A recent study of executive remuneration at UK property companies shows a limited link between pay and performance, Shayla Walmsley reports

The more they own, the more they earn. That's the conclusion of a recent working paper* on UK property investment companies by three academics at the University of Maastricht.
Honing in on the drivers of executive remuneration, the study of 39 property firms found a weaker link between pay and performance than between pay and size.

Take Unite, the UK student accommodation firm 5% owned by ABP, the €211bn Dutch civil service scheme. When the firm, which manages student accommodation funds as well as student halls, undertook a review of its remuneration policy a few years back, it measured the policy against 20 companies chosen by size. "Due to our business performance last year we were also able to pay total remuneration at upper quartile levels, justified by very strong performance against clearly defined measures," says Unite HR director Shane Spiers.

Yet the size equivalence is more complex than it first appears. Compensation quickly increases in small companies, but weakens for executives in large companies. Above a certain threshold, the relationship is negative. In any case, performance is a contested concept. The researchers measured it according to the increase in shareholder wealth, earnings per share (EPS), dividend yield and the discount/premium at which the company trades. It also measured them against sector and FTSE benchmarks.

Yet these narrowly circumscribed financial metrics may be problematic because they focus on the short-term, rather than on measurement against longer-term strategic goals.

"How performance is defined is an important issue particularly in terms of time horizons and performance metrics," says Daniel Summerfield, co-head of responsible investment at the £28bn (€41bn) Universities Superannuation Scheme (USS). At the end of May, USS doubled its investment in UK firm First Property to £100m, following an initial investment in 2005.

"We would like to see a stronger link to the company's strategic objectives, rather than a focus solely on financial targets, to ensure that directors are incentivised to create long-term and durable shareholder value."

If size and management style drive compensation levels, share performance and outside influence - including from institutional investors - drive its terms. Part of the reason is that pension funds are primarily interested in remuneration structures - why and when executives get paid rather than the number of noughts on the paycheque.
The emphasis for pension funds is on long-term incentives. "We look more to the remuneration structure than the numbers themselves, especially to the balance between short-term and long-term incentives," says Eugene Rebers, senior counsel at civil service pension fund ABP.

"Many companies are hesitant about providing information they regard as sensitive in terms of competition," he adds. "It wouldn't be wise to disclose exact targets but they can disclose kinds of targets such as sales, profits or personal factors. They could disclose more than they are doing. Is it deliberate? No - well, maybe a little bit because they can hide behind complicated systems."

Concerning fees and pay, there are two issues. The first is how pension funds tendering their real estate management ensure alignment: effectively, to make outperformance in the managers' interests by tying part of their pay to it. The second is an issue of corporate governance: how institutional investors in real estate equities ensure appropriate remuneration for their holdings' executives.

Either way, they need to work at it. "It isn't common that we have more than a few per cent in a company. We need to team up," says Johan van der Ende, chief investment officer at Dutch healthcare and social work sector pension fund PGGM, who forecasts that collaborative efforts will become, if not the default vehicle of influence for pension funds, at least more common.

It is no coincidence that Kok cites as best practitioners funds ABP and PGGM, and UK pension fund Hermes - all three of which have considerable size and scale. Being an activist investor is neither cheap nor straightforward.

Yet Summerfield claims collaboration on issues such as remuneration can mitigate the cost in time and resources that smaller pension funds are ill able to afford.  "For smaller pension funds, there will undoubtedly be resource constraints," he says. "One way to address this challenge is to collaborate with other pension funds, and to ensure that engagement on these issues is built into asset managers' contracts and their performance is monitored and evaluated."

The involvement of fund managers in lobbying the companies they hold over remuneration has become a key demand of larger pension funds. Does that mean that pension funds are currently doing all the work? No, says Rebers, pointing to Robeco and ING, which "have a more active approach" and which work with the pension fund. "Many pension funds use external managers and we've asked ours to start dialogue with companies they invest in," says Rebers. "For us, it's important; for the fund manager community, money is less important than the business. But they see our point that it's an indication of good corporate governance."

At least it sends the message that pension funds are concerned, according to Summerfield, though he points to hesitancy from fund managers based on the suspicion that the impetus is coming from the corporate governance people rather than the pension fund's senior management.

"Fund managers will want to know that the signals are being sent from senior management and the trustee board," he says.

Although they provided the subject for Kok and his colleagues, remuneration isn't exclusively an issue for listed companies. The issue of fees within unlisted companies is European Association for Investors in Non-Listed Real Estate Vehicles (INREV) territory.  The association has long pushed for more disclosure on fee structures.
For INREV CEO Lisette van Doorn, remuneration is "an important issue - but not the only one" - effectively, part of the wider push for transparency.  She points to INREV's efforts on behalf of its members to ensure fund managers' interests are aligned with those of their pension fund clients.

"Alignment will always be a problem, regardless of the exact product or service," she says. "The question is how you structure it so that the investor and manager are as much aligned as possible, and everyone feels good about it.

"It isn't one-dimensional," she adds. "It's the result of dialogue on broader issues. It also depends on market circumstances, on how much demand there is and how much capital available. In other words, it depends on the investment alternatives."
According to Craig Mercer, investment consultant at Watson Wyatt, the solutions are simple: to increase co-investment- where managers invest in the vehicles they're selling - or equity participation.

"Co-investment is relatively simple. Whether pension funds will get it or not is a different matter," he says. He points out the consultancy tends to favour boutiques' business structure because it makes these options easier to achieve. "It's harder to do in large firms."

His argument that equity participation increases alignment between pension funds and managers echoes the Maastricht researchers' finding that executive shareholding is a stronger determinant of performance than pay levels. 

They found that increasing remuneration (pay - performance sensitivity or elasticity) doesn't necessarily improve performance but executive shareholdings do. In other words, the more they own, the more they earn, with the percentage of a firm's total shares outstanding owned by executives is directly linked to performance.
Earlier US studies of remuneration have also stressed the impact of company size, both in the level of executive pay and performance sensitivity, which tends to be stronger in smaller firms.

"Investors should monitor executive compensation more closely - which is not easy with the extensive remuneration packages that are handed out nowadays - and stimulate executives to hold a substantial percentage of shares," says Kok. "The latter is the only optimal way to align managerial interests with shareholder interests."

The researchers back "agency theory" - that a well-structured board, high insider ownership, and the presence of alternative governance mechanisms enhance performance. "Executives of well-performing firms are more willing to hold shares of their company and long-term compensation packages result in higher insider holdings," they say.

But does pension funds' advocacy work? It isn't clear. "It's always difficult to say if it's the result of our efforts. For a single investor, it's hard to change anything," says Rebers.

In any case, the Maastricht researchers found that institutional investors were involved in only half the sampled firms - a finding they describe as "counterintuitive". 
Yet they found that the more involved institutional investors were, the more emphasis the firm put on long-term incentives. That could count as a victory - that is, if the investors act in certain ways. But Kok points out that their efforts have contributed to regimes skewed towards market - rather than managers' - performance.

"In my opinion, a strong link between pay and performance should hold both in bull and bear markets," he says. "What we noticed in our sample was a link between pay and performance when the market was rising, but when the market crashed after 2000 companies switched from option packages to share packages. The latter are more interesting for executives because shares have less downside risk - as opposed to options: out-of-the-money options are worthless."

The dangers of rewarding the market - rather than executives' performance within that market - are obvious enough. The 2001 downturn saw a decline in both bonus and option plans, with lower average compensation in 2002 reflecting the downturn of the stock market, and a slight increase in 2003 when the stock market picked up again.
With the battering of financial markets in August, directors across sectors began buying shares in their own companies. They may simply have been buying up oversold stock but it looked like a vote of confidence.  Alignment, after all, isn't just an issue for fund managers' fees. Kok claims that pension funds' reliance on passive monitoring may even exacerbate the tendency to reward market shifts rather than managers' performance.

"In the past, one of the ways in which institutional investors could try to minimise agency problems was by stimulating the use of performance-based incentives," he says. "This actually leads to very high (maybe even excessive) compensation in a strongly rising market, whereas companies were able to prevent large compensation losses when the market fell. So institutional investors are not necessarily ineffective monitoring mechanisms, but they should not rely on passive monitoring only."
Pension funds themselves view their role slightly more positively. "We want to be active shareholders. If we can vote, we will vote, and if remuneration is included in that we'll vote on it," says van der Ende.

Together with other institutional investors, ABP is lobbying for advisory notes on remuneration systems - a system that exists in the UK, the Netherlands and Australia, but not in most of continental Europe. Under the system, companies proposing a change to remuneration processes will be obliged to ask for an advisory note. "The most important benefit will be that companies will start a dialogue with investors over approval," says Rebers. "We rarely vote against it - but it is an indication that companies have been in dialogue with investors." 

It's difficult to tell whether the Maastricht study has implications for property investment firms in other countries. As its authors point out, the UK is both the most transparent of all European listed property markets, and it has a higher-than-European-average degree of transparency in executive compensation. Unlike their counterparts in most European markets, UK companies have since the 1990s been obliged to published details of remuneration in their annual reports, including the composition of executive pay and details of executive shareholdings and stock options.

"The UK market has been the leader in detailed reporting on executive compensation," says Kok, pointing out that reporting used to be even more detailed than in the US before Sarbanes-Oxley. "Continental Europe should learn from it."