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ESG Focus: Executive Remuneration In The Spotlight

ESG Focus | Aug 01 2019

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FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

Executive Remuneration In The Spotlight

-Growth in institutional voting blocs is shifting the balance
-Global trends in remuneration KPIs
-Focus switching to long-term incentives

By Sarah Mills

While many environmental, social and governance (ESG) issues may occasionally pull a cynical yawn, there is one ESG subject that always seems to excite management and shareholders alike; remuneration.

As a range of demographic and structural cycles decline, and as the world enters what is largely being dubbed “the era of enforcement”; the shareholder indulgence extended to executive remuneration in the past 30 years is set to be tested.

During periods of growth, which has been the backdrop since the baby boomers entered the economy in the late 1960s, gaining a greater portion of the expanding pie, and consolidating wealth post the fall of the Soviet Union and the information technology boom, have been priorities.

But as baby boomers enter their dotage and demographics shift away from reliable growth, and as the consolidation phase settles, defending the business base is paramount, and the focus is shifting from short-term to long-term profits.

Managing human stakeholders – the wealthy and the community

There are other factors behind this turning tide across Western economies. 

The major beneficiaries of the consolidation phase tend to be majority shareholders in corporations and large investment institutions. Given the immortality (perpetual existence) of corporations, and the power that implies, there exists an innate tension between the two.

Theoretically, corporations exist to enhance returns to shareholders but in reality, this is not always the case. Rogue management, traders, accounts, sales people, and lazy unethical boards, can easily disrupt the balance.

Increasingly the world has witnessed the rise of institutional voting blocs and institutional shareholder activism as a check on corporate freedom.

And, as with most environmental, social and governance issues, there is a strong financial rationale.

According to a Morgan Stanley report titled ‘Executive Compensation Matters’, companies that have failed to pass shareholder votes on pay have underperformed 67% of the time in the year after the vote by roughly -15%.

Then there are the community stakeholders.

As metrics on wealth distribution approach pre-French-revolution levels, social stability becomes a greater priority for big capital holders. Capital, after all, is easily destroyed.

The Occupy Movement in the United States, the Gilets Jaunes in France, the earlier Jasmine revolutions of China and Tunisia are examples of the tensions bubbling below the surface of modern governments.

Three quarters of Australians surveyed consistently believe differences in incomes are too large.  About the same favour redistributing incomes towards ordinary working people.

Throw in intensifying global trade and sovereign competition into the mix, and the stakes are rising.

This is the situation that boards and managements now face, as well as an imminent period of disruption, which will yield its typical quotas of winners and losers, while offering huge potential to drive wealth and freedom to all sectors of society.

Saving companies from themselves

In the past 60 years, there has also been sufficient time to track the historical performance of companies. Shareholders now have the information and resources to better identify risky behaviours and practices.

The intensified focus on executive remuneration is as much about saving companies from themselves as it is about limiting rewards.

Despite being immortal, very few companies, not even large companies, survive more than 30 years.

The average lifespan of an S&P 500 company is less than 20 years, according to Credit Suisse. Even in the relatively stable 1950s, the average age of a company was only 60 years.

The handful of very large companies to survive more than 200 years includes: Cambridge University Press; Sotheby’s of London, Lloyds of London, Rothschild & Co, and Metallgesellschaft.

Major brands to have endured more than 100 years include: Coca Cola; Nestle; JP Morgan; Westinghouse; Mitsubishi and GE.

Much has been made of Jack Welch’s helming of GE during the second half of the 20th century, the only one of its peers to prosper during that period. Yet it too recently succumbed to a series of poor management decisions.

Naturally, shareholders would prefer more of 20th-century GE, and less of the 21st-century GE and, as technology improves corporate reporting capability, giving shareholders greater visibility into the decisions and actions of management, executive remuneration will be a key lever in their armoury.

Global movements on board remuneration and structure

The trend is global.

In Britain, the former Prime Minister Theresa May has proposed far harsher measures to limit corporate power and pay than exist in Australia, including placing employee representatives on boards and remuneration committees, binding shareholder votes on pay, duties to promote long-term success and potential government control over executive pay.

 In countries such as Germany, long-standing agreements with workers ensure that workers representatives sit on boards.

Regulators have been tightening the power of boards to ignore shareholder remuneration votes both in Australia and internationally; and say on pay provisions have been enacted across most Western democracies since the global financial crisis.

The inclusion of malus and claw-back provisions (see below) have also been popular tools internationally, although less so locally. Boards are increasingly tinkering with variable pay components.

In 2015, a proposed rule to The Dodd-Frank Act of 2010 strengthened US clawback laws by enabling companies to take back incentive-based compensation in the event of an accounting restatement after an error or misconduct.

In Australia, the two strikes rule was enacted in the Australian Corporations Act in 2011, giving shareholders the power to spill the board if at least 25% of shareholders vote against the board’s decision on executive pay in two consecutive years.

Battle between soft and hard metrics

Increasingly, shareholders are calling for executive pay to also be linked to soft figures such as customer satisfaction and ESG performance, as shareholders seek to incentivise long-term financial performance and to control behaviours, particularly risk-taking behaviours.

Revenue and profit metrics are the most commonly applied short-term key performance indicators (KPI) for financial performance; total shareholder return (TSR) is the most commonly used long-term KPI.

But their dominance is being challenged.

According to Meridian Compensation Partners in an article titled ‘The demise of TSR as the primary performance measure’, the prevalence of TSR as a key performance indicator against which executive pay is benchmarked rose from 39% in 2011 to 63% in 2017, but has started to decline, retreating to 53% in 2018.

Meridian also noted a fall in the use of TSR as the sole performance metric (39% from 48%); an increase in coupling TSR with an earnings or return measure, and an uptick in the number of those using TSR as simply a modifier rather than a baseline measure.

Morgan Stanley expects in the future, TSR will constitute no more than 25% of total performance benchmarks.

Proponents of reducing dependence on TSR cite its inherent flaws: primarily its limited line of sight; the difficulty in finding comparator companies; and its inability to account for a litany of external influences such as stock volatility, buyouts and weather events.

Also, given the coming period of intense digital and technological disruption, the focus on long-term incentives over short-term incentives may be critical.

The demise of Fairfax Media is a classic example of a company failing to survive industry disruption because of the necessity of maintaining short-term returns.

Fairfax failed to position itself in the digital world because to do so would have meant cannibalising its own revenue. The publisher subsequently lost its “rivers of gold” classified dominance to Seek ((SEK)), Carsales ((CAR)), REA Group ((REA)), and other newcomers.

Changes in the wind

In all, there is no one-size-fits-all solution.

Remuneration varies widely across sectors as do demands upon executives, and the gap between short and long-term performance varies largely between companies. Some industries are also more highly regulated than others.

There is a likely to be a period of at least five years in which companies and industries settle on their own patterns.

However, some general trends are emerging.

Morgan Stanley expects a period of growing alignment not just between the company and minority shareholders, but with the customer, the community and regulators.

“Boards are examining remuneration structures that will better match the requirements of the next decade, keeping a keen eye to the regulators, particularly in Australia, which has the most concentrated corporate oligopolies in the world,” the report states.

Major trends in key performance indicators

Other trends include a divergence in divesting, stakeholder benchmarking, management performance assessment; ESG integration; simplified reports to improve transparency; tougher, tighter, less manipulatable KPIs; greater use of balanced scorecards; tinkering with variable and fixed pay components; the increased use of claw-backs and longer malus periods.

Morgan Stanley expects boards will likely shift to placating minority shareholders and make greater attempts to link remuneration to long-term remuneration.

It says key benchmarks are likely to include: value of base sales; percentage of fixed verus at-risk pay; amount deferred, the date of vestment; balance between financial and non-financial (customer, people, compliance and technology); transparent pay hurdles and metrics; level of board discretion; measurability and objectivity; the level of difficulty in achieving hurdles; and whether long-term incentives should be set at fair or face value.

According to The Australian Institute of Company Directors, one upshot of the renewed focus on remuneration is likely to be demands for greater visibility into pay structures for the whole organisation, to ensure they are set in a manner that will attract talent, limit excess, give a line of sight to conflicts of interest, and reduce internal risk-taking behaviours.

The AICD article says the focus will be on ensuring clarity about risk alignment within the organisation to avoid some of the better known financial scandals, such as the Commonwealth Bank’s ((CBA)) insurance debacle that occurred because of poorly structured incentives for sales staff.

Penalising bad behaviour

Increasingly, the trend has been to penalize executives for bad behaviours that occur on their watch, even if they are not directly responsible.

The favoured way to achieve this to date has been through malus and claw-back provisions in executive remuneration contracts.

Malus refers to the practice of cancelling incentive payments if an executive fails to deliver on those expectations.

To date, the use of malus has been criticised for being deployed at lower levels of organisations – rather than the top. It has also been applied in a discretionary manner. Reformers are calling for clear, consistent guidelines on the application of malus provisions.

Claw-back provisions are more pecuniary than malus and demand executives repay remuneration already vested for failing to deliver under certain conditions. They usually include look-back periods of one-to-three years.

To date, its application at CEO level has been muted, although in 2017, Wells Fargo clawed back US$69m from chief executive officer John Stumpf over a fake accounts scandal. According to the New York Times, it was the largest claw-back in US banking history.

Potential shareholder resistance

It is interesting to note that shareholders have demonstrated resistance to remuneration proposals that are linked to soft metrics, particularly when those proposals appear to serve management.

National Australia Bank ((NAB)) received an 88.1% shareholder strike on its 2018 plan that collapsed short-term and long-term incentives into one, with 40% paid in cash each year and the remaining 60% deferred for at least four years.

It included some softer metrics, such as customer and regulatory outcomes, as well as risk and compliance gateways.

Coming as it did, just after posting a -$3.3bn fall in profit, the proposal was roundly rejected by institutional shareholders.

It is not surprising that on a subject with so many diverse stakeholders and opinions, that the regulators have been called in.

(To be continued in Part Two)

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