Executive pay must be linked to value creation
05 July 2016
The Institute of Directors in Southern Africa’s (IoDSA) Remuneration Committee Forum has
released its fifth position paper called “Value creation and executive pay” on the practical
measures that boards should take in order to link executive pay with the value they create
for the company and all its stakeholders.
“Executive pay is one the most visible and criticised aspects of corporate governance,” says
Ray Harraway, Director: Remuneration Services at EY and Chair of the Remuneration
Committee Forum. “I don’t think anybody really objects to high executive pay so long as it is
directly linked to the value that executives create for the company and its stakeholders.
However, getting the link between pay and performance right is extremely difficult, and
that’s the issue this paper aims to address.”
At the heart of this problem is the difficulty in understanding value creation. Before
anything sensible can be said about executive remuneration, boards and their remuneration
committees have to understand what, for the organisation, constitutes value—and how the
company creates value. Once that is understood, the remuneration committee can begin to
establish what the desired outcomes are, and what drivers are important in achieving them.
A major stumbling block is that, according to 2013 research by McKinsey, only 34 percent of
directors surveyed agreed that the boards they served on fully understand their companies’
strategies.1 Such an understanding is a prerequisite for understanding what value creation
looks like and thus, ultimately, how executives should be incentivised.
Overemphasis on outcomes at the expense of drivers is one of the common shortfalls of
executive incentive schemes, Harraway says. Outcomes may take years to achieve, so they
are an inadequate measure of executive performance over the short term, whereas
drivers—those actions that lead to the desired outcome—can be better indicators of
progress in the short term.
To be effective, incentive schemes need to be multifaceted. Both outcomes and drivers
should play a role in the design of the schemes, as should a balance of short-term financial
performance and long-term sustainability.
Thus, for example, while a rise in the annual share price is obviously important, it should not
be at the cost of investment in R&D and training, which are vital to the company’s long-term
sustainability. And profitability cannot be the sole financial measure used—the return on capital has to form part of the equation when assessing executive performance and how it contributes value creation.
Parmi Natesan, Executive Director at the IoDSA and a member of the King IV drafting team,
adds that one of the fundamental shifts in King IV is to make the performance/value
creation aspect of governance more explicit.
“Setting remuneration levels is never going to be an easy exercise, and nor will it ever be a
simple matching of actions and results, so the remuneration committee will always need a
certain amount of business acumen as well as discretion. Nonetheless, if the value-creation
levers are well understood, the committee will be better placed to incentivise the right kind
of executive behaviour,’ says Harraway. “For instance, if there is a conflict between actions
that might result in lower profits in the short term but are likely to drive long-term value,
the incentives should default in favour of the latter.”
The paper “Value creation and executive pay” can be downloaded by visiting
Photo caption: Ray Harraway, Chair of the Remuneration Committee Forum at the Institute
of Directors in Southern Africa, says few object to high executive pay so long as it is directly
linked to the value that executives create for the company and its stakeholders.
1McKinsey, “Improving board governance: McKinsey Global Survey results” (August 2013), available at http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/improving-boardgovernance-mckinsey-global-survey-results.