Financial Daily from THE HINDU group of publications
Wednesday, Aug 14, 2002
Corporate - Trends
CEO Remuneration II: Issue of pay versus performance
Ram Kumar Kakani
ACCORDING to corporate finance, every firm has broadly two objectives: To maintain a high degree of current profitability; and, to ensure high growth rates in future profitability. The relative emphasis on the two objectives depends on the various conditions prevailing for the firm in question. So, corporate performance can be defined and compared in two ways corporate efficiency, and corporate growth. Both are important to understand and appreciate corporate performance.
In this segment the corporate performance data of 16 large manufacturing firms is studied vis-à-vis their managerial remuneration data over 2 decades, with the conclusion that managerial remuneration (aided by changes in corporate laws) has significantly increased over the last two decades in sharp contrast to corporate financial performance.
Sampling and period
For the purpose of this study, publicly listed manufacturing firms were drawn from the top 200 large private corporates with data being available for over two decades. A sample of 16 firms was drawn from the population by random sampling without replacement technique. They are ACC, Arvind Mills, Bajaj Auto, Ceat Industries, Century Enka, Electrosteel Castings, GEC Alsthom, GSFC, Hindustan Motors, ITC, J. K. Corp, Kesoram Industries, Kirloskar Cummins, Larsen & Toubro, Siemens and Tata Steel. The study period was taken as 22 years, starting from 1979-80 to 2000-01. This would reduce the influence of temporary factors and business cycles.
Table 1 lists down the performance measures used for the study from the corporate growth and efficiency points of view. With the data available, it was difficult to measure the positive contribution made to society by a company. Hence, a new measure `welfare' was devised. It is the ratio between the sum of operating profits of the firm, wages to the employee's and all welfare expenses (such as donations) to the firm's total assets. The more this ratio the more will be the benefit to society from the firm.
In Table 1, simple yearly averages of the above measures of the sample firms were used in the analysis. The empirical results are:
Corporate growth and managerial remuneration
Table 2 gives the comparative trends in managerial remuneration, employee wages, sales and PBDIT on an absolute basis. These clearly convey that CEO packages have increased way ahead of PBDIT, sales and employee wages. It is clear that the sweeping changes in the Companies Act 1956, have resulted in corporates paying their top bosses more. Although quantitatively, these increased remunerations are found to be less than the limits specified by various sections of the Companies Act, there has been a quantum leap from the earlier days of restrictions.
As the above sample includes only large corporates, the growth figures of managerial remuneration in comparison to corporate performance parameters may be small compared to that in smaller companies.
From Table 2, it is obvious that though PBDIT and wages of the sample firms were the same at Rs 16 crore in 1979-80, employee wages have lagged way behind PBDIT at the end of the study period.
It is observed that the growth in managerial remuneration is almost 5 times the growth in employee wages in the study period. This might even indicate that the growth in profits of the sample firms was probably due to either technology improvement or capital investment, which has resulted in increased corporate profits at the expense of employee wages. In comparison, the growth in corporate managerial remuneration has been very high in the last eight years.
Meanwhile, Table 3 gives the compounded annual growth rates of sales, PBDIT, managerial remuneration and employee wages for some sub-periods. It is clear that the changes made in the Companies Act in 1987 and 1993-94 has made the managerial remuneration grow faster. The employee wage growth rate has been the least. The wide disparity between the annual growth rates of managerial remuneration and other variables (that is, growth in sales, PBDIT, and employee wages) is largest when calculated from 1992-93 to 2000-01. This coincides with the significant changes brought in the Company's Act in that period. It appears that the CEOs had "fully utilised" the removal of the restrictions in their remuneration. This would not have been so glaring had sales, PBDIT or employee wages increased correspondingly.
Corporate efficiency and managerial remuneration
Both corporate efficiency indicators and managerial remuneration have changed from 1979-80 to 2000-01. While in general MR/PBDIT ratio has increased, an exactly opposite trend is observed in the corporate efficiency indicators. The decrease has been very clear in the case of Welfare and ROCE (return on capital employed). Even the ROE (return on equity) of our sample companies has declined continuously in 1995-2001.
It implies that while compensation for CEOs has increased, this has not resulted in a positive change in the performance from the point of view of all other stakeholders including equity shareholders. This raises the question of justification in the phenomenal rise in managerial remuneration.
Hence, to the extent of the sample, it can be stated that had the CEO remunerations been based on any of the above corporate efficiency indicators, these would have decreased. Compared to the US, the above remuneration may be less but if the remuneration is compared with to other highly developed economies (such as Denmark, Germany and Japan) and some of the consistently better performing corporate giants (Sony and Mitsubishi) the remuneration is high and not justified.
Thus, the despite the small sample size, the general directional findings suggest that: The liberalisation of the Indian economy aided by the sweeping changes in the Companies Act appear to have positively affected and increased the managerial remuneration of CEOs in the last two decades.
These changes in the Companies Act have in all probability helped managements remove the stigma attached to the increases, despite these increases not working positively for the corporates as far as their performance in terms of growth or efficiency is concerned.
Increase in managerial remuneration has not helped improve the performance of these largely profitable corporations. On the other hand it seems to have decreased their performance parameters with respect to shareholders, the entity and the society at large.
Such singular devotion to increase their individual payoffs at the cost of corporate performance seems to be highlighted by the recent exposures in the scam-tainted corporate world.
After all, corporate corruption cannot exist without the top managements' compliance, if not connivance.
While this may not be the general characteristic of CEOs, it can be argued that the pious hopes of the Companies Act to motivate corporate excellence among CEOs by increasing their remuneration has been belied.
Food for thought
The working group's recommendations on the Companies Act also favour the continuance of the present trend on managerial remuneration.
The revised guidelines might have given the corporate the required autonomy to increase the remunerations for directors, thereby allowing them to attract and retain the best talent.
However, as the analysis shows, the increase in remunerations has definitely not led to a corresponding increase in corporate performance.
Possibly, only a few companies, such as Reliance Industries, have shown consistent growth in sales and operating profits, which are comparable to growth in managerial remuneration.
Hence, shareholders, Government and all other stakeholders need to look into the matter and take necessary steps, such as linking the managerial remuneration with the long-term performance of the company and not just linking it to the firm's net profits.
Suitable provisions have to be incorporated in the Indian Companies Act so that managerial personnel would become more accountable to their acts of commission and omission.
CEO pay packets have been a debatable issue from time immemorial. Some see them as the outcome of managerial greed unhindered and even backed by compliant board of directors.
Others worry that senior executives are not paid enough to attract the finest talent to corporations rather than to such fields as working in overseas firms, consulting, etc.
Yet others say that these high pay packets are due to the high competition for skilled human capital sector from the emerging new economy sectors.
Evaluating these arguments in this debate and taking into consideration the subtle issues, here are suggestions on the composition of the managerial pay package:
Consider first the role of immediate forms of compensation salary and current bonus in the pay package. By whatever formula these payments are established, the payoff to the manager reflects only the firm's revealed performance up to the payment date. However, the time horizon relevant to shareholders is in principle unlimited since all future residual cash flows the firm is expected to generate should be impounded in the share price. Therefore, managers may need to be given an explicit claim to those future cash flows to encourage proper attention to decisions that will favourably affect them. Hence, firms might contemplate limited stock options as a way out.
Incentive payments yield behaviours that are more attuned to perform. Hence, incentive formulas are to be created in a work environment that is destined to change ideally for the better. So for high-technology firms, incentive compensation is an important part of gaining a competitive advantage within an industry. To encourage senior management to be willing to make cash distributions to shareholders when profitable investment opportunities are not present, the compensation package might be so structured that the proportion of pay comprised of salary and bonus increases with the firm's dividend payout ratio.
What all the above means is that compensation arrangements in practice should be diverse encompassing such disparate elements as profit sharing, operating profit-linked incentive, bonus, stock options, deferred compensation, and pensions. A major motivation for the creation of these components is probably the crying need for a "just" and less controversial managerial remuneration, which will not only reduce the widening gap but also simultaneously fuel the individual to succeed.
(The authors are faculty members at XLRI, Jamshedpur.)
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