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Investors are pressing boards on executive pay

16 April 2018 by Oliver Parry

Investors are pressing boards on executive pay - Read more

Remuneration will once again be the main issue of contention between companies and investors

In February, Morrow Sodali published its annual Institutional Investor Survey, which sought to measure investor expectations on a range of environmental, social and governance (ESG) issues.

The survey is designed to help boards more easily understand investor priorities and the 2018 edition, the third of its kind, received responses from 49 global investors, managing a combined $31 trillion in assets.

Participants expressed their views on matters such as ESG engagement, board practices, activism and investment stewardship strategies. However, once again, it was executive pay that stood out as the primary theme.

According to the survey, institutional investors are expecting to up the ante when scrutinising pay policies, demanding enhanced disclosure of pay metrics, seeking a closer alignment between pay and performance, and also searching for an approach that more effectively links pay to the interests of employees and other long-term stakeholders.

Although it is hard to anticipate the reaction each specific resolution may receive from investors, the institutional investor survey is a useful source of information that can help guide governance professionals’ thinking ahead of the AGM season.

An important juncture

The debate around corporate governance in the UK has shifted substantially in the last decade. After the financial crisis in 2008, regulators scrambled for solutions.

As a result, the UK Corporate Governance Code, the bastion of good corporate behaviour, was revised in 2010 and 2012 by the Financial Reporting Council. Alongside this, substantial regulatory changes were introduced by the then Financial Services Authority.

Its successor, the Financial Conduct Authority, introduced a revised remuneration code and the new Senior Managers and Certification Regime.

“The recent collapse of Carillion may well spark yet another review of our system of corporate governance standards”

Between 2014 and 2016, there appeared to be a period of reflection and consolidation. Regulators and UK ministers wanted to give the post-financial crisis changes time to bed in before doing anything else.

However, the unexpected and sudden collapse of the retailer BHS in 2016, which left a huge pension deficit, focused policymakers’ attention again on how our biggest companies are run.

Substantial alterations to the UK Corporate Governance Code as well as a raft of legislation have now been proposed, and although the recent collapse of Carillion may well spark yet another review of our system of corporate governance standards, we nevertheless already stand at an important juncture.

Litmus test

It is often said that the litmus test for how well our system of codes and standards are working is the AGM season.

Since the so-called ‘shareholder spring’ of 2012, investors, regulators and other opinion formers have scrambled for solutions to the apparent escalation of executive pay and rising rewards for CEOs and other executive directors.

Despite this, according to the survey’s respondents, once again executive pay will be one of the main areas where boards and shareholders are likely to disagree. It would be an understatement to say that it is well-trodden ground.

It is difficult to estimate just how many roundtables and corporate governance events addressing this topic I have been to in total, but in 2017 alone I attended at least 14 events related in some way to high pay.

Pay ratios

Based on the survey, further pressure will be put on companies with excessive pay practices, particularly when the CEO pay ratio is introduced.

The CEO pay ratio has already been introduced in the US, following the passing of the much-hyped Dodd-Frank Act from 2010, and it is expected to come into force in the UK shortly. Indeed, 61% of respondents suggested the pay ratio will be a useful statistic.

Many respondents stated that this is a good starting point, but according to one investor: ‘It may not have immediate value. However, the statistic would be useful to track over time and compare with peers.’

Comparatively, some of the respondents indicated: ‘A better tool would be CEO pay vs the average in the executive committee.’

Many respondents suggested companies should continue to increase engagement with key stakeholders to discuss the logic behind the rationale and its appropriateness. The pay ratio mechanism will certainly put the spotlight on company pay but questions are being raised whether this alone will effect change.

Respondents want the culture within capital markets to change and businesses, remuneration consultants, head-hunters and other key players, such as shareholders, will all play important roles in this.

Better links

Currently, the link between executive pay and company performance is negligible, according to many in this survey, and this has fuelled arguments for reform of corporate compensation packages, with an overwhelming 88% of respondents stating ‘pay for performance’ is the most important executive remuneration issue.

‘Rigour of performance targets set under incentive schemes’ was the second most important issue, with 46% of respondents suggesting it as a key issue – however, compared to last year, this was a 16 percent-point drop.

When evaluating remuneration plans, institutional investors are interested in receiving information on the sustainability metrics used, particularly those linked to a company’s risk management and business strategy.

For example, the incorporation of climate risk into remuneration plans is likely to be a key topic for the most exposed industries.

“The worst case scenario is governments cap pay or increase taxes to rein in excessive pay”

Investors increasingly expect remuneration committees to create the right structures for their businesses and strategy, which clearly links pay to the long-term success of the business.

It is also expected that remuneration committees make better long-term decisions and it is important that the remuneration committee chair has a proper understanding of the company strategy and its performance drivers.

Investors recognise the sensitivity behind disclosure of targets but there is an appetite for better explanations why a target might be commercially sensitive and for companies to provide more colour on the timeline for metrics to be disclosed.

Investors are also seeking more granularity around how performance metrics are aligned with the implementation of the company’s long-term strategy and how they are linked to long-term value creation for shareholders.

Some 73% of respondents agreed that it is ‘very important’ to have better disclosure on metrics, especially those related to business strategy and performance. The remaining respondents (27%) agreed it is ‘important’. Perhaps even more importantly, zero respondents said it was ‘not important’.

Engage on the issues

For many opinion formers, executive pay is the gift that keeps on giving. However, as this survey points out, there is a clear desire on behalf of investors to make a change. It of course needs to be a two-way street.

Boards must be willing to address the issue head-on and engage with investors, especially when revising or setting a new remuneration policy. Equally, investors must, when they feel it is an issue, engage directly with boards.

Carillion is another obvious example of why the issue of high pay will once again emerge as a key theme in the 2018 AGM season. Regulators, politicians and journalists will continue to demand better alignment between pay and performance, both pre-emptively and retrospectively.

However, the worst-case scenario is that governments actively consider capping pay or increasing taxes to rein in excessive pay, as stakeholders become increasingly marginalised.

Only proper engagement on this topic, between the owners of the company, namely the investors, and its custodians, the board, can prevent this. A private sector solution is better than more government interference and regulation.

Oliver Parry is corporate governance director for the uk at Morrow Sodali Group, and is speaking at ICSA's annual conference

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