A new era in executive compensation

By Piia Pilv

2009 proved a watershed in executive compensation – and not just because of the legislation introduced in the US and Europe aimed at containing the kind of "excessive" pay that was judged to have caused the financial crisis. More fundamentally, the unprecedented levels of volatility in a very short space of time last year exposed serious flaws in many corporations’ compensation practices – not least the fact that they weren't flexible enough to adapt quickly to rapidly changing conditions.

Where they did respond – with salary cuts or freezes – they took a blanket approach, which for many had damaging consequences.

For example, a common mistake many European multinationals made was to look only at what was happening in Europe but impose salary freezes globally. Asia was largely unaffected by the crisis and continued to award salary increases in the region of 10 to 15 percent. It’s no surprise then, that many European companies lost their top performers in Asia last year. Similar consequences ensued from imposing salary freezes in countries such as Brazil, which experienced 20 percent inflation last year.

There were similar variations between different industries. For example, some low-cost retailers had their best year ever, while the financial services and construction industries were hit very hard. Some industries that were hit hard in Europe thrived elsewhere. Often the existing compensation policies are not flexible enough to taken into account such.

The main lesson to be learnt from last year's experience is that companies' compensation structures need to be more flexible and more tailored, while also being framed within a much tighter regulatory structure – which varies significantly from country to country. In the UK, for example, the new tax on bank bonuses is very strict and applies to a large group of financial services companies. In Switzerland, by contrast, the regulations are less stringent and apply to only a small number of financial services companies.

But legislation sometimes has unintended negative consequences (evidence suggests that where legislation is strictest, compensation rises furthest, for example), so it is crucial that companies adhere to the best practice advocated in the emerging new corporate governance codes, rather than sticking to the letter of the law but compensating for it elsewhere.

For example, in countries like the UK, where bank bonuses are being restricted, base salaries are rising – some were up by 40 per cent last year, and this year we are seeing increases above 50%. So overall, levels of compensation are unchanged. That clearly isn't "best practice". Nor, arguably, is the trend of UK banks opening offices in Geneva in order to avoid the stricter regulation in the UK.

In this complex new environment, the need for rigorous benchmarking, based on robust and relevant market data, is more important than ever. Companies need to compare themselves to others of a similar size, because including much larger companies in a peer group will inflate the average. They also need to benchmark on an industry, country, European and even pan-global basis. But although such information is crucial, companies should not slavishly follow it and instead use it as a reference point and basis for designing policies that are appropriate for their own particular organisation.

So as well as complying with the law, adhering to the spirit of corporate governance codes and benchmarking themselves against appropriate peer groups, companies also need to exercise a large degree of common sense – something that has been absent from many compensation policies in the past.

Mercer too is raising its game in terms of the quality of information it is gathering on executive compensation, and by the end of the year our Executive Remuneration Guides (MERGs) will represent an unprecedentedly detailed analysis of what has happened during the financial crisis and its aftermath, at market, industry, geographic and even employee group level. We are also starting to gather information about best practices. Given the amount of criticism and negativity about executive compensation, we want to provide some positive guidance on what companies should be doing, rather than what they shouldn’t be doing.

A number of best practices are already emerging. Here is a selection:

The number of "controversial" executive pay practices – such as "golden parachutes", perks and severance payments – have either fallen significantly or disappeared altogether.
To discourage excessive risk taking, executives are being encouraged to align their interests with those of the shareholders by owning a significant amount of company shares for significant lengths of time.
Growing numbers of organisations are now scrutinising the risk inherent in their executive compensation practices as an important factor in governance.
There is a better balance between fixed and variable and short- and long-term pay, a better balance between financial and non-financial performance measures, incentive plans are better aligned with the company's risk appetite, business goals and individual performance, and there are stronger checks and balances – including greater transparency and disclosure and more robust board oversight.
Most companies in the US and Europe now position base salaries at the market median, rather than in the upper quartile.
While annual bonus levels still vary between countries, overall, companies in financial services and elsewhere have reduced the bonus potential to limit the upside and windfall payouts.
There has been a major shift away from country-specific towards industry-specific pay benchmarking – with clear rules for peer group selection and maintenance. And more customised remuneration policies mean that, increasingly, pay is segmented not just by industry, but also by business division, organisational level and function and even, for the most critical jobs, by employee.
Across all countries and industries there is more effective remuneration governance, helped by more powerful, independent and professional remuneration committees and underpinned by emerging legislation and corporate governance codes.

Piia Pilv is a Mercer Partner and leads Human Capital's rewards segment in the EMEA region. Based in Amstelveen, Netherlands, she can be reached at +31 20 431 37 00 or piia.pilv@mercer.com.
To discuss the executive compensation issues further, you may also contact Mattias Klefback, Information Product Solutions Centre of Excellence Executive Remuneration Leader EMEA. Located in Stockholm, he can be reached at +46 8 505 308 41 or mattias.klefback@mercer.com.