Oral statement to Parliament

Executive Remuneration

History There is now broad consensus across the main political parties and many business and investor groups in support of “responsible capitalism…

History

There is now broad consensus across the main political parties and many business and investor groups in support of “responsible capitalism”. This precludes lavish payouts for failure or mediocrity, and addresses widening inequalities in remuneration. There is also a common understanding that Britain’s recovery from its profound economic crisis must be led by successful private enterprise and that entrepreneurs and good managers will expect competitive rewards. The debate on executive pay has to reconcile these two objectives. That is what I will try to do today.

It is worth remembering some of the recent history in this area.

At the time of the dotcom boom and bust, there was a considerable concern about payments for failure, not only for those riding the Internet wave, but more widely. In America, Home Depot, Disney, Global Crossing and of course Enron - here, Railtrack, Marconi, and others. A spate of enquiries and rule changes followed, including the 2002 UK regulations requiring fuller disclosure of directors’ pay.

But the conventional view until recently was that extremes in rewards were acceptable, so long as the broader economy was growing. We can all quote Lord Mandelson who was: “intensely relaxed about people getting filthy rich as long as they pay their taxes.” That is not to criticise my predecessor who reflected a widespread view at the time.

And so under the last Government income and wealth inequalities grew, far faster than the still-expanding economy. Executive pay escalated, despite no clear overall improvement in corporate performance. City bonuses rocketed in particular - the total paid out more than tripling between 2002/03 and 2007/08, from £3.3 billion to £11.6 billion. And then the banks collapsed, revealing in their fall a history of appalling mismanagement and reckless risk taking whose consequences were largely felt by the taxpayer and ordinary people who lost their jobs or held shares in the banks.

If this was meant to be “pay for performance”, it was a performance the rest of the economy could have done without.

But enormous rewards have continued and the sense of entitlement is undiminished. Most of these activities are specific to banks and I sympathise with good British businesses who feel they are in the dock because of misbehaviour in another part of the parish.

When I talked 18 months ago at my party conference about “shining a harsh light into the murky world of corporate behaviour” and criticised irresponsible capitalism, this caused paroxysms of rage and I was accused by sections of the media of being a Marxist.

In fact, I was merely using the language of a former Prime Minister, Ted Heath, a generation ago, when he railed against “the unacceptable face of capitalism”; and indeed, the writings of economic liberals like Adam Smith or 20th century liberals like Keynes. These concerns are now being echoed across the political spectrum.

But the issue is not who got there first. We need cross party consensus, as we have broadly achieved in pensions policy. A problem that has been long in gestation will take more than one parliamentary term to resolve. That’s why I welcome the fact that all three major parties now want reform in executive remuneration.

This issue will not be fixed immediately. Behaviour needs to change in boardrooms and companies across the country, and no amount of government micromanagement can do it alone. In other words, this will need a change in culture. I have heard how much easier it is to keep pay ratios low in Sweden, for example, or in Germany, because the culture is less tolerant of extreme inequality. Yet these are countries which are outperforming us economically. No single one of my suggestions is a silver bullet, but together they should help a necessary transformation to get underway.

This cultural issue isn’t just about pay. Last year I asked Professor John Kay, working with businesses including Sir John Rose, to look at how our equity markets might cause UK business perspectives to be too short term, and how to shift this to the longer term approach of our successful competitors.

But on pay, we need to develop a shared analysis that there is a problem.

What is the problem?

The issue is partly about “rewards for failure”. But it is not just that.

There is also a ratchet in executive pay with everyone believing that they should be paid well above average and that they should be benchmarked against US peers when they live and work in the UK. It is of course a logical absurdity for everyone to be paid above the average, let alone in the top quartile. Imagine if this happened with workers’ pay awards. There would be galloping wage inflation and loud business objections about our loss of competitiveness.

But somehow when the ratchet is at the top of the pay scale there is a change of language. We are told that, to compete in the global market, ever escalating pay is essential.

The globalisation excuse doesn’t stand up to scrutiny. While it is true that rising executive pay is a global phenomenon, trends in inequality at the very top are very divergent between countries, despite them all operating in the same global economy. There are world class companies in the Nordic countries, Japan, Holland and Germany who take a very different approach to the UK and US.

But let me be clear. There is a legitimate role for high pay for exceptional talent and performance - quite apart from high returns to successful entrepreneurs - and I will defend that.

Even so, although the “49% pay increase” headlines this year may be a statistical exaggeration, the median pay increase of 12% at the top was a radically different outcome from the 2.3% increase - a cut in real terms - for average workers. And this is a continuation of trends which have lasted a decade.

And although corporate profits have rebounded since March 2009, this is not all about the heroic efforts of executives. In 2009 the world looked down a barrel, and it was the State, using taxpayer’s money, that turned it around as well - through expanding fiscal deficits and Quantitative Easing.

What we can and cannot do

Of course executive pay reforms alone cannot resolve wider inequalities in income and wealth. This is mainly a tax issue relating to wealth and income. Hence my enthusiasm for cutting taxes for those on low and middle incomes who work hard, and also for increasing it on unproductive wealth.

Pay reforms cannot deal with massive returns for owners of capital including private equity, hedge funds and unlisted private companies. Depending on the basis of those returns, this can be a tax, regulatory or competition question. And those returns are justified where they reflect scarce talent and skills.

They cannot also deal with other abuses like environmental damage, exploitation of workers and consumers, or asset stripping. These are issues for regulation and competition policy.

Currently they can only in part deal with the vexed issue of bankers’ pay and bonuses. Banks are a special case because currently they are directly or indirectly supported by the taxpayer. A proper resolution needs bank reform to deal with the “too big to fail” problem; stronger capital and liquidity requirements; the lack of competition, indeed all the other factors that destabilised and nearly destroyed the sector.

I am also asked by critics why - as an addicted fan of Match of the Day - I don’t make the same fuss about the Premier League footballers who earn upwards of £50,000 a week. But here, failure - whether by managers, players or the club - is severely punished. Rewards, for the few, are lavish but playing and managerial careers are usually brief. Quality is clearly recognised and acknowledged. There is also a high level of ethnic diversity - not a feature of British boardrooms. And it is not a committee of Manchester United players who set the pay of Wayne Rooney. The fan base does not expect a puritanical approach to equality and will tolerate some wide differentials; but it does expect rewards to reflect merit.

When it comes to directors’ pay, therefore, we are not dealing with the wide range of issues affecting fairness but a relatively narrow set of issues. The central one is the agency problem that arises from separation of ownership and control between the principals, or shareholders, and their agents, the executives. Without any constraint, there is an incentive for executives to use their superior knowledge and contacts to further their interests rather than those of the company. Directors are meant to provide this constraint, and nowadays are largely successful - compared to the 1960s when, as I read in The Economist, the Board was described as a “big blob of nothing”. The biggest obvious gap of course, is in relation to the directors’ own pay.

The barriers to entry in the closed world of remuneration committees; and the ratcheting effect of everyone striving to be in the top quartile add to this problem. Moreover, pay packages have become impenetrably complex making the job of scrutinising them harder

The papers I issued last September, on narrative reporting and on executive pay, were designed to explore these issues in depth. The proposals I am now setting out respond to these factors.

What is clear from the evidence is an appetite for reform in the corporate and investment worlds. In recent months, the CBI; the Institute of Directors; the Association of British Insurers; the National Association of Pension Funds, have all acknowledged that the current situation is not sustainable.

But it is also clear that change will not happen without Government intervention - to quote from the SMF, that this is an area requiring us to be pro-market, but not naively free-market. We have a role in setting the framework. I do not want to see private sector salaries being set in Whitehall, but I do accept the business view that Government has a legitimate role in finding answers to what is a market failure.

This is why I am proposing a package of measures to tackle this issue on four fronts. To boost transparency; give shareholders more effective control; increase the diversity of remuneration committees; and encourage major businesses and investors to lead by example.

Transparency

Let me turn first to transparency. There is a strong consensus that company remuneration reports are too dense and opaque, and in many cases contain too much data and too little information. It is difficult for shareholders to establish precisely how executives are rewarded let alone make an informed judgement on whether they are being incentivised and rewarded appropriately.

We are proposing new rules that will require remuneration reports to be split into two sections: one detailing the proposed future policy for executive pay; the other setting out how pay policy has been implemented in the preceding year. Too many reports are currently an unintelligible mix of the two.

When outlining future policy, Boards and their remuneration committees will be expected to explain in the report why they have used specific benchmarks and how they have taken employee earnings - including pay differentials - into account in setting pay.

One specific issue is the use of pay ratios between CEO and average employees. This is being used in the public sector and is a genuinely useful metric which could be used in the private sector. But I recognise its limitations. Different types of companies will have different ratios, because of the nature of the business. A company employing thousands of relatively low-paid, low-skilled shop-workers will inevitably have a much wider pay ratio than a firm that outsources most of its unskilled labour, for example.

Companies also will have to explain how they have consulted and taken into account the views of employees. This will happen automatically in employee-owned companies and the Deputy Prime Minister has set out a wish to see this radically extended. But, already, in the UK, employees in large companies already have the right to set up Information and Consultation Arrangements, allowing them to receive information and discuss issues about the company for which they work - including their bosses’ pay. This mechanism is not being extensively used at present and perhaps employees are unaware of it. I would encourage them to take this up and put executive pay on the agenda. Here is a useful mechanism that already exists and it is more practical and less problematic than trying to put worker representatives on Boards.

To reflect the fact that pay is not set in isolation, companies will also have to explain clearly and succinctly how the proposed pay structures reflect and support company strategy; how performance will be assessed; and how it will translate into rewards under different scenarios.

In particular, they will need to open up the performance criteria for bonuses - an area which is currently shrouded in mystery - so in future companies will have to justify why they are deserved. If performance really has been “exceptional”, it should not be too hard to explain how.

Some of the very worst behaviour has been with departing executives. Sometimes companies have found it easier to give a generous exit than put up with embarrassment of admitting that a top executive did not work out. This seems to be the epitome of a perverse incentive, and is miles away from the experience of ordinary workers. So we will similarly expect to see greater openness on exit payments, including the contractual terms offered to executives.

In the backwards-looking section of the report, companies will have to provide a single figure for total pay for each director and explain how pay awards relate to the company’s performance. They will also have to produce a distribution statement, outlining how executive pay compares with other dispersals such as dividends, business investment, taxation and general staffing costs.

These measures will give shareholders the information they need to ensure effective scrutiny of the businesses they have stakes in. But the reality is that transparency only gets us so far. Alongside more information, shareholders have told us that they need new powers to hold the board to account. They do, after all, own the company.

Shareholder powers

The introduction of advisory votes on remuneration reports nine years ago was an important step in encouraging shareholders to engage actively with the companies they have stakes in. But the limitations of that approach are why we are now having to look at more radical options. The time has come to introduce binding votes on directors’ pay.

Today I want to propose specific options to give shareholders a binding vote which, taken together, should empower shareholders to get a grip on pay. I invite you all to help us work through the detail to finalise our plans.

Drawing on views from the investor community, the options I favour include:

  • Binding shareholder votes on the future pay policy for the Board as a whole, including details of how performance will be judged and real numbers on the potential pay outs directors could receive. Companies will have to include a statement on how they have taken account of shareholder views and the result of previous votes.

  • A requirement to get binding shareholder approval for any directors’ notice period longer than a year and on exit payments of more than one year’s basic salary or the minimum contractual amount, whichever is the lower - which gives shareholders more say over payments for failure;

  • A vote on how the company has implemented the approved pay policy in the preceding year, including the amounts paid out. Some have said making this vote binding would not be workable; it would create a lawyers’ charter, as the right to payments already earned could be challenged in court. I will consider whether we need further sanctions that could be applied when a significant number of shareholders dissented in the advisory vote.

Alongside this, I want to see shareholders using their new rights to annual re-election of directors. Ultimately, if shareholders remain unhappy with what is going on, they can vote down the chairman of the remuneration committee, or the chairman of the company. Think of this as a vote of no confidence. If they are really worried about the whole Board then they can reject the annual report and accounts as at present.

I intend to publish more details on these proposals in the coming weeks. When I do, I will also be seeking views on the thresholds used to determine whether a vote has succeeded. For example, the future pay policy might require approval by 75% of the votes cast.

But we also need to make it easier for companies to withhold or recoup pay awards when performance has not lived up to expectations. The banking crisis has already seen financial services sector subject to clawback provisions in executives’ contracts, and companies in other sectors are starting to follow suit.

I will be asking the Financial Reporting Council to consult on amending the UK Corporate Governance Code to require all large public companies to adopt clawbacks.

Finally, we have to ensure that shareholders are incentivised to use the new powers that will be available to them. The FRC will be updating the Stewardship Code, first introduced in July 2010, which sets out how institutional investors should exercise their shareholding rights effectively, and requires them to publish their voting policy on issues such as pay. I am encouraged by the number of investors already signed up, and I strongly encourage the FRC in its efforts to develop the Code further.

Opening up remuneration committees

Alongside these reforms to increase the information available to shareholders and bolster their ability to act on it, we also need to shake up the way that decisions on pay are made.

That starts with throwing open the door to the boardroom and letting in some fresh air, fresh faces and fresh thinking. I would like to see, for example, a couple of directors on every board who are new and have not previously served on boards. I would note that Boards need to understand consumer and workplace vantage points in particular, as well as high strategy.

When I meet RemCo chairs, I am always impressed by how they are people with a lifetime of achievement behind them. Knights of the Realm, Lords, extraordinary businesspeople - extraordinary people often capable of combining several careers. But why should it be that way - why not more people with the achievement before them? I am not implying a conspiracy, but merely pointing out how difficult it is to appreciate the typical viewpoint if you breathe such rarefied air.

The homogenous appearance of most remuneration committees is symptomatic of the lack of diversity in UK boardrooms, which is why we have been working to broaden the membership base. Encouraging headhunters to look beyond existing board members. Requiring companies to report on their boardroom diversity policy from October this year. And adopting Lord Davies’ recommendations designed to boost the proportion of women on boards. This is an issue of business performance not of political correctness. So far there has been a modest improvement in FTSE100 companies but little below that. Shareholders and Boards need to step up their game here.

We must also face up to inherent conflicts of interest in setting executive pay - whether their effect is real or potential. So in future there will be a requirement for greater transparency around the role of remuneration consultants, including how they are appointed, to whom they report and whom they advise, and their fees.

I welcome the suggestion from some RemCo chairs that Boards should end the practice of serving executives sitting on the remuneration committees of other large companies. This is not a widespread practice because shareholders are generally good at stamping out obvious conflicts of interest: just over 5% of remuneration committee members in the FTSE all-share index are also serving executives. All the same, 5% is 5% too many as these individuals have a clear interest in reinforcing rather than challenging the status quo. And I find it hard to understand how a CEO of one company can have time, for example, to chair the RemCo of another.

Sector-led reform

Ultimately, of course, there is a limit to how much government can achieve in terms of cultural change. There is no substitute for leadership from companies themselves and their owners. Remuneration committees and institutional investors need to change their behaviour. They need to uphold the Corporate Governance Code, which makes it clear that executive remuneration should be tied to performance and a company’s long-term success not merely pay lip service to it.

Responsible business leaders are waking up to that fact and understand the need to respond to the substantial and growing pressure to deal with the culture of excessive rewards. I stand ready to work with them, and with investors, to thrash out what gold-standard company reporting should look like and then act on it.

Deborah Hargreaves, who chaired the recent High Pay Commission, will be establishing a new project which launches next week to monitor the state of pay at the top. This High Pay Centre will make a valuable contribution to this important area and keep it high on everyone’s agenda.

But corporate Britain must also show leadership. So I shall close by challenging this country’s world-class companies and executives to embrace the reforms I have outlined, and work with us to renew public trust in UK business.

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