Growth – is it a dirty word?
How incentives worked in the past
By now, the application of 20:20 hindsight to the UK [ex-]Chancellor Kwarteng’s ‘mini-budget’ is almost complete. Everything which might ‘jolt Britain out of its economic torpor’ (FT, Sept 23 2022) has been scrapped, to be replaced with something a whole lot less exciting, including a new Chancellor.
I am not going into the politics of this. Many others have already done so.
But one legacy remains: lifting the ‘cap’ on annual bonus. Specifically, relaxing the 2014 EU imposed cap set at 100% of salary (2x that with shareholder approval).
Broadly, the City of London is deemed to have a ‘big smile’ about uncapping bonus (FT, Sept 23, 2022). We are having to assume, here, that ‘lifting the cap’ is the same as ‘uncapping’ bonus (they are not quite the same thing – see Note A).
Even Sir Douglas Flint, former Chair of HSBC says uncapping bonus will make the UK more competitive. With his seal of approval, it has to work, surely.
The problem lies in the execution of an ‘uncapped maximum’. I am not talking here of the contractual knitting (or, rather, unpicking) required to move bankers from high salaries to lower salary plus higher variable pay. What I am talking about is the impact any uncapped bonus has on performance overall.
Let’s examine what actually happened where uncapped bonus used to exist: take a money broking firm as an example. Bonus was linked to ‘desk revenue’, and a simple, uncapped, formula translated annual (even quarterly) revenues into bonus cash paid. The good news for participants in the bonus plan was that they enjoyed what they would refer to as ‘transparency’, and we typically refer to as ‘line of sight’. What the team on any desk saw was their own performance - right in front of them - and that performance directly drove what they were paid in bonus. No ifs, no buts, no deferrals, no risk discounting, no linkage to the Group’s performance, no analysis of trailing performance, no future match, no payment in equity.
That transparency, that direct drive mechanism, was the engine of growth. There is no question about that. The same is true of a waiter counting tips, or of a drinks firm selling cans of fizzy pop around the world.
The problem lies in how you define performance. Is more and more revenue from more and more money broking desks a good thing for the owners of that business? [It turned out to be a very bad idea, in retrospect] Just like more and more insurance underwriting isn’t necessarily a good thing for the owners of an insurance company, in the long-run, nor is it necessarily a great idea to be exposed to every currency under the sun. But that is what you get when you uncap ‘desk bonus’ for money-broking teams. It is what you would get if you uncapped bonus in any business which required capital, which under-wrote risks at a corporate level, that had to make careful allocations of any resource at the corporate level.
Uncapping bonus means you get what you pay for - growth - so you better make sure that what you grow is what you actually want.
Which brings us neatly to the question: what do we want? One might call this the Kwarteng Dilemma: do we want just Growth? We clearly do not want to use up the planet’s precious resources to do so. We do not want to exacerbate a climate crisis. We need to grow the economy to grow our tax base to fund initiatives like the transition to Sustainable Energy – but to grow requires us to burn finite resources.
In the end, today’s incentive compensation designs mirror this Dilemma precisely:
- Executive pay in 2022 includes some variable pay, but it is not uncapped [see Note B]
- More pay than previously is subject to achievement of long-term goals [see Note C]
- Both short-term and long-term pay is increasingly subject to higher Environmental and Social (‘ESG’) hurdles [see Note D]
- Those ESG hurdles are increasingly more stringent, more quantitative, and the proportion of pay linked to their achievement is also increasing.
Incentive Compensation design is, in a nutshell, NOT designed purely for growth.
- Uncapping bonus vs Lifting the Cap on bonus: for executives, the lifting of bonus cap doesn’t necessarily mean the same as uncapped, and nor is it necessarily ‘encouraged’. The Proxy Voting Agency ISS, for example, “does not typically support uncapped bonus schemes”. For listed companies, the normal corporate governance safeguards would still apply to contain bonuses being “uncapped”, i.e. avoiding excessive pay or paying for failure, deferrals (into equity) of bonus greater than 100% of salary, use of discretion re. malus and clawback, disclosure of rationale for increases and so forth.
- Median annual bonus pay-out for the CEOs of FTSE 100 companies has increased to 90% of maximum, with median bonus opportunity for CEOs now at 200% of salary (i.e. 2x). Where pay-outs are over 100% of salary, the Investment Association (IA) recommends that the remaining portion is deferred either into cash or shares. So, as such, the majority of companies operate what is effectively a compulsory deferral scheme. The average amount deferred is around 25 – 50% of the annual bonus for 3 years. A very small number of companies (~1%) then match that (1 to 1, 1.5 to 1, etc). Some investor groups have published guidelines stating that annual bonus targets should be worth no more than 50% of the maximum amount available.
- We are seeing an increase in long-term incentive plans in the FTSE 250, reflecting a tightening of the market for talent - recruitment and retention is a bigger issue for Remuneration Committees. Although performance share plans remain the most prevalent form of long-term incentive, we have seen an increase in the use of restricted share schemes as some organisations conclude tougher target-setting requires more generous grants, so opt for less performance risk and smaller grants.
- The prevalence of Environmental, Social And Governance (‘ESG’) measures has increased, with ESG measures the second most commonly used measures amongst FTSE 250 annual bonus plans, with over 50% of companies incorporating ESG into the company’s long-term incentive plan.