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The Actuary The magazine of the Institute & Faculty of Actuaries

When is too much not enough?

The proposed compensation package for Jonathan Bloomer, the chief executive of Prudential, with its potential for a gain of over £6m if the share price doubled, was strongly criticised by institutional investors in May this year, and Prudential was forced to climb down. This could be the beginning of a significant change in executive compensation in the UK. It shows that there are enough similarly inclined institutions that are prepared to say to one of their own: ‘this is too much’.
As Prudential is one of the largest institutional investors in the UK, the approval of its bonus scheme would have made it harder for it to take issue with incentive schemes in companies in which it invests itself. This is not a concern which has held back its rivals such as Schroders, which has awarded a lucrative pay package to its new chief executive. But Prudential has adopted a more hair-shirted regime. Indeed, it has been reported that Peter Davis gave relatively low pay as one of his reasons for leaving his company chairman post.
What are the drivers of change in executive compensation, and what can we expect to see in the future?

Drivers of change
Consolidation in the insurance sector has been relentless and is expected to continue, with large companies growing almost exclusively through acquisitions. We expect consolidation within countries to increase, as the efficiency gains are often higher than in cross-border acquisitions. This is because in many markets ‘buying market share’ is becoming too expensive, and acquisition is the only feasible way to grow. As a result, we can expect performance measurement to capture the value created through both growth in revenues and increase in economic spread the difference between the return on capital and the cost of capital.
The ability to provide a diverse range of sales and service channels is also increasingly important. Tracking performance by channel will be essential for understanding how value is created in the business. This will mean allocating accountability for performance to the right people, and closely tracking the performance by channel, product, or customer for example, tracking revenues by channels rather than by branches. This has implications for how performance is measured, and it will mean obtaining meaningful management information systems.
Increasing shareholder value is becoming the primary objective of companies and the overwhelming priority for senior management. In 1991 only 3% of FTSE100 CEOs regarded increasing shareholder value as being their key objective. Now over 80% regard it as the main objective. Acquiring companies will now need to justify the value of future acquisitions, and so will need to introduce tougher, value-based, performance metrics to deliver the performance. Executive incentive systems will be an important tool in obtaining synergy from acquisitions.
The implementation of a shareholder value-based management approach can have dramatic results. One example is taken from a life insurance company let’s call it X Life. Before experimenting with value-based management, X Life had identified three important value drivers: expense ratio, mortality, and the growth in new premiums. The puzzle was that two of its top competitors had higher profit margins, despite the fact that X Life had superior results in the three areas that management thought were most important. Through a valuation analysis, the company identified three new value drivers, namely the policy lapse rate, the volume of reissued policies, and investment yield. Investment yield was just as important as the expense ratio. X Life’s management decided to track investment yield regularly and to study opportunities to increase it through improved cash management and portfolio optimisation techniques.

Executive compensation strategy
A compensation strategy needs to balance three main objectives: gearing, retention, and cost (see diagram below).
Wealth gearing measures the strength of an incentive concept in aligning the reward to shareholders with that of executives (ie wealth gearing measures the sensitivity of executives’ expected wealth from employment to changes in shareholder wealth). For example, Bill Gates has a highly geared package, because a 10% change in Microsoft’s share price would lead to a 10% change in his wealth. For most CEOs in the UK, the wealth gearing is poor ,with less than 0.5% change in employment-related wealth for a 10% change in shareholder returns.
Alignment deals with what financial economists call agency costs. As agents, executives will often pursue their own interests which, if not aligned with those of shareholders, may lead to poor company performance. Full alignment is achieved when executives’ and shareholders’ fortunes are moving in the same direction. A highly geared package which is aligned in the wrong direction can lead to disastrous results. New value-based performance metrics, such as economic profit, cash value-added and cashflow return on investment, can ensure that the executive’s reward is aligned in the right way. For example, in the insurance sector, metrics that measure the value created by acquisitions and the value created by different channels, products, or customers are going to be of increasing importance.
Balancing these compensation objectives entails difficult trade-offs:
– If we choose high gearing to provide strong motivation while keeping costs low, we create substantial executive retention risk during business downturns (ie executives may leave).
– If we maintain higher gearing and protect against retention risk, the average expected cost of the compensation package rises.
– If we instead choose to emphasise cost containment and retention risk, the gearing may not be significantly motivating.
In the UK, the debate is usually carried on in terms of immediate shareholder cost so long as the package is in line with those of other companies, shareholders are not too concerned. However, to motivate the desired behaviour, appropriate gearing is critical.

The balance of compensation packages
Compensation packages normally have three main components:
– fixed compensation (which includes base salary and executive benefits);
– short-term bonuses; and
– long-term incentives such as share options.
From the executives’ perspective, base salaries can be characterised as fixed income, resembling debt payments. As long as the company is a going concern and the executive remains employed, these payments will be made. Short-term bonuses should be performance-based and should align with shareholders over the medium term. Long-term incentive plans further extend the time horizon and have the potential to shape the overall wealth gearing of the compensation package. The compensation package should encourage executives to have a multi-year perspective and pursue strategies that create sustainable value. Executives should think and act as owners because they are faced with both the accountability and opportunity of owners. We evaluate the wealth gearing of compensation packages by using a compensation risk map, as shown below.
Currently there seems to be a paralysing trade-off in deciding between the cost of incentives needed to attract and retain the best talent, and the cost to shareholders. If managers are paid more like entrepreneurs, though, UK companies will be more aggressive, innovative, and competitive, while also being more sensitive to risk management.
While we can expect a slowing in the growth of executive pay as shareholders become more active, we believe it would be foolhardy if the pendulum swings too much the other way. Shareholders should not wish to pay £2m for someone who turns out to be a dud rather than £4m to someone who turns out to be a star. The real waste would be the £2m, not the £4m. Provided that high pay is tied to tough value-based performance metrics, shareholders should have no complaints about providing market-leading pay.