Big is not necessarily beautiful. The rewards executives receive for leading a company are facing greater scrutiny as anger over inequality has led to strikes, protests and defunding campaigns. It’s bad for business if directors receive six-figure salaries, bonuses, shares and pension contributions while the guys working on the shop floor are struggling on the minimum wage.
The chief executive of clothing and homewares retailer Next being handed a 50% pay rise at a time when families are struggling is the latest example that has put the issue under a microscope. Tesco and the Restaurant Group, which owns Wagamama, have also faced questions from shareholders concerning the rewards they have handed their leaders in difficult economic times.
Finding a balance between companies needing to attract and retain talent while avoiding accusations of being greedy is not easy. “Talent at the top can make a difference in terms of financial performance, but they need to balance having strong leaders with a prudent allocation of investor capital and robust, objective and transparent incentive metrics,” says Peter Dervan, senior director of stewardship at Manulife Investment Management.
Karoline Herms, senior global ESG manager at Legal & General Investment Management (LGIM), has two decades of investment management experience, which has seen her work with companies on their remuneration proposals. “Remuneration has been a bit of a hobby-horse for me,” she says. “It is a window into a company’s governance structures, which, as an external investor, you don’t often see.
“You get to see who is really wearing the trousers,” she adds.
When is enough…enough?
Herms says that LGIM trusts boards to govern their company, which includes setting management remuneration. “Essentially, we trust them to do it right, but we take our responsibilities as an active shareholder seriously. We know our voting rights when looking at remuneration proposals and the accountability of directors,” she adds.
The decision on what is appropriate to incentivise management lies with the remuneration committee. “If it is their belief that they must give a significant pay award, they can do so as long as it’s structurally long-term aligned, reflects strong performance and is potentially measured against benchmarks,” Herms says. “We want to see the management outperform the market.
“We also expect the committee to look at other issues. So, for example, the stakeholder experience, the size of the company, market sentiment, and, especially if it is a large payout, potential reputational risks. These cannot be ignored. “Ultimately, it is the committee’s responsibility to persuade us that a pay award is justified,” Herms says.
LGIM doesn’t have a threshold for how much a company pays its senior leaders. A pay deal being linked to long-term sustainable performance is more important. “We look at the structure of pay and how it aligns with the experience of the workforce, of the shareholders and wider society,” Herms says.
Although useful, the ratio of how much the chief executive is paid compared to that of an average employee can be confusing. “We accept that comparability is difficult across different companies and sectors. It is not a red flag for us,” Herms says.
When assessing if an executive’s pay is extravagant, comparing the pay structure to a reasonable peer group could help. “If a company pays its executives to a degree we deem excessive relative to their peers, we may have an issue with that,” Dervan says. “You need to incentivise executives to remain with the company, but success is defined potentially differently by different parties,” Dervan says.
Cash or paper?
The structure of the pay package also needs to be considered. A large bonus may seem extravagant, but it could only be paid if the company hits certain targets. An executive receiving a $1m cash bonus, for example, is likely to be a different proposition from receiving the equivalent in shares.
“We might have better tolerance for payments made in equity as opposed to cash if those equity awards are tied to strong operational hurdles. Achieving that equity payout could significantly enhance shareholder value,” Dervan says.
It is not just a question of why an executive is being paid so much, but how, or when, it is paid. “Is it purely in their salary, where they just need to sit in their seat to earn pay, or tied to strong financial or operational metrics that could result in unlocking shareholder value?” Dervan says.
“We are long-term investors; therefore, we want pay packages weighted towards three-to-five-year periods,” Dervan says. “We want to incentivise outperformance against a peer group and we want to incentivise alignment with shareholders through equity ownership, so we want [pay packages] weighted more towards equity compensation than cash,” Dervan says. “We want robust challenging metrics over the longer term,” Dervan says.
The right metrics
You want metrics that incentivise fundamental outperformance. Return on invested capital is such a measurement, which is weighted towards not just equity, but performance-related equity.
“You need to incentivise executives, but you need to do it in a responsible and reasonable way through a responsible and reasonable use of shareholder investor capital,” Dervan says. “The wrong incentives can certainly threaten long-term value,” Dervan says. “That is why we work with companies to encourage the right metrics and the right incentives that seek to drive outperformance over the long term.
“You could have a good year of performance, but is that worth a significant increase in pay? We want to incentivise performance against the long term,” Dervan says. “It may not be enough just to look at stock performance. It is great if the stock price goes up, but we pick companies for a reason. We pick them because we expect them to outperform the market,” Dervan says.
He doesn’t want executives benefiting from just riding the market. “Some people could point to a share price going up over the last year, but if everybody’s share price went up you have performed thanks to macro tailwinds. Nothing fundamentally has changed at the company,” Dervan says.
“A revenue target could encourage executives to empire build, to just go after acquisition after acquisition without measuring the success of any post-merger synergies,” Dervan says. “The right metrics, like return on invested capital, can help balance that.”
It is difficult to compare the responsibilities of the directors to those of the wider workforce. “Directors are having to walk a bit of a tightrope here,” Herms says. “Different risk and responsibility levels are rewarded differently.
“Executives are employees of a company and work on behalf of shareholders and other stakeholders, from the workforce to the supply chain,” Herms says. “For that they are generally quite well paid. They get a salary, a bonus and participate in share incentives.”
Clare Richards, director, social, in the responsible investment team at the Church of England Pensions Board, says that no one is saying everyone should be on exactly the same pay. “That’s not the point,” she adds. “It is about getting a more holistic sense of what rewards mean within a company, rather than just being fixated on one or two numbers.”
Shareholders should not fall into the trap of high pay, means high reward. “Interestingly, we have not found clear evidence of a link between high pay and better performance, which is essentially what shareholders want,” Herms says.
She points to research by not-for-profits and Morgan Stanley that shows high pay does not necessarily produce high profits. “In fact, over the years, their total shareholder return is less than that of other companies’,” Herms says.
A wide pay gap between directors and the factory-floor employees could cause unrest leading to low productivity and strikes, which could ultimately impact profitability. “The biggest risk for a company is a disconnect between management and the workforce,” Richards says, adding that it is all down to communication. Does the workforce understand that the executive team are driving the value creation needed to protect the jobs of the wider workforce?
There are other risks. “Consumer-facing companies could face a public backlash,” Dervan says. “Consumers seeing such a wide pay gap between workers and senior management could become a brand reputation issue.”
Manulife has enjoyed some success in ensuring that corporates are not being extravagant when paying their executives.
This is the result of a mixture of policy and support for shareholder proposals to get boards to think about the ratio of CEO to median worker pay. “We have seen more disclosure of that ratio,” Dervan says. “We need maybe a little more of a history of data to see how it correlates to company performance and the workforce, but at least that data point is out there for boards and investors to consider.”
Income inequality is not the only issue here. “This is another externality investment managers need to grapple with in sustainable investment, like climate change or water risk,” Dervan says.
Herms says ESG issues can be financially material in the medium to long term, so this should be linked to executive remuneration but warns that when it comes to the metrics, there is no one-size-fits-all solution.
“Not all ESG metrics are made the same,” she says. “It is going to be specific, based on the sector, and on where the company is in terms of disclosures.” Herms says that LGIM asks companies, especially those carrying higher ESG risk, to include relevant and measurable targets in their executive pay packages.
“Our mantra is what gets measured gets done,” she adds. “If the metrics have a direct impact on an executive’s take home pay, the attention they give that will be manifold.”
Including appropriate ESG metrics in executive pay is much more than just signaling. It should address financially material risks and opportunities. “We would expect companies that have a big influence on the climate to include climate transition targets in their pay.”
Like emission reductions, and water conservation, these issues cannot be solved in a year. Dervan is seeing more companies including environmental and social factors in terms of their annual bonuses. “Right now, companies are comfortable in the one-year term, measuring these and incentivising them, but they are struggling with incentivising them over the long term.”
Quantitative metrics investors can measure year on year include: how many tons of greenhouse gas emissions were reduced? How many gallons of water did you reduce? By how much did you reduce your exposure to deforestation in your supply chain?
Companies are integrating environmental and social factors into their executive compensation plans, but for Dervan, more work is needed in this area. His concern is these factors are not being included in longer-term pay packages.
Unless investors treat the topic of executive pay seriously, they could lose out while executives laugh all the way to the bank.