged for a period of time. 

Companies may therefore want to take more time to consider the policy they put to a vote to ensure it is likely to be fit-for-purpose and flexible enough to cope with a range of likely scenarios without needing significant amendment for a number of years. Arguably a weakness of current main market policies is that companies are not able to depart from them in extreme situations such as hiring an interim CEO, whereas this is possible in most EU markets.

Fortunately, given that companies on the main list have already been down this road, the company’s remuneration consultants should have experience at drafting the policy and remuneration report. They should be able to help the company to ensure that the policy is flexible enough not to need frequent amendment as well provide advice and drafting support to ensure the policy document and remuneration report informative and helpful and do so in a way that is succinct while getting the key messages across.