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The black box of executive compensation

Opinion
London - German companies need to do much more to live up to the transparency standards required by democracy in the age of globalisation.

German companies are not helping public trust in the way they obscure remuneration policies for top managers.

There seem to be two ethical standards, one for the general public and another, much laxer one, for top executives.

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A VW badge sits on the grille of a VW BUDD-E concept electric vehicle in the Volkswagen pavilion at the CeBIT 2017 tech fair in Hannover, Germany, last Sunday. VW is singled out by the writer, saying that Volkswagen’s compensation system for its top executives ranges in the bottom third of the transparency rating - it is opaque.Photo: Bloomberg

Companies should be forced to release information on executive compensation. Or else, it will remain a black box.

If you are a shareholder of a German publicly traded company and you want to understand the top executives’ financial incentives - well, good luck with that!

Sure, by now you can at least find out how much they are paid, but not why. As it turns out, compensation reports of German companies are not very transparent, so that the factors that drive executive compensation remain in the dark.

For example, SAP’s Bill McDermott made 15 million euros (R204.16 million) in 2016, of which 12 mollion euros is performance-based. Success was measured with help of criteria such as revenue and operating income.

However, no word is said about his specific performance targets? Was a 1percent, 5percent or 10percent increase in revenue the target? Moreover, does a 10percent increase in revenue lead to a 10percent increase in salary? In addition, are the two criteria equally important - or is revenue the main driver?

Even though some of Germany's top companies offer slightly more information, not a single salary of one of the altogether 180 DAX executives can be constructed with the information available to shareholders.

Commonly, companies employ performance criteria that are unobservable to shareholders or they do not specify the measurement and results. Other firms remain quiet on the respective weights of the criteria, leaving the question on their relative importance unanswered.

No info on targets

Worst of it all, not even a single company reveals information on the performance targets entirely. There is no way of telling what causes the level of the compensation - it is a black box.

The executive compensation transparency rating by the Flossbach von Storch Research Institute takes a look at the level of information given in the companies’ annual compensation reports.

HeidelbergCement, Germany's 23rd-ranked company by market cap, has the most transparent compensation system. The firm only omits a few performance targets and lacks in observability of some performance criteria. The reports offered by BMW, Daimler and Siemens are almost as transparent.

At the bottom of the rating, one finds Adidas, ProSiebenSat1 and SAP. Hardly any information besides the mere mention of performance criteria can be found in their annual reports.

With the information available, there is no way of finding out how their executives are incentivised.

Is the opacity spurious or systematic? German regulators have made several attempts to achieve more transparency in executive compensation. The most recent step, the German Corporate Governance Code, is the industry’s self-imposed (that is, voluntary) regulation.

Expecting a voluntary framework, which in addition is only optional, to force a company to reveal more information than required is of course a foolish thought. Hence, the suspicion of a systematic refusal of full disclosure is more likely.

Shareholders’ and workers’ dissatisfaction with the state of executive compensation is more present than ever before. Especially Volkswagen caught negative attention as the company kept paying out extremely high executive salaries - even though suffering from the dieselgate scandal.

Volkswagen’s directors recently tried to squash the debate by limiting executive pay to 10m annually. No word, however, regarding the core of the problem, the non-transparency of executive compensation performance criteria.

Volkswagen’s compensation system ranges in the bottom third of the transparency rating - it is opaque. In the 2015 dieselgate scandal, which pushed the company’s operating income below the critical threshold of 5billion, all bonus payments were supposed to be cancelled. Instead of sticking to this clearly delineated bonus/penalty system, the company decided to lower the threshold to zero so that the executives would still get their awards.

It is not just Volkswagen, but other top German companies as well that are not helping public trust and confidence by the manner in which they obscure their remuneration policies for top managers.

Workers and union members complain about getting fired in bad times, while executives awarded themselves with generous pay checks. The obscurity of executive compensation systems enables them to undermine the incentive mechanisms.

The company’s directors are the ones who have the final say. It lies in their hands to provide full disclosure of the incentive mechanisms. However, the evidence is indisputable - up to now they have simply not decided to do so.

Even at Volkswagen, where the board is packed with labour unionists and social democratic politicians, compensation is opaque and incentives are blurry.

One wonders what the German government is waiting for. On the one hand, it is concerned about ever more citizens joining demonstrations about large international trade agreements, which often mainly benefit the largest firms.

Opaque reporting

Allowing firms to continue their practice of opaque reporting while paying very generous levels of compensation for top executives only heightens the public’s concerns.

If the feeling of two ethical standards - one for the general public and another, much laxer one for top executives - persists, that sentiment may even be a real and present danger to the foundations of democracy.

No politician can rely any longer on companies living up to what they should be doing. The evidence clearly shows that they are not willing to do so. Unless companies are forced to release information on their executive compensation practices, this crucial issue will most probably remain a black box.

That is why the release of this information should be mandatory. Not taking this critical step further undermines democracy.

Philipp Immenkötter is Senior Research Analyst at the Flossbach von Storch Research Institute. This article initially appeared on The Globalist. Follow The Globalist on Twitter.

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