A study commissioned and just published by the CFA Society gives a very good analysis of how the pay of public company directors bears little relationship to fundamental measures of company performance. It also highlights how they can game the system by accepting LTIPs and bonus systems that rely on performance measures such as earnings per share when what really matters is whether they achieve a good return on capital invested. The authors suggest this has in reality been less than 1% per year over the last 11 years.
The study was undertaken by Weijia Li and Steven Young of Lancaster University Management School. Here’s an extract from their report which highlights the issues:
“Collectively, our findings suggest a material disconnect between pay and fundamental value generation for (and returns to) capital providers. The research suggests the need to redirect the spotlight on CEO pay away from a focus on pay levels and broad calls for more performance-related pay arrangements, towards a more refined discussion about the type of performance measures employed.
Two key themes emerging from the results are: (i) the critical nature of performance measure choice in the debate over CEO pay arrangements; and (ii) the need for future recommendations on pay to focus more attention on linking incentives and rewards more directly to performance metrics that reflect long term value creation for capital providers.
At one level, the widespread absence of value-based metrics in CEO pay contracts is surprising given their compelling conceptual basis coupled with considerable evidence from consultants and academics on the benefits of value-based management systems. Practically, however, value-based metrics tend to be more complex to compute (particularly where cost of capital is concerned) and more difficult to implement (especially at lower levels of the organisation hierarchy).”
As many experienced investors know, it’s return on capital that really differentiates good management from bad. But when you have performance related pay schemes that are focussed on earnings per shares, or share price performance, it’s easy to go empire building so as to increase your pay. For example, borrow money for an acquisition so as to increase earnings.
This report is yet more evidence of how performance related pay schemes have led to massive increases in pay without matching improvements in performance (they report that median FTSE-350 CEO during the sample period was £1.5 million measured at 2014 prices). Pay has gone up by 82% in real terms over the review period.
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