Align purpose with performance and pay
for sustainable long-term value creation
EXECUTIVE PAY INSUFFICIENTLY ALIGNED WITH LONG-TERM VALUE CREATION
Over the past decades, executive pay has seen tremendous growth, resulting in more and more public outcry as well as frequent discontent among the company’s stakeholders (including shareholders). Not only is the level of pay leading to criticism, but the structure of pay, which impacts behavior, is also meeting considerable and growing resistance. Remuneration structures are often designed to stimulate short-term profit maximization instead of creating long-term sustainable value, disregarding environmental, social, and governance (ESG) considerations.
Executive remuneration is traditionally focused on an alignment with the interest of shareholders (principal-agency theory) but the mismatch in access to information, combined with a difference in time horizon between shareholders and management, makes it possible for managers to influence their pay beyond the contractual intent.
Corporate executives more and more are considered to have a role as stewards working toward long-term value creation for all stakeholders, integrating all assets (financial, social, and environmental) to generate sustainable contributions to its shareholders, employees, its customers, and society at large.
What is needed is a thorough review of executive remuneration practice. Reward Value intends to contribute to the development of the required changes, and acts from an analytical, factual, and independent base. Reward Value is a not-for-profit organization and involves all relevant stakeholders in the development of its recommendations. Furthermore, Reward Value not only develops research, but it also can support the effective implementation of the required change.
Changing entrenched ideas on remuneration policy will require broad support from all stakeholders and a strong factual foundation. Reward Value has commissioned SEO Amsterdam Economics to support the initiative with extensive analytical research. Reward Value will continue to develop close cooperative working relationships with institutional investors, business schools, and the business community as partners in the development of recommendations for better performance-based pay reflecting long-term value creation and corporate contribution to society and nature.
ELEMENTS OF RESEARCH
A central feature of any remuneration policy is an agreement on the ‘yardstick’: the measure of success used to gauge the firm’s performance.
Many CEOs are rewarded for mainly short-term financial targets. Yet share- and stakeholders rarely want short-term financial success if it comes at the cost of long term value. For this to change, performance yardsticks must also change.
Together with the Dutch Impact Institute Foundation, we’re developing a database of firm-level social and environmental monetized impacts. This database will allow us to assess the ‘net societal value added’ of firms by netting financial impact with the financial value of social and environmental impacts (both positive and negative). This results in a more truthful measure of firm sustainable value creation for all stakeholders to which compensation may be tied. Once finished, this approach of monetizing firm impacts has several useful features. The direct measurement of net societal value creation spurs CEOs to act with societal interests in mind. Similarly, direct measurement implies that decompositions of financial and various aspects of non-financial value should be possible. This offers CEOs and stakeholders the tools to assess where firm behavior should be directed. Relatedly, given that all impacts are expressed in the same units of account, trade-offs between various stakeholder interests become transparent and comparable. Taken together, the role of this impact yardstick then becomes severalfold: it incentivizes the right behavior but can also be analyzed to guide strategic decisions and supports fairness in firm behavior by rationalizing the trade-offs between various stakeholder interests.
Most people agree corporations should focus on long-term outcomes. There is far less agreement on what ‘long term’ actually means. Is 5 years long term? 10? If it is 10, why?
In terms of compensation policy, the appropriate long-term may be the term at which different measures of firm outcomes converge. Shareholders may be willing to forego short-term cash profits in return for future gains that result from current period investments. This expectation of future profits is discounted into asset valuations, but at some point, such expectations should materialize for the foregone short-term cash profits to be worthwhile to the investor. Likewise, material non-financial issues affect future firm performance (human capital, climate risks, etc.), but it takes time for such issues to affect the firm’s bottom line.
For compensation policy, the optimal long-term may be at the nexus between current and future costs and benefits for shareholders and stakeholders. A measure of CEO performance is ‘fair’ if it has had sufficient time to ‘absorb’ all relevant financial and non-financial costs and benefits. In this research project, we aim to estimate this term: how long does it take for accounting and share-based performance to align and how long does it take for non-financials to be appropriately accounted for in profits and valuations.
The explosion of corporate purpose statements reflects a rapidly growing expectation that corporations have a responsibility to keep societal interests in mind. Corporate Vice Presidents of ESG engage publicly with external stakeholders, commitments are made to UN sustainability goals and intentions are announced at AGMs.
But talk is cheap. As well-intentioned as a corporations employees might be, the decisions that matter often deviate from stated objectives. Advertising agencies and communication consultants are paid to skew disclosures and other touchpoints for engagement and paint the corporation in a friendlier, greener light.
In partnership with the Diligent Institute (US), we’re developing an AI-powered tool to assess the extent to which firm attitudes, attention and actions align – both internally (does the firm do what it says it does) as well as externally (are firm views on material stakeholder interests similar to those of the stakeholders themselves) and is such alignment reflected in the CEO remuneration design. This assessment of alignment or conviction will help us to better understand whether companies focus on the right issues (the relevance of the sustainability topics is checked against the SASB materiality map), have embedded these issues in their incentive designs, and whether management is empowered to drive long-term societal value creation (as measured in our impact yardstick).
The need for such a tool is pressing for several reasons, but not in the least because ‘impact’ may be a slow-moving variable. Pivoting to a green business model takes time, and the effects of that will only become apparent in the impact yardstick (see above) after an implementation lag. Until the pivot is finalized, there still is a need to track progress and to truly assess CEO performance. The conviction barometers may be one tool to track firm attitudes, attention and actions in support of aligning purpose, performance and pay.
Whilst many stakeholders, boards and shareholders will agree that compensation policy can be improved, there is less agreement on what this change should constitute. This may be partially attributed to the fact that evidence on the efficacy of new models for rewarding CEOs is scarce. The resulting paradox is that willingness to change is low, and no new observational data becomes available.
We’re finding a way out of this problem by running online, laboratory and within-firm experiments. This allows us to test potential new compensation models so that we can arrive at evidence-based compensation policy that drives the right behavior by CEOs. We take a broad approach to this experimental redesign of remuneration and consider factors beyond the classical principal-agent approach, including leadership style, personality traits, teamwork and culture.
Successfully implementing and safeguarding a modernized approach to remuneration requires many companies to adopt such a policy. This requires a certain coordination between different investors, stakeholders and companies in order to arrive at a common picture of what is good policy. After such a common standard has been developed, it must be established and embraced so corporations can be challenged for failing to address outdated practices.
Together with stakeholders, we will contribute to the development of a common standard by drawing up a set of principles for responsible remuneration. This set of principles can be used by companies and stakeholders as a guideline for drawing up a remuneration policy and as an instrument for setting up appropriate engagement around CEO remuneration.
Companies are bound by various requirements for their reporting on remuneration, both through legislation and regulations and through (self) regulation in the form of governance codes. Companies are generally compliant with such requirements, but despite such compliance, concerns remain about the extent to which shareholders and stakeholders can successfully monitor companies' remuneration policies. This is partly the result of the fact that remuneration reporting is often not standardized, companies have a relatively large amount of freedom to define broad standards at their own discretion, and only rarely offer extensive and substantive substantiation for the choices made in the remuneration policy. Concerns about the "quality of transparency" are the result. To help companies design their remuneration reporting in such a way that the expectations of stakeholders and shareholders can be met, we propose to develop a guidelines document for high-quality remuneration reporting. In such a document we not only map out what the best practices are now, but especially how they can be improved. By sketching such an 'ideal type' of remuneration reporting, we hope to encourage market parties to make their own remuneration reporting more transparent, for example by standardization and by offering more substantive explanation of choices in remuneration.
One hurdle to overcome for companies to implement a new (type of) remuneration policy is that until several companies have implemented that policy, there will be concerns about the implementation process, especially in the form of actually drafting contracts and implementing the policy. . To remove this (temporary) friction, we propose to develop an implementation model (or models) that are as concrete as possible that can be implemented off-the-shelf at companies (with minor adjustments). This means that we develop model contracts and a number of process descriptions that can be used directly by the selection, nomination and remuneration committees of companies (or the non-executives charged with such activities). The development of such documentation makes it clear to companies that the new policy can be legally implemented within current laws and regulations and that the new policy is practicable (and how). With this we remove possible objections and show the way to successful implementation.