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You might think that company boards had learned the lesson by now that formula-based “long term” incentive plans serve little purpose other than to enrich the odd lucky top manager. But never mind that doing the same thing repeatedly and expecting a different outcome is a classic definition of madness: non-executives continue to rubber-stamp these flawed schemes, while retaining an inexplicable faith in their worth.
The latest so-called LTIP to turn into a sort of demented Fixed Odds Betting Terminal in reverse, spewing out mountains of cash in return for little evident input, is that of Persimmon, a British housebuilder.
Conceived in 2012, at the end of a depressed period for the construction sector, this is apparently poised to shell out options worth about £232m to just three of the company’s executive directors, as well as hundreds of millions more to those further down the chain. To say that is rather more than the board originally advertised is an understatement almost as large as the jackpot. Nor is Persimmon the only housebuilder for whose bosses Christmas has come early. Last month, Berkeley Homes revealed that it was handing executives £92m in bonuses through a similar (if marginally less generous) scheme.
Predictably, the problem in both cases stems partly from the board’s very human inability to see round corners. Persimmon might have extended the scheme’s term from the usual three-five years to a decade, and ruled out the use of leverage, in the hope of excluding the customary crass financial engineering. What the directors did not foresee, however, was the government’s “Help to Buy” equity loan scheme for homebuyers, worth about £7bn to date, which has both pumped up new house prices and boosted completions. The company’s stock price more than quadrupled, turning an already over-generous mechanism into something wholly absurd.
But an inability to see the future is not the only thing wrong with these monster incentives. They are misconceived on virtually every level.
First, there is the basic misapprehension that they solve the so-called “principal-agent problem” — getting executives to act in the interests of owners rather than just themselves. In practice, incentivising managers to perform certain tasks simply leads them to prioritise those tasks over others. And as the economist Diane Coyle has observed, the fact that the tasks in question are generally tied to easily observable indicators, such as the share price, dividends or trading profits, tends to distort behaviour.
In particular, it vaunts short-term over long-term gains, and quick share price increases over the tough haul of producing excellent products that customers actually want to purchase. Yet this remains the only reliable way to drive up the value of an enterprise over the longer term.
Then there is the fact that setting metrics for years in advance can be counterproductive. To return to the housebuilders, their schemes were tied critically to the task of returning capital to shareholders. That might seem sensible for an industry that is contracting or in a fallow period. But in the case of the housebuilders, this was not the situation. Thanks to government policy, the sector was actually in expansionary mode.
True, there is one saving grace for Persimmon and Berkeley: they are at least flourishing at the same time as they are handing out these monster bonuses. But it is as likely for long-term schemes to end up showering riches on executives at times when the company is struggling. Take the case of BP, for instance. The oil company paid its boss Bob Dudley $19.6m in 2015 because of a complex long-term formula. Yet that same year, the company made a $5.2bn loss.
Two things follow from these observations. First, boards should recognise that they are not appointed simply to rubber stamp formulas that are devised by consultants. They are there to exercise judgment, and they cannot perform that role if they tie themselves in knots with elaborate forward-looking employment contracts.
Second, they also need to abandon the magical thinking that showering executives with gold is somehow the only way to get a company to flourish. The evidence says otherwise. A recent Lancaster University Management School survey found that, over a decade, the correlation between performance and pay among FTSE 350 bosses was negligible despite the growth in “performance based” payments. Returns on capital barely budged, yet pay rose 80 per cent.
A myth has grown up that chief executives will not put in the effort unless they have a juicy LTIP in their back pockets. Shareholders should call this bluff and scrap performance pay for the most senior people. Bosses should receive a fair fixed wage for a fair day’s work.