Is the era of unjustifiably high pay packets in the boardroom coming to an end?
A company that sells products for children found itself at the centre of an adult debate late last year. Toys R Us became another high street retail chain to lose the fight against online competition when it collapsed into administration in September. The story remained in the headlines thanks to the company asking the courts for permission to pay its executives bonuses that could have seen them share up to $32m if Christmas sales targets were achieved.
This request fanned the flames of the debate on executive pay. For investors looking for sustainable growth, the pay of those sitting around a boardroom table matching the performance of their company is a hot topic. The question many shareholders ponder is does setting high salaries or dangling large bonuses in front of executives produce better performing companies? And if not, does an underperforming company handing over a large proportion of cash to its directors create a less sustainable business? Toys R Us is a case in point. It sought the protection of the courts after losing $1.8bn over five years. However, while standing on the brink of administration it shelled-out $8.2m to various executives to stop them jumping ship. This was followed by the
request to share millions of dollars among 17 executives if sales targets were met.
Many might find it difficult to justify such rewards for people who were at the helm of the company when it crashed into administration. But for Ric Marshall, MSCI’s executive director of ESG research, offering bonuses to the directors of a failing company is not his main concern. “Part of the problem here is that they are asking for an extraordinary amount in the face of what could only be a short-term solution to a bigger problem,” he says. “To agree to pay-out a huge amount because they managed to turn it around for one season makes no sense from an investor perspective.” Marshall adds that these bonuses could only benefit short-term traders looking for a quick bump in the stock. “For most institutional investors that is not how they work anymore,” he says. “They want to invest in a company that is going to last.” He acknowledges the challenges bricks and mortar-based retailers face, believing that the board needs to find a strategy that will create sustainable value for decades. “It may need to partner with someone, they may need to go online or they may need to think about what is beyond online,” he adds. “That is where the big bonuses should be in my view.”
OUT OF WHACK
Marshall believes his views stand on strong foundations. In October he published a report into the relationship between the remuneration packages of chief executives of US companies and the performance of their businesses. Its conclusion was an eye opener: the size of a chief executive’s paypacket does not reflect long-term shareholder returns. The study – Out of Whack: US CEO Pay and Long-term Investment Returns – found that chief executive pay in 61% of the 423 MSCI USA Index constituents was poorly aligned with the company’s total shareholder
return (TSR) between 2006 and 2015. Amongst the most poorly aligned companies, 23 underpaid their boss for superior stock performance, relative to their sector peers, while 18 overpaid for below-average stock returns. “I’m always sensitive to talk about cause and effect, but clearly they are not well linked [here],” Marshall said. In around a third – or 163 – of the 423 companies sampled, the pay collected by the chief executive was generally well aligned with TSR. “There are pay plans that seem to be working, but that is a minority,” Marshall says. The report highlighted that there is a stronger alignment between pay and performance in the short-term, but this evaporates when taking a longer-term view over 10 years. Marshall says that three years is the typical testing and vesting period for most longterm incentive plans (LTIP). “The problem is that from a long-term investor perspective they are holding these positions for longer than three years, so longer-term that connection is lost and you end up with a random effect,” he adds.
WRONG TARGET
There are many components to an executive’s pay package. There is the basic salary, which can be topped up by pension contributions, but there is another element that could be a problem. Bonuses are typically paid annually and so are linked to short-term achievements. Marshall explains that on average 60% to 70% of an executive’s pay is a bonus, which in the US is almost universally equity-based. “So if you see targets that are blatantly shortterm you have got real problems,” he adds. Bonuses, or awarded pay, are intended to align an executive’s interests with those of the company owners and they came under MSCI’s microscope in the Out of Whack study. The result might surprise you. MSCI discovered that the bottom fifth of companies by equity incentive award outperformed the top fifth on average by almost 39% on a 10-year cumulative basis. Marshall says that one reason pay has become so dysfunctional or poorly aligned is that there is an over-emphasis on stockbased performance measures, such as total shareholder return. “When an equity award is combined with targets that look primarily at the value of the stock and not revenue growth, return on equity or operationally-based performance mance measures, that is where you get the biggest problems,” he adds. One solution is to dilute the potential
effects of relying too heavily on stock-based targets. So look for companies that have
incorporated environmental, social and governance (ESG) factors into bonus targets, such as having a low negative impact on the environment. Lucia Meloni, an SRI and corporate governance analyst at Candriam Investors Group, agrees that investors could benefit long-term if performance is linked to sustainable success. “It is a good step for companies to set ESGperformance criteria, which is a long-term measure,” she adds. One company that has penalised its boss for a poor operational performance is BT. The telecommunications group announced in May 2017 that it was scrapping its chief executive’s bonus following a profit warning. An accounting scandal that left the group more than £500m out of pocket was blamed alongside a £42m fine for inadequate compensation payments linked to late broadband installations. In the end, the chief executive’s pay for the year to April 2017 was 74% lower than it was 12 months earlier.
THE SHAREHOLDERS STRIKE BACK
Investors have become more proactive in the area of executive remuneration. In recent years, more and more investors have voted to reject the pay deals offered to executives. Meloni says that this was because some packages are seen as excessive and are not linked to performance, adding that shareholder revolts against remuneration reports are a “signal that they are not fair”. In one example, almost a third of shareholders in luxury brand Burberry did not back the remuneration report on the pay of its executives in July 2017, believing it to be too generous. Meloni believes that investors could use their influence by voting to help build sustainable businesses. “In the long run it is going to be an important instrument for the shareholders and management will have to deal with it,” Meloni adds. A lack of disclosure appears to be part of the problem. Investors need to know the details of what needs to be achieved for the boss to collect their award. “Is it a share-based incentive? A long-term incentive? What is the performance criteria? How it is calculated? Are the targets challenging?” Meloni asks. “Very often they are not [challenging], so they can be easily achieved.” She adds that disclosure in this area is improving, but more work is needed. “They want to disclose more. We have seen throughout the years that there is a will to disclose more [details] because they are facing a lot of opposition. There is an improvement, but there is a lot more to do on this.” Candriam practices what it preaches. In 2015 it voted against 49% of resolutions
relating to executive pay. A lack of transparency, challenging performance conditions or a lack of correlation between pay and performance were behind its decisions. For Candriam, executive compensation must promote performance without excessive risk-taking, but it is not just about financial targets. It believes that pay in the boardroom should not be disconnected from employee lay-offs or incidents that have a negative impact on the environment.
HEAVYWEIGHT SUPPORT
The drive to disclose more information has the support of government and industry. In August business secretary Greg Clark outlined the government’s plans to reform corporate governance. The headline here was that all listed companies must publish a pay ratio of its chief executive’s pay to that of the wage of its average UK worker. For Meloni this is an important move. She says that if there is a huge difference in the pay between the chief executive and that of the company’s average worker then “maybe we have to think about what is wrong”. The government also wants companies to clearly spell out what their remuneration policy is and what executives have to achieve to earn their bonuses. This is to help justify why the boss is worth so much. The industry’s attempt to rebuild trust in executive pay structures came from the I nvestment Association’s (IA) Executive Remuneration Working Group. It floated 10 proposals in this area in July 2016. The group spoke to more than 360 investors, asset owners and workers before drawing up its recommendations. It sought to simplify pay structures and improve the alignment of the board’s interests with those of the shareholders. It rejected a one-size-fits-all approach and instead opted for a pay structure that works for shareholders at each company. It mirrors the government’s proposals in that it wants companies to justify why they have set the chief executive’s pay structure and what targets have been set. The group wants to make remuneration committees more accountable. It believes that there are concerns companies are not adequately responding to “significant” shareholder opposition to what they pay their executives. The debate over executive pay packages will continue to rage even after Toys R Us closes its doors for the last time, but with research failing to find a long-term link between pay and performance and with Westminster backing higher pay disclosure, we could be on the brink of an era of more justifiable rewards for executives.
