Variable pay for CEOs: Are Indian companies doing it the right way?
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Bengaluru: In 2008, when Quebec-based Valeant Pharmaceutical International Inc.’s chief executive officer J. Michael Pearson took charge, his compensation model made headlines.
The package contained millions of dollars in stock that would vest only after he met certain targets. Also, he was given a long-term deferred stock award, valued at $140 million when it was granted in 2008, which he could not sell till 2017. Besides, he had to buy $3 million in Valeant stock with his own money. Analysts praised the model as it focused on long-term performance.
When some analysts pointed out possible malpractices this could lead to, Valeant chairman Mason Morfit told The Wall Street Journal that the board keeps a close watch.
What followed was a dramatic turn of events.
The CEO raised prices of Valeant drugs steeply to meet internal profit targets. In his seven years as CEO, the stock price soared over 1,000%, and revenue jumped 1,073% to $7,710.1 million in that period. At its peak, Pearson had close to $3 billion worth of stockholding.
But then came a federal probe into the price increases, leading to Pearson’s exit in March.
This cautionary tale can be revisited as results for fiscal 2016 pour in and we get a glimpse at the way firms structure their compensation for CEOs, and how they reward performance.
As a concept, variable pay has been around for centuries—even the East India Company is said to have offered such benefits to its employees to retain them, according to Margaret Makepeace, a senior archivist in the India Office Records at the British Library in London, in her book The East India Company’s London Workers.
But variable pay became part of corporate culture in India only in the 1990s when economic reforms opened the doors wider for multinational firms. Since then, the concept has spread.
In the 1990s, variable pay accounted for just 20% of a CEO’s compensation. That has steadily increased to about 50% now, said Anandorup Ghose, reward consulting practice leader at consulting firm Aon Hewitt India.
There are companies that pay much more. Cognizant Technology Solutions Corp., in a regulatory filing on Friday, said its CEO Francisco D’Souza earned $11.95 million in 2015. And 94% of it was variable pay, including stock options worth $10.4 million, as D’Souza helped the company—based in the US but with most of its workforce in India—exceed revenue targets set for the year.
The metrics of a CEO’s performance are usually reviewed every quarter and are linked to revenue, profits, talent and share price.
“The risk with variable pay is when too much weightage is attached to any one of the metrics, they could lead the CEO to make short-term decisions which could later not benefit the company,” says Nandita Gurjar, former group head of HR at Infosys Ltd.
In fact, Ravi Venkatesan, former chairman of Microsoft Corp. India Pvt. Ltd and Cummins India Ltd, and chairman of Bank of Baroda, believes linking CEO pay entirely to metrics such as annual revenue and profits is “wrong and dangerous”.
“A CEO’s job is different from a sales leader; a CEO must create a competitive flourishing enterprise, not just deliver another quarter. A CEO’s performance cannot be judged by short-term metrics like revenue and profits any more that you can judge a prime minister’s performance by GDP growth” he says.
Today, variable pay is used to reward performance, but historically, variable pay in the information technology (IT) sector came about when people were on the verge of losing their jobs after the 2002-03 dotcom bust.
“The concept of variable pay was introduced as an alternative to protect jobs in a downturn when salary costs would force companies to lay off employees. Variable pay would instead soften the blow and could be used to reduce cost and save jobs,” says Gurjar.
While there is no prescriptive answer for whether it drives performance as there is no direct causality, Ireena Vittal, member of several boards and a CEO coach, believes it is the competence and character of a CEO that drives performance in addition to compensation. “It is one of the important factors, but not the most important,” she says.
In the past, human behaviour experts such as Alfie Kohn, in his book Punished by Rewards, questioned the use of incentives, saying that while it seemed to work in the short run, it is a strategy that ultimately fails and even does lasting harm as it destroys intrinsic motivation in individuals.
However, most listed companies swear by it. About 88% of Indian companies have some form of variable pay, say experts.
To be fair, companies are exercising caution while handing out variable pay as a large portion of it is in the form of long-term plans like share-based payments or ESOPs (employee stock options) and restricted shares, says Anubhav Gupta, solution head-executive compensation and governance at Aon Hewitt.
On an average in India-listed companies, of the variable pay, 56% is in the form of long-term incentives and stock based, adds Gupta.
“It is completely wrong to assume that you need to motivate a CEO with a fat package. Great CEOs tend to be motivated primarily by the thrill of building a great business,” says Venkatesan.
It is not just the way variable pay is structured, but the overall fat increases in executive compensation that Venkatesan finds worrying.
In the past five years alone, compensation for top management has gone up by about 40-53%, says Gupta.
“In the compensation committee of boards, there is no one who is a voice of moderation. The compensation committee of boards is driven by compensation consultants to approve ever fatter packages, fuelling an arms race that threatens to spin out of control, ” he says.