What is the point of market practice in executive remuneration?

In some respects, it may seem odd that market practice is relevant to any particular company’s remuneration strategy at all. Even within the same sector, companies have different business strategies, and a key objective of designing executive remuneration structures is to link compensation to the successful implementation of the company strategy. To this end, boards, advisers and shareholders put significant effort into looking at the performance conditions for bonuses and long-term incentives.

This process is inherently challenging, not least because setting targets means trying to anticipate company performance in the future. Performance conditions and targets should link to the key performance indicators the company has identified as being associated with the successful implementation of its strategy.

Consequently, the selection of performance conditions and targets is the most bespoke part of the overall remuneration framework. One would expect a wide variety among companies – even when they operate in the same sector.  

Even here, however, there are certain measures that dominate the selection of performance measures, for example profit before tax (PBT) for bonuses and earnings per share (EPS) and total shareholder return (TSR) for long-term incentives.  The ease of using something familiar perhaps overweighs  the desire to ensure the appropriateness of the measure for the particular company. 

When one looks at the overall maximum incentive opportunities and types of incentive structures used, meanwhile, market practice tends to dominate conversations.

In part, this reflects the difficulties both companies and shareholders have in achieving a meaningful dialogue about remuneration. Adherence to market practice saves time, gives companies a defensible position and offers some reassurance to   shareholders.

Nevertheless, it is dangerous to just assume market practice is suited to a particular business’s circumstances. How shares are delivered to executive directors, and under what circumstances, should still be aligned to the company’s strategy. For some, where the impact of management decisions may give rise to outcomes much later, it may be appropriate to have long lock-in periods for shares. For others, with no ongoing risk once revenues have been delivered, an annual incentive may be the most suitable.

Market practice can be a useful part of the discussions, but it should not be the end of them.

This is also the case when it comes to dealing with practical problems around incentivisation and retention. Again, market practice will be relevant, particularly with regard to the latter, but companies must also manage the tension between the two. While retention needs certainty, the very nature of incentivisation is uncertainty of outcomes.

Historically, share plans have attempted to do both at the same time and, as a result, have done neither very well in most cases. Evidence suggests, however, that executive teams are more likely to be overly rewarded for mediocre performance when a company is operating market practice arrangements than with tailored arrangements designed around the company’s strategy.

In recent years, we seem to be seeing companies starting to move towards share plans that are more deliberately designed, with rewards more closely tied to the company’s actual strategy and performance, rather than being distorted by luck or random market effects. It will be interesting to see if this trend continues. 

It’s also striking that, in general, listed companies do not operate the principles applied by most private equity houses, which tend to award one block of equity up front. In this case, the value of the award is determined over the investment period and may even decrease if the share price falls or other conditions have not been met.

Given that the tenure of most listed CEOs is four to five years, it could be argued that this method would reflect the actual impact they have over their term. But instead, most listed companies operate annual awards with three-year rolling performance measurement and vesting periods, so that only the first and second grants are likely to be completely measured by the time of their departure.  

In this and other aspects of remuneration, there is no single answer, and there will naturally be variations between companies.

Some companies have broken from market practice and put in place bespoke solutions. However, it is incredibly challenging to get support for atypical arrangements. The key question is often whether the ultimate customer of the remuneration, the executive directors, feel strongly enough that they want something different, and whether the remuneration committee is willing to invest the amount of effort required to make it a success. 

Understandably, this is often not the case, so market practice arrangements continue to be a compromise most settle on, even if they satisfy no one completely. 

Approval code: NTEH7062628