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Simple steps to correct executive salary spiral

When Rio Tinto chairman Jan du Plessis delivered a 3120- word speech to the Royal Institute of International Affairs in London last week, a 107-word paragraph got all the attention.

When Rio Tinto chairman Jan du Plessis delivered a 3120- word speech to the Royal Institute of International Affairs in London last week, a 107-word paragraph got all the attention.

In it, he said a "spiral" in executive pay in the past two decades "simply cannot continue . . . many businesses sometimes appear to have lost all touch with reality".

Boards and remuneration committees of public companies have been prepared for too long to support remuneration levels that were not demanded by the marketplace, and they needed to be "much more responsive" to how the public, shareholders and employees perceived them, he said.

Du Plessis was talking about the need to rein in executive pay to help restore public trust in companies and the free market system, and he touched on many other issues.

Personal and corporate wealth had accumulated effortlessly ahead of the global crisis partly because the world had chronically under-priced credit, he said, and history would record the development of the credit bubble as a collective failure of oversight by bankers, businesses, investors, central bankers, regulators, and governments (I would add media to the list of those who were asleep at the wheel).

Du Plessis said he might be criticised for diagnosing the disease without offering a cure, but said the correct diagnosis was half the battle, and concluded that those responsible for the excess, including company directors, should accept "how we got into this mess and [accept] our own responsibilities . . . individually and institutionally".

That final thought is actually the other half of the remedial care equation, and part of the prescription, as du Plessis implies, is for boards to develop some backbone.

They are operating in a seller's market: the demand for top quality executives is greater than the supply. They nevertheless have the power to control pay levels. As Nancy Reagan famously declared when launching her Drug Awareness campaign in America 30 years ago, they should "just say no".

It is easy to get lost in the labyrinthine architecture of pay systems, and one of the quick corporate reactions to the Rio chairman's speech was that remuneration rules were too complicated, and actually working to push pay higher.

Neither assertion is correct. The pay system was constructed piece by piece in response to weaknesses, and there is no compelling case to dismantle any of it. Complicated disclosure is also preferable to no disclosure at all, and it is highly unlikely that publicising pay deals leads to higher pay. Top executives and boards don't need to read rival annual reports to work out the going rate. They pay remuneration consultants to do that job, and were doing so long before disclosure rules were tightened to give punters more insight into pay-setting procedures, and pay levels for top executives and directors.

Let's look at what a good remuneration system should do.

Managers should care about the company they lead, and its success, and be rewarded if they help produce it. Remuneration structures deal with that, firstly holding base pay down and overlaying it with bonuses that are paid for performance in terms of operational excellence in the short term, and in terms of the value added by the executive in the longer term, say three to six years. That makes sense. In listed companies the performance link is underlined by the issue of shares or options on shares as compensation. Shares dominate the long-term portion of the pay package, and while cash makes up most of the short-term (one year) component, shares are becoming more important there, too.

The risk of rewarding executives for failure is met now in several ways. Long-term packages have become lengthier, and vesting delays extended, putting more "pay" at risk even after an executive departs. Termination payments that exceed average base pay must be approved by shareholders, and a listed company's remuneration policy is subject to the two strikes rule, where non-binding votes of more than 25 per cent against a company's remuneration report in two consecutive annual meetings result in a new motion that could lead to a vote on all directors.

Peer group measures have also been introduced. They could be more effective, in companies including the one du Plessis leads, Rio Tinto. Executive heads should have rolled after Rio's ill-timed $US38 billion acquisition of Alcan in 2007, and Rio's current pay system review should reverse a 2010 decision to expand and dilute Rio's performance peer group to include non-resources companies.

Once again, however, there is no case for scrapping peer benchmarking entirely. Used properly it makes it less likely that directors will be rewarded for floating along in a bull-market tide that lifts all corporate boats.

There's room for more. Companies should not be able to bypass shareholders and buy share scheme shares on-market, for example, and the amount of capital that can be pledged to the pay schemes should be finite.

Top executive salaries have actually been trending down since the global crisis. Average CEO total pay in 2010, the year of the Australian Council of Superannuation Investors' latest survey, was 9.9 per cent lower than in 2007. But they are still 9.3 per cent above 2006 in Australia, and 2006 was 21 per cent above 2005. They are costing companies and those who lead them society's respect, and that's too big a price to pay.

It's up to the non-executive directors, and they don't need new remuneration structures. They need to deflect executive pressure for inside deals a jump in short-term pay to boost termination payout calculations, for example and they need to tell CEOs that the period before 2007 was a bubble, not the base. If they don't break ranks and overbid each other, a CEO pay cut of 25 per cent is achievable.

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