CFA UK has been pleased to support the development of a forthcoming research paper on the link between executive remuneration and economic value creation by Weijia Li and Steven Young of Lancaster University Management School. Li and Young’s study (which picks up on a pilot project run in 2014) is intended to contribute to the debate on this topic and might inform future consideration of remuneration committee reports on the design of executive compensations structures.
The report’s findings are relevant to the design and administration of senior remuneration arrangements among UK listed companies. The research is based on an analysis of Chief Executive Officer (CEO) pay structures and their alignment with corporate value creation for FTSE-350 companies over the period 2003-2014/15. Companies create value when they generate economic profits, defined as returns to all capital providers in excess of the weighted average cost of raising funds. Economic profits differ from accounting profits and share returns because the latter metrics do not include a charge for the full cost of invested capital.
The report’s key findings are summarised:
- Total annual realized pay for the median FTSE-350 CEO during the sample period is £1.5 million measured at 2014 prices. Total pay for the median CEO has increased by 82% in real terms over the period, with an otherwise linear trend halted only by the financial crisis in 2008-2009 when pay levels slipped back to 2006 levels.
- The level of value creation over the same period has been low in absolute terms and erratic from year to year. The median FTSE-350 company generated little in the way of a meaningful economic profit over the period 2003-2009 (i.e., after adjusting for the full cost of funds), and although performance improved from 2010 onwards the median firm generated less than 1% economic return on invested capital.
- Simplistic metrics of short-term performance such as earnings per share (EPS) growth and total shareholder return (TSR) are the dominant means of measuring performance in CEO remuneration contracts. Worryingly, these metrics correlate poorly with theoretically more robust measures of value creation that relate performance to the cost of capital.
- Pay is correlated with value generation at a primitive level: CEOs generating positive economic profits receive 30% higher median total pay than their counterparts generating negative economic profits. Pay outcomes also distinguish between value creation realized in share prices and value creation that remains unrealized.
- Despite relentless pressure from regulators and governance reformers over the last two decades to ensure closer alignment between executive pay and performance, the association between CEO pay and fundamental value creation in the UK remains weak.
Says Will Goodhart, chief executive of CFA UK:
“Remuneration committees have spent more time than ever before this year in reaching out to shareholders and stakeholders to discuss compensation structures. There is an intense focus on pay levels coupled with calls to find better ways of aligning senior executives’ incentives with long-term value creation, which for our members is more often measured through economic profit than through accounting profit. Compensation practices in the UK have come a long way in recent years, but this report’s findings demonstrate that there is far still to go and that too few of today’s popular approaches – such as EPS and TSR - genuinely align senior executives’ pay with the economic value that they create.”