The CEO pay ratio itself has several weaknesses, although its disclosure is mandated by the US Securities and Exchange Commission (SEC). Notably, both workers’ median pay levels and company size vary widely across sectors. For instance, the consumer discretionary sector includes a large e-commerce company, with many low-paid distribution staff. Additionally, companies have flexibility in selecting the median employee to measure against the CEO’s pay level. Such disparities make meaningful comparisons hard.
It’s clear that several factors have driven the long cycle of executive pay inflation. For today’s investors, the key issue is to ensure that executive pay is linked to the right targets
Clear Objectives Drive Positive Performance
Metric-based executive compensation has a simple rationale: pay should be linked to performance that enhances a company’s long-term value. But to be effective, executive compensation schemes need clear objectives underpinned by specific KPIs that are aligned with the company’s strategic direction.
Our review of 2020 earnings per share (EPS) for companies in the Russell 3000 Index highlighted the importance of clear objectives. This analysis compared actual 2020 EPS versus the absolute target EPS in executive compensation schemes. We found that the top 1% of performers in the index achieved actual EPS that was not materially different to target EPS (approximately 5% difference on average). The inference is that outperformers tend to have a clearer idea of their strategic direction and that this is reflected in their KPIs. Conversely, the bottom 1% of performers in the index had a greater disparity between actual and target EPS (greater than 200% difference on average, as in most cases actual 2020 EPS was significantly lower than target).
In the same way, through our firm-wide engagement campaign, we’ve found that companies with a clear understanding of ESG factors that are material to their business set specific and meaningful executive compensation targets that are more effective in taking them to the next level. For instance, we have met with companies that have created a combined target for employee retention and diversity and inclusion (D&I). This demonstrates the companies’ desire to create and maintain a genuinely diverse and inclusive workforce, rather than simply exerting a one-time effort to hire more minority workers. {cut out}
Skeptics see ESG-related KPIs as a distraction from the primary goal of enhancing companies’ long-term value. We disagree. A proper understanding of the importance of ESG factors to the long-term future of a business can improve the clarity and effectiveness of executive compensation targets. From our perspective, it’s not ESG that muddies the waters around executive compensation. Our Russell 3000 analysis shows that the bottom 1% performers not only failed to achieve their predefined earnings targets and other financial metrics about 80% of the time; they also found ways to juice their annual executive bonuses through other nonfinancial metrics such as strategic or operational goals that aren’t necessarily linked to ESG.
Four Components of an Effective Compensation Program
Based on our proprietary data analysis and engagement activities, we think there are four key components of an effective executive compensation program.
- Accurate incentive metrics—that reflect the company’s strategic focus and direction.
- Real executive effort required—the underlying KPIs need to be sufficiently robust and challenging to require extraordinary effort from executives in return for performance pay.
- Safeguards against “windfalls”—or other excessive payouts. These should include comprehensive clawback provisions in cases where touted success has proven to be illusory, and limits to payouts in the event of a change of control.
- Clear benchmarks—must be applied, based on robust methodology for comparing executives’ pay with relevant peers. This should ensure that compensation committees do not simply board an upward-only escalator powered by the latest and highest awards.
Putting a Ceiling on Executive Pay
Pay equity is a vexed question. In practical terms, investors have few mechanisms to impose limitations on executive pay. For instance, in the US, despite a “say on pay” shareholder vote, there is no regulated limit on the absolute dollar amount that companies can pay senior management. The SEC’s requirement to report the CEO-to-worker pay ratio is intended to highlight anomalously high pay—but cannot directly control it.
That’s why it’s so important for investors to assess the efficiency of compensation practices in terms of cost and talent management, and to insist on performance pay alignment with clear, specific goals. The ability to influence executive compensation programs is one of only a few tools investors can use to exert pressure. And they should use that ability to ensure businesses are managed both effectively and responsibly, and with a long-term horizon. Long-term success, by nature, integrates the interests of various stakeholders including shareholders, employees and customers. Neglecting these stakeholders ultimately raises an existential threat for the company itself.
Incorporating ESG into Executive Pay Structures
Recent research from NYU Stern Center for Sustainable Business (Stern) supports our views on the importance of incorporating ESG targets and KPIs into executive pay structures.
Stern’s 2020 meta study (aggregating evidence from more than 1,000 studies published between 2015 and 2020) found a positive correlation between financial performance and active integration of material ESG factors into investment strategies (as opposed to portfolios with negative screening only). Their research showed a positive relationship for 58% of the underlying corporate studies, focused on operational metrics such as return on equity, return on assets, or return on stock price. Stern reported that 13% of the studies showed a neutral impact, 21% showed mixed results (with the same study producing various positive, neutral or negative results) and only 8% showed a negative relationship.
Our own proprietary screening of sample companies that use ESG-related metrics in their executive compensation programs reinforces Stern’s findings. We looked at a range of US and UK companies with varying market capitalizations across different market sectors to identify those that integrated ESG metrics into their programs in a specific and strategic way. Then, we contrasted them with companies that adopted vague ESG-related KPIs. The results showed that companies with specific and actionable ESG targets paid a lower percentage of revenues to named executive officers (NEOs) relative to companies with vague ESG KPIs (0.31% versus 0.40% respectively). This highlights responsible expense management on the part of the companies that were more ESG-aware.
ESG Incentive Metrics Will Continue to Evolve
Aligning executive pay packages with ESG targets is a work in progress. Some sectors—including asset management—are behind the curve. But by starting with the right goals and learning from best practice across industries, the catching-up phase should be rapid and effective. At AB, we have already included D&I-related goals in our executive pay programs and are on track to evolve the plan as we advance our own governance on material ESG areas. We are confident that many others will follow.
Robert Keehn, Proxy and ESG Engagement Associate from AB’s Responsible Investing team, contributed to this analysis.
