CEO Incentives:
Pay, Performance and Parity

CEO compensation is a topic in the boardroom, by the coffee-machine and in newspaper headlines. The holy grail of CEO incentives is to motivate performance, and align company, shareholder -and stakeholder interests to create long-term sustainable value for all. Easy, right?

A few noteworthy publications appeared on the topic recently and the increasing effort to integrate ESG metrics in executive compensation has enjoyed some spotlight. This article merely touches upon some of the most relevant points, it’s just the tip of the iceberg on this hugely important and interesting topic. Let’s try to divide the topic into smaller bites:

b. Structure - when is a long-term incentive really working

1. Hiring the right person
2. How do companies vs investors view what matters in executive compensation?
3.  How to align pay and performance
   a. Quantum -
   and pay ratios  
4. Is ESG integration in executive pay an elusive goal? What are the individual company’s most material ESG issues and metrics?

1. Hiring the right person: it might be difficult to motivate executives with any pay structure or quantum of pay, if they do not have the intrinsic motivation to take the company to the next level while navigating reputational and regulatory risks. At the same time, it is important to provide the adequate pay to executives with the right personality, skills, work ethics, knowledge, insights, network - and headspace. Research has shown that CEOs’ personal traits will influence their behaviour and aptitude. So, finding the right person and establishing an agreement that aligns the company, the new CEO, shareholders and other key stakeholders is critical. In order to find this person, the company needs to be very clear on its purpose, vision, mission and the corporate culture it wants to bring to life.

2. How do companies vs. investors view what matters in executive compensation? A recent practitioner report on CEO compensation that surveyed directors and investors presents some interesting insights about the differences in perspective between companies and investors regarding executive pay. Boards feel that they are already offering lower pay and relatively standardized pay structures, just to avoid controversy over CEO pay. So what should determine the target quantum of pay for a new CEO? According to Edmans, Gosling and Jenter (2021), investors focus overwhelmingly on the new CEO’s ability, while directors also mention CEO pay at peer firms, the new CEO’s other employment options, their previous pay, the financial motivation of the CEO and the outgoing CEO’s pay. When it comes to making CEO’s incentives more long term, investors believe this would make the CEO take better decisions, while directors worry that longer-term incentives would lose their effectiveness, would lead to a higher absolute pay which could outweigh the benefits or could hinder attracting/ retaining the CEO they want. These findings illustrate the different perspectives on the two sides and the importance of the balancing act to come to a meaningful solution that works.

3. So this brings us to the question: assume there is a perfect candidate and the directors and investors are aligned in their thinking on the CEO compensation. How does one come up with the right quantum and structure? Calculations based on the Proxy Insight, a global shareholder voting database, showed that investors have voted against or abstained on director remuneration in the past 3 years in about 8% of the cases. Proxy advisors recommended to vote against executive pay packages on about 15% of the cases (the number varies across advisors). Compensation committees are keen to avoid significant pushback from investors on pay packages, so directors engage in the process of devising the package with investors and are willing to provide more and more disclosure and transparency. Investors need to be explicit on what they expect, even if their expectations may not be rule based (i.e. have very clear opinion on the exact amount and precise structure) but more contextual (consider the proposal in the context of a given company’s size, growth potential, value creation model, etc.). The more flexible approach is mainly applied by active investors with bottom up stock selection approaches and relatively concentrated portfolios where analysts and portfolio managers know the board members and the executive teams on their investee companies. Quantum: While there is no one size fits all, investors expect boards to consider the quantum of executive pay, including consideration of absolute pay caps. Regional , sectoral and asset class differences are alive and well. At the same time, the over-reliance on the argument of the uniqueness of every company raises the eyebrows of more and more shareholders. A relevant indicator in this context is the pay ratio between the highest pay individual and the median pay at the company. In the wake of the Covid-19 pandemic we have witnessed a heated debate on voluntarily adjusting CEO pay downwards - most easily done through an adjustment of their variable pay - especially in cases where the broader workforce was reduced or experienced a pay cut. Paying out full bonuses when companies benefitted from public aid also led to a pushback from many investors. What should be the total cap on executive pay depends on the company’s performance, commitment to sustainable value creation for all stakeholders, long-term resilience, as well as their outlook and the role the CEO can play in all of this. Also, in an era of increased sensitivities about diversity, equity inclusion and income inequality, it is incumbent on the board to justify disproportionately levels of quantum.

Structure: A recent research done by Focusing Capital on the Long Term (FCLT Global) draws attention to four key decisions when redesigning a remuneration plan: (1) the performance linking of pay, (2) the instrument of pay), (3) the time horizon of pay, and (4) the required holding levels of company securities. Variable pay performance targets should be ones that are attributable to CEO performance / decision making and that they can be held accountable for - kind of a ‘CEO alpha’. That is to say, the strategic long term objective of the company should be ‘translated’ to the key deliverables of the CEO that will enable achieving these objectives. Long-term incentives should be long-term – move beyond the widely-used three year term - and aligned with the purpose and the business cycle of the company. As of now, there are several ways pay is structured between fixed, short-term incentives, long-term incentives and other benefits. On the one hand, there may be a great year when share prices sky-rocket and CEOs receive a generous payout, but it’s important that they recognize the bounty years might end and they should not expect an overall increase of granted stock options in the next years to make up for the perceived loss of income once share prices go down again. On the other hand there is merit in granting incentive pay as annual share awards, perhaps in the form of restricted stock–with a long-term holding requirement that could even extend beyond the executive’s employment in the company itself—a concept called “career shares”. In that way the executive is exposed to the long-term performance of the company, good or bad, in a way that is not tied to specific performance indicators – whose relevance could diminish or change over time. If you ask me – this is certainly an approach I think will become more widespread.

4) Integrating sustainability goals in CEO pay packages
For this, we need to consider what may be the most relevant sustainable factors that incentive plans should be tied to – and from whose perspectives these should be assessed. Tying CEO pay packages to irrelevant sustainability-related factors or factors that are not attributable to the CEO miss the mark, or may even be detrimental. Companies should be able to explain how relevant sustainability factors (that the company has direct impact on) have been defined and whether the company has been tracking its performance on these factors for a few years before tying their compensation to it. Is it a sign of mature stewardship to encourage companies to link sustainability and other qualitative factors more clearly with company strategy and operations, and ultimately long-term value creation, to confirm their ‘North Star’, their purpose. Companies generating high profits in the short term at the detriment of communities and ecosystems are unlikely to be resilient in the long term.

Tying the ESG metrics in long-term incentives to the mission of the company and moving to an end-to-end cycles enables management to be more flexible about the path they adopt to meet their established goals, which become progressively more ambitious (gateways) while the performance metrics remain the same. This approach holds executives accountable instead for stable long-term, outcome-based goals. Combining this with a share ownership requirement by executives that they need to hold for a number of years even after leaving their office should also help to drive long-term planning and thinking. I recognise, all this is much easier said then done. I strongly believe it can be done if we are clear on the “North Star’: to motivate performance, and align company and shareholder - and stakeholder - interests to create long-term sustainable value for all.