Investors are putting company fat cats on rations until they can prove they deserve a larger share of the corporate spoils, but does it improve sustainability or drive talent away?
Contrary to popular belief, there is such a thing as bad publicity. Just ask John Lyttle.
The first six months of 2020 were a happy time for the chief executive of online clothing retailer Boohoo. Second quarter sales jumped 45%, the share price climbed 38% and he saw off a revolt by almost a third of the company’s shareholders to secure a 30% pay rise and pocket a £1m bonus. It must have seemed like the Covid pandemic was something that affected other people. But then, early in the second half of the year, his luck changed.
A Covid outbreak in a Leicestershire factory that makes clothes for Boohoo gave the business the type of attention few would welcome. Undercover reporters found poor working conditions in the factory and made claims that staff were being paid as low as £3.50 an hour, less than half the £8.72 minimum wage for those aged over 25.
Boohoo became the poster boy for modern slavery and its value soon shrank by 23%, or £1bn. With the company hit by such a scandal, the validity of Lyttle’s reported £1.5m salary and future bonuses, which could top £50m, is being questioned.
Such scrutiny is not limited to executives engulfed in a PR storm. The compensation packages that corporate leaders receive and what targets they must achieve to collect their bonuses help investors form an environmental, social and governance (ESG) profile. Is it good for the business if executives are receiving a seven-figure salary while the company is continuously losing money?
The equality issue is also a risk. If the chief executive is getting paid thousands of times more than the guy on the shop floor then there could be resentment, which could lead to operational inefficiency and ultimately reputational damage.
Executive pay is not just about financial performance anymore. More and more institutional shareholders are seeing success as sustainable profit growth and acting in the best interests of the staff, suppliers, local community and the environment.
“Executive pay is the bread and butter of ESG,” says Meredith Jones, a partner and global ESG practice lead at Aon. “ESG is an attempt to take more of a stakeholder than a shareholder point of view.”
This feeds into builing a sustainable business. Performing well financially, ESG and pay are interlinked,” says Lloyd McAllister, a responsible investment analyst at Newton Investment Management.
“We expect executive pay to be linked to a company’s long-term strategy and its goals,” says Jennifer Law, vice president, BlackRock Investment Stewardship. “We expect executives to be rewarded for delivering strong and sustainable returns over the long term.”
Law believes that a lack of correlation between executive pay and company performance is a sign of a weak oversight of management by the board. “Poor pay outcomes are symptomatic of deeper governance concerns, rather than the cause of them.”
Michiel van Esch, governance and active ownership specialist at Robeco, says that understanding what the board needs to do to secure their full salary tells you what the company’s priorities are.
“Remuneration allows you to understand the credibility of a company’s ambitions,” he adds. “If you have climate targets as a key performance indicator in management’s renumeration package, then the issue is a priority at the highest level, not just something the sustainability reporting team are looking into.”
Poor pay outcomes are symptomatic over deeper government concerns, rather than the cause of themJennifer Law, BlackRock
Law adds that in the past there was less focus on governance structures in companies that performed well. Complacency can set in during good times, resulting in governance weaknesses. It is too late to wait until the tougher times arrive to address these weaknesses. “It is important to look at governance structures on a consistent basis, even when companies are performing well,” she adds. Newton also sees executive remuneration as a governance issue.
“It is different from the E and the S pillars of ESG, which are more industry or region specific,” McAllister says. “It is a universal factor for us, we look at it in every circumstance.”
Across the world, asset owners are putting asset managers under increasing pressure to ensure their portfolio companies have adequate executive pay policies. “It is something that you have to look at and look at carefully,” says Michael Herskovich, BNP Paribas Asset Management’s head of corporate governance. “If a CEO is getting rewarded when return on equity is 5% while the market expects 8%, there is something wrong.”
Herskovich recalls a case when one of his fund managers sold a stock because he was not convinced the company’s forecasts were achievable after considering the executives’ pay deals. “A few months later, the company announced its interim results and reduced its forecast,” he adds.
This is an issue that more and more investors are factoring into their decision making. “Shareholders are becoming more vocal about what they want from a pay structure,” van Esch says. “They are looking more into whether pay structures fit into their voting policy.”
One person not underestimating the importance of how much a company’s executives are paid is Fred Isleib, director USA, ESG research and integration at Manulife Investment Management. “For those factoring ESG into their investment decisions, executive pay is critical,” he adds. “It sits squarely within the governance framework.
“At the end of the day, what executive compensation speaks to is how well a company values its shareholders and how willing it is to promote and create capital accretion over the long term.”
For Isleib this is too important to limit to an ESG checklist. “Every investor should look at executive compensation because you want management teams that are being incentivised properly.” To ensure this happens, Manulife continuously reviews this topic in its portfolio companies. “It is something we do as responsible investors,” Isleib says.
He makes it clear that Manulife’s approach should not be confused with trying to cap the upside on any compensation plan. “The key for us is to make sure that there is alignment between shareholders and the economic return of the corporation and how the stock has performed.”
Fear of the ballot box
Boards are taking notice of shareholder concerns. Last year, according to Deloitte, the chief executives of the largest 30 companies on the FTSE were paid on average around 7% less last year than they were in 2018. While chief executives pay remained static across the wider FTSE1OO, financial directors fared worse taking a 12% hit to their pay.
Lower compensation packages are reported to be the result of new hires or the early impact of the Covid crisis being felt in some parts of the world, but there could be another reason.
In June, 67% of investors voted down Tesco’s pay policy over fears that bonuses were being inflated by an incomplete peer analysis. A month later, shareholders vetoed the proposed pay deals for the directors of budget airline Wizz Air after profit targets were missed.
Performing well financially, ESG and pay are interlinked.Lloyd McAllister, Newton Investment Management
Could BA be next? Shareholder group ISS is urging investors to reject outgoing chief executive Willie Walsh’s proposed £800,000 bonus at a time when the national carrier is looking to cut 12,000 jobs.
This is not a new phenomenon. In 2018, 70% of Royal Mail’s investors did not support a 17% rise in the new chief executive’s salary or a £900,000 pay-off for the departing one.
The fear of shareholders voting against their pay deal is enough to bring executives to the table to discuss the issue. “Losing a vote is embarrassing, a sign that they are not doing their job to the satisfaction of their shareholders,” McAllister says. “The vote acts as an underlying driver to avoid an embarrassing situation at the AGM.”
Newton voted against 89% of its North American holdings’ pay structures last year, as so few companies in the US link pay to performance. “You can gain a lot of insight on a company’s figures, forecasts and vision by looking at its executive pay policy,” Herskovich says.
BNP Paribas AM has opposed around a third of all management proposals from its portfolio companies this year with executive pay the most popular issue it votes against. “Our opposition rate is 60%, so there is a lot of room to improve,” Herskovich says.
What to look for
How much the leaders of a company are paid is a consideration when BlackRock assesses companies’ overall ESG practices. Compensation that promotes long termism is one of the asset manager’s five engagement priorities.
“Executive compensation needs to be linked to the company’s long-term strategy and how the company performs,” Law says. “In the past, conversations around executive compensation, certainly in the UK, have been about pay in isolation rather than looking at the full picture.”
When assessing pay, BlackRock looks at a company’s performance, strategy and targets, alongside how it is positioning itself to address its key risks. “Undertaking analysis in this broader context with a focus on strategy is forward looking, while looking at pay in isolation is backward looking,” Law says.
“Executives need to be cognisant of the broader environment in which they are operating and what they are receiving relative to their employees,” Law says.
Another firm that is not looking at this important topic in isolation is Manulife. There are three things it wants to see when compensation committees set an executive’s pay. First, has it been set in a way that promotes capital appreciation. Second, that it will not force a director to take too much risk to hit their targets and, finally, that the level of pay is appropriate to its industry peers.
Second, that it will not force a director to take too much risk to hit their targets and, finally, that the level of pay is appropriate to its industry peers.
For McAllister, executive pay is an important part of company analysis. “It sets the incentive structure of the organisation and we want to make sure that pay structure is aligned to the strategy we have bought into.
“We want to see the executives’ pay tied into those long-term performance metrics, so we can be sure that executives are being paid for performance,” he adds.
After the storm has gone
Executive pay has become a bigger issue in the past five years for investors and stakeholders and will continue to grow, especially as we are heading into a difficult period for the global economy. “If we go into a deep downturn, the magnifying light will become stronger,” Isleib says.
He hopes that during any downturn ahead, compensation committees and the executives themselves will recognise the hardships that employees are going through. “It would be bad reputational PR to see executive pay escalate while the workforce is being laid off,” Isleib adds.
This is a common theme among those managing mandates for institutional investors. “Events over the past few years have kept executive pay in the headlines,” Law says. “How boards manage the impact of the Covid-19 crisis will keep it in focus.”
Executive pay is the bread and butter of ESG.Meredith Jones, Aon
Jones would like to see the pain felt across an organisation, not just on the factory floor. “Covid-19 has highlighted that in terms of pay cuts and furlough.
“When companies are doing well there is more proportionality when it comes to reward so when they experience pain that should be shared proportionally as well,” she adds.
The good news is that half of FTSE100 companies have cut the pay of their executives, perhaps temporarily, due to the pandemic, Deloitte has discovered, so more work might be needed here.
“The executive compensation issue is going to be more sensitive in 2021,” Herskovich says. “If financial results are not good and you are reducing your workforce then, potentially, some cases might come up.”
Another issue is that most company targets are now irrelevant thanks to the pandemic. “Being director of the compensation committee will be harder next year,” Herskovich says. “It is not easy to find the right balance between rewarding management for their work during such a complex time and having a disconnection with performance.”
This is a time that could highlight that the success of a company is not just reliant on the decisions made in the boardroom. “Covid has highlighted that the workforce is crucial in value creation and when it is taken away it is devastating for the economy,” McAllister says, believing that employer-employee relationships will grow in importance.
“Employee satisfaction is linked to above-average share returns. A poor relationship with employees can lead to productivity declines, a lack of satisfaction, increased staff turnover and higher training costs.
“The interest of employees and shareholders can be aligned if the right incentive structures are put in place,” he adds. “This is definitely going to increase in importance post-Covid.”
The ideal policy allows the leaders of a company to earn more money in good times but less when performance is not so great. However, van Esch would be surprised to see a deep fall in pay across the board as some pay structures do not take downturn risk into account. “In theory, some pay structures should correct for it, but this does not always work in practice,” he says.
Despite this, Jones believes that growing awareness of the issue among corporates is a sign of an “acceleration” to a more stakeholder than shareholder model. “It used to be that an executive could justify getting their full pay if they hit free-cash flow or earnings targets,” she adds.
“Given that Covid and climate change are putting a spotlight on environmental, social and governance issues and the global conversations we are seeing on social justice, we are to a point where that proportionality of pay and sharing of benefits becomes more important.
“As awful as it has been, Covid-19 has proven which executives are taking a holistic view of all their risks and opportunities, not just the ones that show up on their balance sheet,” Jones says.
An executive’s compensation is typically not just their salary. There are other rewards that can be hidden from the headlines, such as bonuses and pension contributions.
BlackRock has seen a reduction in pension contributions for executives in the UK, down from 25% to 30% of salary. In 2017, BlackRock amended its EMEA voting guidelines to express its expectation for executive pension contributions in line with those of the broader workforce. It outlined these new guidelines to the largest 300 listed companies in the UK. “Within a year-and-a-half, a substantial portion of these companies reduced their executive pension contributions,” Law says.
The message is getting through. One of the UK’s largest banks has reduced executive pension contributions to 10% of salary from 30%, and the new chief executive of a large insurer receives a pension payment of 14% of salary versus the 28% its previous chief executive received.
Talent costs. You want the best people running your company and you want to keep them motivated. “You are trying to balance attracting the right talent at a senior level while not wanting the pay disparity to demotivate the employees,” McAllister says. “There has to be fair distribution of the rewards to the business’ various stakeholders.”
If we go into a deep downturn, the magnifying light will become stronger.Fred Isleib, Manulife Investment Management
The problem has been that too many leaders have been paid a fortune for a mediocre performance. Marissa Mayer’s five-year stint as chief executive of Yahoo is an example. She received a $239m (£179m) compensation package while overseeing losses and the number of monthly visits to the home page more than halving.
Then there is John Lyttle. Remember, the guy who it is alleged commissioned a factory to make dresses and tops that was paying its staff below minimum wage and not providing equipment to protect against Covid? Yes, well he and the two founders will each collect a £50m bonus if Boohoo is worth £6bn in March 2024.
There are many ways to assess if an executive is being suitably rewarded for their results. The pay equity ratio is one such method, but it should not be examined in isolation. “We look at how it has changed over time,” Isleib says.
One person who believes that the crisis has made the ratio even more important is Aon’s Jones. “We have always seen attention on pay ratios, but Covid-19 has put a finer point on that,” she says. “Pay inequality is going to be a bigger issue generally.”
A poor reading on this metric, could point to potential trouble ahead. “If you have an issue with your pay ratio, it means you have an issue with your social approach and your workforce,” Herskovich says. “Over the long-term it is non-sustainable and will impact your results. You need to build a good relationship with your workforce or you could have a strike or the organisation will not work well as the workforce is unhappy.
“Customers are also looking more and more at a company’s approach to social issues,” he adds.
“The pay ratio is not an easy indicator. It is not something you can look at and make a conclusion. We tend to look carefully not at the ratio itself, but the evolution of that ratio. The ratio doubling over three or four years is something that is not expected. We emphasize the evolution of it.
“The pay ratio is a sensitive issue, it is used politically by unions and some companies are reluctant to publish it,” Herskovich says. “It is something that will be looked at more carefully in the next few years.”
Comparing pay levels to those of their peer group is another way of measuring the issue. “When we see a company outside of its peer group range there needs to be strong argument as to why that level does not apply to them,” Isleib says. “If they do not have a suitable answer we need to decide if we are being compensated appropriately as shareholders.”
This could be difficult if companies decide not to disclose the targets management have been set, situations Isleib has witnessed. “That is a red flag for us,” he says.
Aon has an executive compensation group that helps companies to identify their pay peers and ensure they are in line with those peers. “They are doing the things that they need to do to incentivise their executives to stay but at the same time make sure that they are not getting out of line with industry norms,” Jones says.
Executives are becoming more receptive to such conversations. She points to an example of companies where shareholders issued resolutions that prosed tying ESG to executive compensation. Although the resolution failed, the companies in question engaged in dialogue with shareholders and at least one of those companies has included ESG metrics in the executive compensation programme.
If a CEO is getting rewarded when return on equity is 5% while the market expects 8%there is something wrong.Michael Herskovich, BNP Paribas Asset Management
“People are not saying, ‘hey, this sounds like a great figure’. They are trying to make sure it is balanced against the peer group and appropriate for the level of performance,” Jones says.
“It is changing from a straight pay for performance on varied financial metrics to a conversation about the entire stakeholder echo system and being compensated on non-financial risk management and things like employee engagement and retention and talent management and community engagement, cyber security have taken on increased prominence,” Jones says. “This is the next evolution of tying in more of a stakeholder view.”
More than 90% of the equity assets BlackRock manages on behalf of its clients are held in index strategies to finance long-term goals like retirement. This does not stop the firm from being proactive when it comes to executive pay.
It is a common misconception, according to Law, that index managers do not have the stewardship tools to drive change. “Because we do not have the discretion to sell specific companies, stewardship is the only tool available to us to protect and enhance the value of the assets entrusted to us,” she adds.
“The inability to sell means that index managers are there for the long term and will be present long after the current board and management team.”
BlackRock is essentially a permanent shareholder. “Permanency provides a unique opportunity to encourage business practices which are consistent with delivering long-term sustainable financial returns,” Law says.
BlackRock has more than 45 members in its stewardship team, with analysts based in seven countries. This global coverage with regional presence enhances the analysts’ understanding of the local context in which the companies operate.
“Local context is important to do stewardship well, “Law says. In addition, the BlackRock stewardship team is also able to leverage the insights of 200 active BlackRock investors.
Remuneration allows you to understand the credibility in a company’s ambitionMichiel van Esch, Robeco
“We will be looking closely at the decisions boards make in relation to pay this year to see if outcomes are corelated with the employee experience and business performance over a sustained period,” Law says. BlackRock will use its vote to hold directors accountable for their decisions.
Human capital management is another of BlackRock’s engagement priorities. “The social pillar of ESG will come further into focus as a result of the crisis,” Law says. “How companies pursue sustainable business practices, diversity, the experience of its workforce and the sustainability of its supply chain are considerations that have been brought to the fore due to the crisis.”
Not every company is open to such discussions, but the number of those who are is growing, according to van Esch. “If there is a stakeholder philosophy then there will be an understanding that this is part of a societal debate,” he says. “Increasingly, we are seeing that that is understood.”
It is not just public pressure that will keep this understanding in the conscience of remuneration committees. “You will see more emphasis on pay in the coming years due to regulation,” van Esch says.
“Executive pay is something that will remain on the agenda and will receive a lot of focus,” he adds.