UK companies are turning to non-financial pay targets

UK companies are facing a number of challenges relating to the sustainability of their current business models and this is changing the way executives are rewarded, says PricewaterhouseCoopers LLP annual report on UK executive pay.

ëExecutive Compensation, Review of the Year 2007í, shows how, in the FTSE 100, the trend is away from pure financial targets towards non-financial measures. At board level, fewer than 20% of companies now rely solely on measures of financial performance in their annual bonus schemes. The use of non-financial measures to determine executive reward has risen from 35% of bonus schemes last year, to 57% this year. The measures used include customer satisfaction, levels of employee engagement and health and safety, shareholder measures, market share, environmental measures and risk management.

Incorporating non-financial targets into bonus plans can deliver benefits including a focus on the long term and better communication of the business strategy, but as Goodhartís law* states, the very act of using a metric reduces its effectiveness as a measure.

Put simply, if a target is set, managers will often find a way of meeting it. As the NHS has discovered with waiting lists, it is possible to achieve a specific numerical target in a way that was not envisaged and with unintended consequences. The report makes recommendations on how to manage these risks.

Tom Gosling, partner, PricewaterhouseCoopers LLP, said:

ìCompanies have understood for some time the importance of tracking non-financial indicators of performance such as customer satisfaction and employee morale. Now we are seeing a significant trend towards the incorporation of such targets into bonus plans. This can reinforce to employees the importance that the organisation attaches to these measures, and can help communicate strategy in a powerful way. However, companies need to guard against the law of unintended consequences: once these measures start being linked to pay, there is always the risk that they are met in ways that are detrimental to the business as a whole.î

The report looks at the influence of private equity pay on the market for executive talent in the UK. The emergence of private equity has raised questions about the sustainability of the listed sphere. However, the listed sectorís fears that lure of private equity pay opportunities would monopolise top talent, leaving a ëreserve teamí of leaders for everybody else, are unfounded. Private equity is genuinely a much riskier place to be. Recent research** has shown how half private equity funds fail to achieve the minimum hurdle rate of return (around 8% pa) needed to trigger a carried interest payment, a quarter of funds lose around 25% of their value and 10% of funds lose over half their value. Experienced talent is generally less interested in this risk profile.

The success of using private equity style pay models in the listed sector is also examined. The report finds that there are indeed important lessons to be learned about reward from private equity - private equity style arrangements can be helpful where urgent turnaround is needed or the company is in a ëchange or dieí situation. Where such an imperative does not exist, focusing a large quantum of reward on a single set of objectives can lead to distorted or even dysfunctional decision bringing Goodhartís Law into play once again.

The report considers the long term pensions situation. There are now only 32 FTSE 100 CEOs with full ëfinal salaryí direct benefit (DB) pension arrangements. Others have DB schemes to an earnings cap or have moved to defined contribution (DC) or cash arrangements. In an attempt to find a sustainable solution to retirement provision, companies have shifted out of DB into DC. This may be a far from sustainable situation. Regular employees in DC schemes will be lucky to retire on half the pensions they would have achieved in DB. Large numbers of employees retiring on ëpovertyí pensions poses a future headache for companies in the form of reputational risk and a clogged-up succession route - as the organisation fills up with those who cannot afford to retire.

Annual bonus opportunities have increased in FTSE 100 companies this year with one third of board directors receiving above 80% of their maximum bonus potential. New pay measures have meant there is more opportunity to receive some payout, even if profit or other financial targets are not met. And 5% of board directors are receiving no bonus whatsoever.

FTSE 100 board membersí pay has increased at around 5% for senior executives, between 6%-7% for board members and 8% for CEOs. Executive salary increases are still well above pay settlement and increases for the average employee. Remuneration committees remain influenced by market benchmarks, despite requests from the Association of British Insurers for companies to justify positioning of salaries ëat or aboveí median.

The value of long term incentives continues to increase so that CEOs expect median awards of 125% of salary (180% for the upper quartile).

Total shareholder return (TSR) and growth in earning per share (EPS) remain the primary performance conditions in UK plans, though frustration with the perceived lack of relevance for executives has encouraged companies to seek balance with other measures including return on capital employed, strategic project milestones, costs, cashflow, revenue growth and operating margin.