What’s Wrong With Executive Compensation?

LONDON – It’s annual general meeting (AGM) season for public companies around the world, and, as in previous years, one issue has been moving company news from the business section to the front page: executive pay. Companies continue to announce compensation packages for their top managers that leave people agape, not just because the gap between companies’ highest- and lowest-paid workers is so wide, but also because the compensation bears so little relation to firms’ performance.

Nonetheless, a concerted pushback has begun, led by a group that companies and their boards might actually pay attention to: their largest and most influential investors. Hedge funds, pension funds, and sovereign wealth funds are stating that they are looking closely at C-suite remuneration, and that it is time to take reform seriously.

Norway’s sovereign wealth fund, worth $870 billion, has said that it is setting its sights on pay structures. Aberdeen Asset Management and Royal London Asset Management were among a group of shareholders who strongly objected to BP’s proposed 20% increase in compensation for CEO Bob Dudley in a year when BP made record losses, and they joined 59% of investors in rejecting the package. Though the BP vote was non-binding, it was a clear signal to the company and its board.

Similarly, 54% of Renault SA’s shareholders, which include the French state, opposed CEO Carlos Ghosn’s €25 million ($28 million) remuneration package at the company’s AGM in April. It, too, was a non-binding vote, and the board chose to disregard it.

But ignoring shareholder sentiment is becoming untenable. Discontent cuts across all sectors, from banking, with calls for a review at Lloyds Bank, to media and advertising, with an outcry, yet again, about the pay awarded to WPP’s Martin Sorrell; at £70.4 million, his latest package makes him the United Kingdom’s highest-paid CEO.

At Berkshire Hathaway’s AGM in April, Warren Buffett advocated for compensation plans that fit the needs of the business, rather than vice versa. This happens when a “very greedy chief executive…designs a pyramid so that a whole bunch of other people down the line get overpaid… just so it doesn’t look like he’s all by himself, in terms of that fantastic pay-off he’s arranged for himself.”

Part of the issue is that executive remuneration packages have become too complex. Gone are the days when CEOs did the job and were paid a wage. It is almost as if remuneration committees have taken a leaf from Sun Tzu’s The Art of War: “The whole secret lies in confusing the enemy, so that he cannot fathom our real intent.” Explanations for remuneration calculations can run for pages, and often board members who aren’t on the remuneration committee cannot unravel them.

Moreover, bonus targets are fundamentally flawed. Markets are fraught with “unknown unknowns.” Boards often don’t know now what will need to happen later. And that means goals based on the past or the supposed future reward what we currently think rather than actual performance. When pay is driven by strict adherence to targets set 12 months before, CEOs look back, instead of focusing on the present and on what comes next. Compensation needs to reflect whether the CEO won all the battles but lost the war.

But avoiding what might be called the “Dudley Paradox” – a CEO is paid a huge bonus for hitting targets, even as the company suffers major losses – requires boards to stop delegating the entire pay discussion to the compensation committee and waiting for the decisions to arrive, fait accompli, tied up in a bow. The full board should review the company’s operations and strategy thoroughly; only then should the compensation committee set about creating the program to act on it.

Having such a program in place is especially important when a new CEO or senior executive is hired. At a time of great hope and a desire to woo the candidate, desperation or enthusiasm can lead to poor judgment and badly formulated packages, which, once negotiated, are not subject to shareholder vote. A prime example is Yahoo’s firing of Henrique De Castro in 2014. After only 15 months on the job as COO, De Castro walked away with $109 million.

Lastly, CEOs should show leadership in how they manage their own compensation negotiations. If they are responsible for all aspects of the company, then they cannot abdicate responsibility with a “Because I’m worth it” attitude when news of their large pay packages becomes public. More important, they need to recognize that no law obliges them to take what they can get. They could hit the targets and earn the pay, but look at the company’s results and choose to adjust the total accordingly. The CEO needs to be talking about the business of the company to its workforce, investors, and the wider world, not be stuck at the AGM defending the executive team’s salaries.

The revolt against large pay packages won’t go away. For all the reported cases, many more are simmering beneath the surface of public scrutiny. Unless these companies address head-on the quiet hand-wringing among board members and grumbling among investors, they will find themselves on the front pages next. Lucy P. Marcus is CEO of Marcus Venture Consulting.

By Lucy P. Marcus