HRD Briefing 2022: Making Executive Pay Sustainable

Who’d chair a RemCo? This committee is increasingly a public theatre in which some of the most challenging reputational issues facing companies are played out: diversity, inequality, climate change. No longer do RemCos have the luxury of focusing just on shareholder value. A much broader range of considerations now come into play.

My own research surveyed directors of, and investors in, UK companies to understand how they thought about setting pay. Two thirds of directors and over half of investors were prepared to sacrifice shareholder value to avoid controversy on CEO pay. Let’s pause on this finding for a moment: directors believe that constraints placed on them by shareholders prevent them from designing pay in a way that maximises shareholder value! So what does it look like to have a fair executive pay system that’s focused on the long-term good for both shareholders and society?

1. Paying for good – In March last year, Cevian Capital, the European activist investor, wrote to all its investee companies demanding that “significant, measurable, and transparent” Environmental, Social and Governance (ESG) metrics be included in pay plans to drive accountability for short-term progress towards longer term goals (e.g. Net Zero). Legal & General’s recent UK guidance states that “companies that are exposed to high levels of [ESG] risk should include relevant and clearly measurable targets that focus management on mitigating these risks.” It’s becoming widely accepted that executive pay needs to be linked to factors beyond shareholder value.
   
   The momentum seems unstoppable. A joint LBS-PwC study of FTSE-100 companies found that 45% had included ESG metrics in pay, a proportion that continues to increase. And the nature of ESG metrics is changing. Traditionally ESG metrics have related to issues closely connected with shareholder value: employee welfare, safety and engagement, risk management. But increasingly ESG metrics reflect newer and broader stakeholder concerns: the environment, notably climate change, and diversity. Motivations for including ESG metrics are often confused. Some, like Cevian, argue for their inclusion because they are important stepping- stones to long-term shareholder value that need to be given adequate prominence. Others argue for their inclusion precisely because they are not linked to shareholder value and so will be ignored if incentives are dominated by share price, even over the long term.
   
   One dimension where the quality of ESG goals is questionable relates to the nature of the targets themselves. Too often goals are ill-defined input goals as opposed to more objective output goals. In many cases the level of stretch in the goal is unclear. We have developed a detailed set of questions under three main headings to help guide boards through the decision-making process:
   1. Why are we considering including ESG targets in pay?
   2. Are our chosen ESG metrics aligned with strategy and focused on the big issues?
   3. Have we considered and mitigated the risks of including ESG targets in pay?

Going through a structured process ensures the RemCo is clear on its motivations and on the risks to be managed. But we identify four main risks:

• Even if quantitative measures are available, it may not be clear which to use. ESG can be difficult to measure reliably and there’s a proliferation of different measurement approaches for the same ESG dimension.
• This can lead to the phenomenon of hitting the target but missing the point. For example, hitting board level gender diversity goals may make no difference to the realities of gender equality through the organisation.
• Linking ESG to pay can undermine intrinsic motivation. Financially rewarding pro-social goals can lead to them being pursued in a more transactional way.
• ESG targets will often be aligned to strategies the company was intending to follow anyway and so may not be stretching – we know from the data that non-financial targets pay out 10% to 15% points higher than financial targets on average.

The big risk, then, is that more ESG targets in pay leads to more pay, but not to more ESG.

2. Simplifying pay – In his book Grow the Pie: How Great Companies Deliver both Purpose and Profit, Professor Alex Edmans advocates long-term pay in the form of restricted stock, awards of shares that vest over periods of five years or, ideally, more. In our work for The Purposeful Company Report on Deferred Shares we found strong support from investors for longer-term, simpler pay plans. Most investors believed that changing to deferred shares would encourage executives to take better long-term decisions and to execute strategy more effectively, because they will not be distracted by LTIP targets. Following that work a consensus emerged for a discount of 50% in award level compared to the previous LTIP, five-year combined deferral and holding period, an underpin to protect against payment for failure, and a strategic rationale to support the change. This has enabled around 10% of companies to adopt this type of model. However, I fear that what we’re seeing is a rather diluted version of the restricted share model, with investors focused too much on reducing quantum as opposed to creating better incentives.
   
   An unintended consequence is greater executive focus on the annual bonus. The real prize is not target pay that’s a little bit lower. The prize is simpler, longer-term pay that aligns with long-term value creation and sustainability and avoids the adverse behavioural consequences of short-term targets. To address this, we need to look at whether there are ways to incentivise adoption through less onerous discount rates – for example if deferral terms are longer than five years or if annual bonus is replaced by restricted shares. More radical package reforms are needed to gain the full benefits of this simplified model.
   
   
3. Exercising discretion – Whatever the design or measures adopted, it’s become increasingly clear that the RemCo can’t hide behind a formula. Investors expect the RemCo to take a step back to look at the pay outcome through a lens of reasonableness and fairness, relative to the investor and employee experience. COVID-19 has brought this to the fore. But fairness applies to executives too. Companies will find it tough to deliver a further round of tough decisions when the pandemic has destroyed the retention value of many outstanding LTIP cycles. At some point companies will struggle to hold onto key people who have the chance to rebase reward at a new employer or move to the less scrutinised world of private companies.
   
   Application of discretion requires a set of underpinning principles: alignment with shareholder and employee experience, but also recognition of the overarching impact on executives across multiple reward cycles. Investors overwhelmingly think that executive pay is too high in the UK and that boards should do more to reduce it. But it’s little understood how much the UK has dropped down the international pay league over the last decade, not just through restraint on pay levels but also more onerous design features such as deferral, holding periods, and clawback. These are constraints not faced by international or private competitors. It would be unfortunate if the Investment Association’s Public Register may become a badge of honour as opposed to a source of shame.

ESG targets, simplified designs, and discretion are all tools for RemCos looking to ensure that executive pay is viewed as fair and sustainable. But none of the options is straightforward to apply. The job of being a RemCo chair doesn’t look like getting easier anytime soon.

This article formed part of the HR Directors’ Briefing: Scanning the Horizon: Trends and Issues in 2022. View the full Briefing here.