Colin Melvin: Now's the time to reform directors' pay – it will be an all-round winner

The legitimacy of Britain's larger companies in the eyes of their stakeholders – their licence to operate – is in danger of being revoked by public opinion on pay. Their directors are often well-paid even when the company is performing poorly, and those who are asked to resign tend to receive rewards for failure, which is an unacceptable failure of the reward system itself.

Over the past decade, executive director pay has increased at a far faster rate than the pay of employees and the value accruing to shareholders in the larger public companies. According to the High Pay Commission, between 2000 and 2010 the average FTSE 350 director enjoyed bonus increases of 187 per cent, long-term incentive rises of 253.5 per cent and a gain in total earnings of 108 per cent; this was against an average share-price decrease of 5.4 per cent.

Such behaviour is facing a crisis of credibility. Many directors appear immune to the effects of the economic crisis faced by the rest of society. Those who realise profound reform and a significant realignment is overdue and work to improve the way pay and performance are linked will be recognised as true leaders in difficult times.

The standards of behaviour and clarity of purpose that galvanise an organisation to achieve its objectives are vital to corporate success. We need to reconsider the levels and structure of executive pay and ensure they are aligned to companies' long-term success and the experience of their long-term owners, such as pension funds.

Better alignment can be achieved through simpler pay structures and long-term share ownership. In most directors' incentive schemes, three years is considered a long-term performance measure, but this is at best medium term.

The nature of businesses and business cycles mean strategies, capital projects and investment decisions take far longer than three years to be specified, implemented and assessed. We suggest a new model for directors' pay, with a modest annual cash bonus and a grant of shares that must be owned for the long term, both dependent on the achievement of company and personal objectives.

In its role as adviser to pension funds, Hermes EOS has been told by company directors that executive pay has become so complex it is losing its motivational effects. We believe the simplicity of our proposal for payment in shares would also lead to more effective incentivisation.

We recommend that fixed pay for directors and senior management should rise by no more than the average that is awarded to the rest of the organisation. Remuneration committees should also consider pay rises for senior executives in shares to increase alignment with the owners. We believe that the amount paid to many executives takes too much account of supposed market forces. The market for executive directors is at best dysfunctional.

Companies should consult on remuneration more widely and deeply. Remuneration committees should engage with their most important shareholders at an earlier stage. Greater care should be taken to understand the views of the long-term owners of companies, such as pension funds, rather than their agents, the fund managers who often are motivated by shorter-term performance. Companies should actively explain to their employees how and why executive remuneration is aligned to the strategy and desired culture.

Shareholders also have a responsibility to engage with companies on their pay structures and proposals. The current debate on short-termism in investment markets suggests that better ownership of companies or "stewardship" would lead to better long-term corporate and investment performance. However, most pension funds lack an effective stewardship resource to advise and represent their members as good asset owners, exercise their voting rights and engage with the companies in which they invest to promote their long-term value.

We are at a turning point in the evolution of publicly listed companies in the UK. The backdrop of economic crisis and minimal economic growth has meant that the directors of corporate Britain need to reflect deeply on the culture of boards and the companies that they lead. The ultimate success of companies and our economic future will be influenced by boards and their remuneration committees seeking honestly to address the flaws in pay of directors of public companies.

Such reform will help to reconnect these companies with their employees, customers and other stakeholders to provide the basis on which long-term success can be promoted for the benefit of their owners.

Colin Melvin is CEO of Hermes Equity Ownership Services