Here’s who decides how much CEOs get paid

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Warren Buffett and his chief lieutenant Charlie Munger are united in their overt distaste for executive compensation consultants – professionals appointed by the boards of some of the world’s biggest companies to determine the compensation-and-benefits packages of its top bosses. At the annual Berkshire Hathaway meeting in May this year, Buffett said, “If the board hires a compensation consultant after I go, I will come back – mad,” while Munger added, “I have avoided all my life compensation consultants. I hardly can find the words to express my contempt.”

But is the business of compensation consultants getting an undeserved bad rap? “There is always a risk of us having an inflationary pressure on compensation. But the more balanced view is that we act as a controller and brake on executive pay. We’re very aware of what the market rate for a job is and the HR professionals inside the institutions that we deal with need third-party validation of what they are doing. In many instances, I find myself arguing for compensation to go down rather than up. That’s the bit of the discussion that Mr. Buffett might miss because he only receives the headlines where the numbers are going the other way,” says Dubai-based Martin McGuigan, Partner at Aon Hewitt Middle East, who also heads up the McLagan division at Aon that specifically deals with compensation within the financial services sector in the MENA region.

Globally, Aon Hewitt is one of the biggest players in the industry – reportedly, over 70 per cent of the Fortune 500 and FTSE 100 companies in America and the UK have contracted its services to determine the pay of its upper-crust management.

Contrary to what you believe, these consultants aren’t the empowered sharks that dole out packages worth tens of million on a whim to slick CEOs. McGuigan explains its business model. Most organisations have what is known as an internal nomination and remuneration committee (NRC). The NRC is tasked with finding executive-level candidates – often accepting names pitched by headhunters – vetting and interviewing them and, most importantly, will act as the penultimate authority on determining the quantum of pay.

To help them reach that decision though, the NRC cannot rely on headhunters who are motivated by securing a higher pay for their candidate because they are paid a percentage of the final package. Instead, they turn to third-party neutral external bodies like the Aon Hewitt to gather market intelligence on what executives within the candidates’ peer group are being offered and to advise on a fair compensation package. Does he think that compensation packages are far higher today than they should justifiably be? “If a CEO is going to make you a billion dollars and you want to pay him 50 million, shareholders will say, ‘That’s fine. We’re going to make 950 million.’ There is no limit to how much it should or could be, but the control should be in the design of the incentives that ensures shareholders are taken care of first, and that the employees are always paid after the shareholders,” says McGuigan.

In the wake of 2008 crisis, reports of millions being disbursed among the senior management of freshly-bailed out financial institutions caused shareholders to rile against the system that allowed these excesses. As McGuigan explains, 2008 led to the creation of government-backed financial legislation and checks-and- balances to prevent the abuse of the system, though they’ve fallen short of entirely remedying the matter. “The way compensation packages are set up is that one-third is guaranteed pay, one-third annual bonus, and one-third are long- term incentives like equity. It’s the bonus and incentives that are directly correlated to the performance of the organisation they lead, and that component was previously entirely at the discretion of the shareholders. However, in Europe you now have CRD IV regulatory authority that mandates that the bonus of those in the financial services sector in the European Union, can be a maximum of 100 per cent of their fixed component. That didn’t bring total compensation levels down. It was, in fact, bad for shareholders because the guaranteed component of the compensation was increased so that they [the executives] would be eligible for 100 per cent bonus of a bigger number.”

That took away the uncertainty of having these men and women work harder to secure larger bonuses. The higher fixed component, says McGuigan, also had an adverse knock-on effect on end-of-service benefits, pension, and national insurance, among other things.

In countries like America, regulation has had a better impact and now beginning to stick. “In the States, the same regulatory pressure was applied via Dodd Frank, a consumer protection act put in place by the US legislative institutions, in 2009. It capped compensation for senior executives and bank professionals and spelt out exactly how the risk and reward mechanisms should be linked. They made a very strong linkage on how people were incentivised and the risks they took which were previously responsible for the collapse of its financial institutions.”

Everything isn’t always above board though and there is a more sinister side to the compensation consulting business. To navigate, sometimes circumvent, these international regulatory mechanisms, often companies will appoint compensation consultants to sit on their board and NRC councils. “You can’t design [the compensation and benefits] plan and then sit on the same boards and say, ‘What a great plan that is.’ Believe it or not, five or six years ago, you could have done both.”

“So now we’ve seen many [compensation consulting] companies split the design and consulting part from the regulatory advisory part so that they can work both sides of the fence, but under two completely different company structures. Those employees are very clearly divided by Chinese walls internally.”

The compensation consulting industry isn’t a one-size-fits all operation. The packages structured are varied across financial markets worldwide. In the West, executives are gung-ho on equity as their long-term incentives. In the Middle East, where many large corporations are family or state-owned, cash is still king. “In the Middle East, 95 per cent of the deals are cash based and this won’t change in the foreseeable future. Historically, we’ve had a transient population in the region. So when you bring talent in, they are interested in a cash deal because they are able to up sticks and leave with no encumbrances to taking the money with them.”

While the matter of executive pay in the Middle East isn’t very closely regulated or as structured as it is in the West, things are changing even if it’s still a case of the cart leading the horse. “There are many well-run forward-thinking companies who are divesting responsibilities outside of its family members to professionals. To secure the contract of these talented individuals, they [the companies] will revamp and reinvigorate their internal perspective on pay and use proper executive compensation metrics and techniques. It is happening, but slowly.”

The executive compensation business is here to stay. As McGuigan points out, companies will always require third-party validation and intelligence on the prevailing market conditions during the hiring process. “Shareholders will always demand an expert point of view on the reasonableness of what is being put in front of them.”

If McGuigan is right, Buffett might never be able to rest easy.