A new contribution to the issues associated with “termism” in pay has just been published by the UK government. It is well worth a read, and not only for its comments on pay matters.
The final report of Professor John Kay’s independent review of UK equity markets and long-term decision making was published on 23 July 2012. The Review’s principal concern was to answer how well equity markets are achieving their core purposes: to enhance the performance of UK companies and to enable savers to benefit from the activity of these businesses through returns to direct and indirect ownership of shares in UK companies. On pay matters it recognizes that there is a potential misalignment of incentives that arises at every point in the investment chain, and not just with executives of listed companies.
We summarise the review’s comments on pay matters below, with comments by Guerdon Associates in italics where appropriate.
The underlying principle for the paper’s chapter on pay is that market incentives should enable and encourage companies, savers and intermediaries to adopt investment approaches which achieve long-term returns by supporting and challenging corporate decisions in pursuit of long-term value.
It follows from these principles that:
· Any bonuses paid in the equity investment chain should be closely related to the agent’s performance in determining long-term value, and the vesting of the bonus should be dependent on the realisation of that long-term value;
· Rewards should reflect long-term value creation rather than the size or volume of transactions.
Since the Review was established, rightly or wrongly, executive remuneration has attracted more controversy and public attention than any other issue related to equity markets. The issue has been the subject of extensive review and consultation by the UK Department of Business, Innovation and Skills, resulting in Government reforms aimed at giving shareholders greater clarity on executive remuneration and greater power to address disproportionate pay (see our article HERE).
While the Review did not intend to cover the same grounds, it was required to consider how the structure of executive remuneration may contribute to, or detract from, good long-term decision making.
The Review asserts that bonuses and similar rewards for senior executives in UK companies were relatively unusual until the 1980s, when share option schemes became increasingly common.
We would take issue with this, as there is far more evidence to suggest profit shares and bonuses have been a common feature of British commercial life since at least the time of the first Queen Elizabeth. However, we would agree with the view that share options were not common in the UK (or Australia) until the 1980s, imported as they were from US practices driven more by tax regulation in that country than anything else.
The Review further asserts that non-business professions do not need incentives to drive appropriate behavior. Unfortunately, by citing politicians as an example they may do this assertion an injustice. Many wonder what political behavior would be like if government and opposition politicians’ pay was linked to sustainable economic growth.
The Review questioned specifically whether current executive remuneration structures provide incentives to make good long-term decisions.
The Review points out that returns from options were asymmetric – managers shared gains, but not losses, with shareholders. Executives benefitted from general rises in the stock market and from changes in market sentiment towards the sector in which the company operated, developments not related in any way to the performance of the business or individuals concerned. Share price movements over the short-term are often the result of speculative trading or changes in expectations of the performance of a company rather than the actual performance of a company: over the long run, short-term expectations and long-term outcomes may be very different.
As a result of these criticisms, ‘long-term’ incentive plans were widely implemented in place of options grants. Typically these employ a variety of financial metrics – either absolute or relative – and make awards based on periods of up to three years.
The average tenure of a UK corporate chief executive is in the range 3–5 years. Probably most important decisions about the performance and activities of a large, complex business will have consequences extending well beyond that period. And the incentive scheme is generally asymmetric in nature: it rewards good performance but the punishment for poor performance is, at worst, (compensated) loss of office. An incentive scheme that pays out during the term of office of the executive is thus biased against long-term decision making in two ways:
· Faced with particular strategic choices, there is an incentive to make decisions whose immediate effects are positive even if the long run impact may not be;
· Managers will be anxious to make strategic choices whose consequences are likely to be apparent within a short time scale.
There are paradoxical consequences. ‘Long-term’ incentive plans with a time span of three years may actively encourage short-term decision making. Incentives related to short-term share price movements, may in fact be more supportive of long-term decision making because share prices are generally more forward looking than historic accounting data (though such incentives will create many distortions of their own, particularly those related to expectations management).
Therefore, to be consistent with a long-term approach to decision making:
· Any bonuses should be paid in shares
· The required holding period of those shares should extend significantly beyond the executive’s tenure with the company
Recommendation 15: Companies should structure directors’ remuneration to relate incentives to sustainable long-term business performance. Long-term performance incentives should be provided only in the form of company shares to be held at least until after the executive has retired from the business.
Asset manager remuneration
Many of the Review’s comments about executive bonuses also apply to bonuses awarded to asset managers. As with corporate managers, the probable effect of any performance incentive is not so much to make the person or business try harder as to make them try differently. Bonuses should achieve alignment of the asset manager’s interests with those of the clients in the long-term absolute return on the fund.
Ideally, an asset manager would be remunerated by drawing rewards almost wholly from the value of the portfolio of holdings in the funds under his/her control, thereby ensuring that short- and long-term interests are identical to those of the savers whose money is invested in the fund.
Few asset managers have initial wealth sufficient to enable them to pursue this structure, although many hedge fund managers and some private equity managers do have significant personal commitment alongside their investors. In the case of hedge funds, however, this personal commitment is usually in conjunction with a charge based on a percentage of assets under management and a performance fee.
The Review’s concern, however, is primarily with the remuneration of managers employed in the long-only, or predominantly long-only, stewardship activities regarded as critical to the equity investment chain.
Recommendation 16: Asset management firms should similarly structure managers’ remuneration so as to align the interests of asset managers with the interests and timescales of their clients. Pay should therefore not be related to short-term performance of the investment fund or asset management firm. Rather a long-term performance incentive should be provided in the form of an interest in the fund (either directly or via the firm) to be held at least until the manager is no longer responsible for that fund.
Some asset managers (typically those in large firms or in subsidiaries of large financial institutions) are subject to the FSA Remuneration Code, which reflects the recent EU legislation. The requirements the code imposes seek to counter incentives for excessive risk taking in institutions whose failure might pose systemic risks to financial markets. They require that a significant portion of performance-based remuneration should be linked to the overall performance of the firm. The Review does not underestimate the significance of systemic risks in the financial system, but argues these risks do not, to any substantial extent, arise from the potential financial failure of asset management firms. Systemic problems in the asset management sector are likely to be the result of the failure of particular funds. The successful funds of a failed asset management firm will be rapidly acquired by other asset managers. To the extent that EU and domestic regulatory authorities regulate asset managers’ remuneration, they should seek to align the incentives of asset managers with the long-term performance of the funds they manage.
The misalignment of incentives between financial advisers and their retail clients, which is created by commission payments, has been a central issue in the financial services industry for many years. However even if the sources of this commission bias are removed, fee-based financial advisers will still have a bias towards action. It requires strength of character to advise a client to do nothing, and few clients will pay much for that advice.
Bias towards action is an inescapable feature of a transactions based system of intermediation. The bias to action is common for investment consultants and corporate advisers. The most effective offset to this is to favour a relationship based style of dealing over a transactional one; but this depends on effectively transmitting that perspective down to the principals dealing with the client.
The Review did not make recommendations regarding financial advisers, investment consultants or corporate advisers.
The Review does not believe that the Government or regulatory authorities should mandate the structure of remuneration packages for company directors or asset managers. The preference is for a shift in practice driven by the application of fiduciary standards throughout the equity investment chain and by the statements of good practice the Review has set out for company directors and asset managers.
For those interested in the overall function of equity markets and systemic drivers of “short termism” we suggest that the UK review is an interesting read, if only for the ideas it may provide an interventionist government driven by populism and polls rather than incentives based on long term sustainable economic growth. It is unfortunate that the Review, while “independent”, was light on econometrics and lacked the rigour of, say, an Australian Productivity Commission report. Nevertheless, there is the distinct possibility that the recommendations of the Review will be acted upon. Better forewarned and armed…as they say. The UK report can be read HERE. © Guerdon Associates 2022 Back to all articles