Principles of Executive Remuneration 1

Newsletter 2020-02

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In structuring executive remuneration it is important to keep 5 key principles into account. Any misalignment of executive remuneration with company’s purpose and long-term social value creation will in the long run destroy value for all stakeholders including shareholders.

In the five principles of executive remuneration, we highlight key issues to be taken into account in designing, reviewing and assessing executive compensation policies and practices. 

To decide the incentives of a corporation’s executives is to influence the firm’s behavior. Understanding executive behavior in response to remuneration policies is of vital importance. Reward Value is executing an experiment based on the Behavioral Agency Model (BAM) to analyze executives’ response to its remuneration model….

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A corporation’s stated purpose only has meaning if it is reflected in its executive incentives. Many companies have embraced the triple bottom line concept of people, planet and profit into their purpose statements. We believe the realisation of such statements is dependent on three different P’s: Purpose, Performance and Pay. The alignment on this axis is a key contributor to successful realisation of sustainable purpose…

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Fair remuneration rewards executives for corporate performance relative to the firm’s peers, independent of macro market fluctuations. The long-term incentive should reward the executive for sustainable value creation in excess of normal market returns and should not reward or punish executives for general market movements.

Our concept of ‘performance’ is essentially relative. We deem performance value creation in excess of value creation that would have happened anyway and/or under alternative decisions. Unfortunately, this alternative state of the world is unobserved, and we hence need to estimate it. 

There are several ways of dealing with this problem. Companies with equity compensation relative to a peer group already employ one of them: relative performance evaluation. Performance is the share price change between two periods relative to the share price change of the peer. Thus, it is the excess stock return over a peer group. This is akin to what in the econometrics literature is known as a difference-in-difference analysis. 

As a matter of principle, this technique is incredibly powerful. For executives, it provides a hedge against common shocks (they can still outperform their peers even in a declining market). For investors, it provides an incentive for executives to perform better than an alternative investment and it supports efficient risk-sharing. 

Current implementations of relative performance evaluation, however, are suboptimal in at least three dimensions.

  • For executives, the hedge is broken upon vesting; implying that their wealth-to-performance-sensitivity is increasing over their tenure. This either implies that executives will have to be additionally compensated for bearing this risk and/or that executives have increasing incentives for manipulation over their tenure. 
  • Executives often influence peer group selection, resulting in a sub-optimal peer groups and thereby biasing performance evaluation and thus the pay-out. 
  • Peer groups typically consist of specific peers, often direct competitors. For executives, this means that their hedge is only against common shocks to competitors, not overall market conditions (except when the shock to peers and the overall market is identical). For investors, the question is whether performance relative to competitors is the relevant margin. This latter question depends on how investors make (or should make) decisions. Do they first pick a group of similar companies to invest in, and then pick the best one; or do they aim to find the best investment overall?

A firm’s  interests are best served by rewarding executives for long-term value creation, not short-term financial results. Given the much-needed long term orientation, the pay-out of the long-term incentive should be skewed (either fully or largely) to beyond the term of office of the executive. This liberates the executive from focusing on annual performance targets, avoids unsustainable behavior maximizing end-of-term value (i.e. pay), and allows the executive to capture the durability of his/her value creation.

Incentivising the long term requires a specific remuneration structure. In our view, short-term pay should be avoided. More generally, the compensation design should avoid ‘wrong’ incentives in terms of risk-taking or the timing of rewards (a ‘no harm’ principle for compensation design). Given the fact that annual vesting cycles reintroduce short-termism in executive behaviour, annual vesting should be avoided as well. Taken together, for appropriate remuneration design there are several ‘phases’ to be considered. The first phase is the pre-term phase. The executive has no influence over the strategic direction of the company in this phase. The second phase is the term phase. During these years, the executive develops and implements a long-term vision. Here, value creation is equivalent to sustainable long term value creation (SLTVC) above and beyond the counterfactual value that would have been generated in the absence of purposeful executive decisions. In the third phase, the SLTVC continues, but at some point, less and less of this post-term value creation is attributable to the old executive, and more and more to his/her successor (the fourth phase).

Based on this, the executive should be rewarded in proportion to SLTVC during phase 2 and 3, but with the final settlement of the reward at the end of phase 3 (i.e. after his/her post-term value creation has ended). Deferring final settlement until the end of phase 3 creates an incentive for the executive to be mindful of the long-term success of the company even after his/her term has ended.

A corporation can create or erase financial value, societal value, and environmental value. The mix of incentives a firm offers its executives underscores its commitment to those values. Basing executive remuneration on long-term value creation through integrated financial and non-financial performance assessment allows organizations to align pay with long-term firm societal impact. Reward Value is developing such impact measure combining existing databases from established standard setters like IFRS, SASB and GRI.

An open question in terms of remuneration design is whether targets should be parallel or integrated. Parallel is to mean that i) executives have targets for both financial and non-financial performance, ii) that the compensation design puts weights on financial and non-financial performance. Integrated is to mean that executives have a single target that reflects true societal outcomes, and that this measure is automatically reflective of the weights on financial and non-financial performance. In this way, incentives are aligned to create impact for both shareholders and stakeholders.
The parallel approach is principally the same as current practice. Improvements are made through better measurement of these targets, and a governance model that assigns more weight to non-financial vis-à-vis financial outcomes. 

The question then becomes how to assign optimal weights to financial and non-financial performance respectively. In deciding on weights, it would be useful if financial and non-financial performance were expressed on the same scale so that (potential) trade-off between financial and non-financial performance is reflected in the same unit of account.
Two routes are available: express financial performance in terms of non-financial performance, or vice-versa. Practically, this latter route seems preferred for two reasons. First, this already is common practice in social cost-benefit analyses employed in public policy making. Secondly, it aligns closely with policy resolutions of market failures that typically aim to put a price (e.g. a tax) on the societal costs implied by that market failure. Clearly, efforts towards monetisation should also be standardised. This means that there will have to be a system of (sectoral) common prices or cost-factors for social impact. 
If non-financial performance is monetised, the question of whether to integrate or not becomes almost insignificant. True societal value creation then is the balance of financial and (monetised) non-financial value. This is also the approach taken in a recent proposal from the literature called Impact Weighted Accounts. It remains, however important to disallow trade-offs outside of the planetary and societal bounderies as detailed in the book Doughnut Economics of Kate Raworth.

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