Pay for luck?

CEOs are paid blockbuster salaries because, so the argument goes, they considerably contribute (or are seen to contribute) to company success. In 2019 Elon Musk made 40,000 times more than his average employee. He is not alone. In 2021, in the middle of the pandemic, the CEO-to-employee pay ratio reached a new high: 399-to-1. Investors are in revolt. Employees too. Is it time for responsible remuneration? 

Why executive pay matters

Executive pay is one of the most important mechanisms of corporate governance. Boards can use it to align investors, stakeholders and executives’ interests. According to media wisdom, a company paying its CEO hundreds or thousands of times more than the average employee cannot be called “responsible”. Executive pay has always been a controversial topic.

More recently, keeping remuneration in check has become a growing concern. Public pressure is mounting. Boards worry because falling sales, accountancy scandals and disappointing earnings are no longer the only indicators that it is time to sell a stock. There is now a new signal: executive remuneration. The problem is not only the level of compensation but also its structure. The ultimate acid test is whether we are paying CEOs for luck or for performance. 

The pressure is on

Earlier this year the Singapore Exchange announced stricter requirements for remuneration disclosure of listed companies. Last autumn the OECD consultation for the revision of the G20 Principles of Corporate Governance placed executive pay among its top priorities. Norway’s super powerful oil fund recently told its boards to sharpen up their act on executive remuneration. Proxy Insights reported that in 2020 European investors (think UBS, BNP Paribas, AXA) voted against more pay awards at S&P 500 companies. Netflix is not only losing customers but also pay votes (see last year’s proxy season). In the UK, the Investment Association told company boards to keep executive pay in check, given the ongoing cost of living crisis and the struggles many employees face.

Haven’t we seen all of this before? Possibly. Public outrage against executive pay has always been there. What is different now is investors’ voices on pay and society’s post-pandemic renewed focus on equality and justice in and outside of work. 

Recent developments

Let’s look at a few top CEOs: James Gorman of Morgan Stanley has recently seen his yearly pay cut down to $31.5mm after the latest profit drop. His compensation structure features a base salary, cash bonus, deferred equity and performance-based stocks. Apple’s Tim Cook agreed to cut 40% of his 2023 package following shareholder pressure. He used to enjoy a base salary, cash bonus and deferred equity, a juicy $49mm in total.

One might think, this is corporate America. Think again. At the end of last April, almost 60% of investors in FTSE 100 Unilever voted against the remuneration report, a sentiment unseen for over two decades. Among those who claimed that the proposed pay was significantly higher than peers and cited poor stock performance are the likes of Blackrock and Vanguard. Fundamentally Unilever investors object to high fixed remuneration because they do not find it directly links to performance, raising doubts that the CEO is indeed paid for luck. In Germany, Volkswagen's investors have criticized the proposal to increase CEOs’ maximum pay while all over Europe workers have been on strike, pressing for higher pay to cope with the cost of living crisis. At Italian UniCredit, investors just rejected a proposed 30% increase for its CEO’s pay. Although these votes are not binding as they occur after the fact (and the above executives will enjoy pay increases), they represent an important rebuke to management and boards and a clear indication that priding oneself on purpose, social impact and a sustainable agenda must be reflected in the reality of performance and executive pay.

Executive pay & ESG

Research indicates that well-governed companies pay-for-performance while poorly governed ones pay for luck. Contrary to popular assumption, a big chunk of ESG performance is executive pay. Pay connects to environmental sustainability, social equity and good governance. Fundamentally executives should be required to earn their way into star compensation if they deliver success, not on the promise of it and their pay should be determined keeping in mind the relation to average employee pay. Otherwise, where do all the promises of equity and justice go? Setting executive pay is difficult because there are so many factors at play, but help is on hand.

Given that the energy sector is under huge pressure to formulate responses to the low-carbon transition, and that most research on executive remuneration is in the energy sector, we draw lessons for other industries. There are two mainstream ways of linking pay to climate change. In the Anglo-American model, companies set narrow incentives related to emission cuts in individual business units, while in the European model, broad climate incentives relate to the overall corporate strategy. Under investor pressure, Shell, BP and Chevron agreed to incorporate carbon targets in their executive pay mix.

This is good news because it means that business is starting to see carbon emissions as a KPI (key performance indicator). Practices include short-term and long-term incentives paid out as annual bonuses and shares respectively. In 2022, climate metrics represented on average up to 8% of short-term incentives and up to 4% of long-term incentives.

The way forward: executive pay as an ESG metric

Under considerable pressure from investors, companies across most industries are pledging to cut carbon and achieve climate neutrality. They are also pledging to be fair, inclusive and to protect their people, the number one asset. They need to create and implement business models and ways to deliver on their commitments. We live in an age where carbon, equity and trust have become key performance indicators. Investors and employee pressure may turn out to be a major force in reaching those goals. 

So far, making executive pay a true ESG metric in and beyond carbon emissions involves a certain degree of experimentation, and there is scope for refining the current modus operandi. Companies (and investors) are learning. Experimenting is a great business practice. Ultimately boards and investors need to engage with one another to see what works and adjust to avoid unintended consequences. There are many challenges to designing incentives based on hefty corporate goals: where to start, how to handle measurements across the value chain, market and societal conditions across different countries, evaluation against ever-changing peer groups, defining targets precisely (what does it mean to “cut carbon emissions” or to be “fair”?).

It will take time for holistic incentives to become more attractive. As companies create and learn best practices, the scope for performance evaluation relative to precise targets will increase to better reflect management contribution rather than “pay for luck.”