For public companies and the people that lead them, the trend toward greater transparency in compensation practices has had positive outcomes. The formula is simple: Create value for all stakeholders in a company, increase earning potential.
Since the advent of Say on Pay in 2011, the voice of outside stakeholders in executive compensation planning has been amplified. Though this provision is non-binding, it’s shined a brighter light on the mechanics of how executives are paid and given shareholders an important seat at the table.
In the subsequent years since the rule was put into place as part of Dodd-Frank following the financial crisis, the economy boomed. Up through 2019 and into early 2020, the U.S. economy overall saw steady growth for nearly a decade and the lowest unemployment levels on record. Then came COVID-19. And social unrest around racial inequity. And continued concern about the trajectory of climate change and other environmental degradation.
In 2021, there is a hotbed of discussion around how public companies can use executive compensation as a lever for corporate leaders to “do the right thing.” In this context, “the right thing” is not an empty morality play. At such a fraught time, boards are taking very seriously the idea of how they can structure executive pay to better create value for all stakeholders in a company. As social and environmental responsibility in Corporate America comes further under the microscope, executive compensation continues to evolve, extending beyond incentives based solely on the bottom line into a more holistic impact on society at large.
Executive pay has always been connected to performance in some way, shape or form, but the manner in which compensation packages have been awarded and ultimately earned has greatly changed over the past 40 years. An oversimplified version of this history might look something like an evolution from a focus solely on company value through cash and a bonus exclusively for financial performance; to inclusion of market value with the introduction of stock options to incentivize corporate leaders to influence share price; and finally to a much more comprehensive viewpoint on stakeholder value, looking beyond financial and market performance.
The final “stage” in this brief and crude overview of pay for performance is by no means static, chiefly evidenced by the trends in the past five years. Companies are rapidly moving away from time-based stock options, which are awarded to executives for longevity, becoming more valuable as the stock price increases. The recent 2021 edition of the Equilar report, Equity Compensation Trends, noted that 46.2% of the Equilar 500, consisting of the largest U.S. companies by revenue, offered this type of compensation vehicle to their executives, down from 54.4% just five years earlier. Meanwhile, 87% of companies included performance equity in their executive compensation packages in 2020—which also include stock awards, but only if more nuanced and varied targets are met—up from 78.4% in 2016 (Figure 1).
The trends in pay for performance over the past few decades mean executives are heavily invested in their companies, which is widely agreed upon as a good thing. The question then becomes what these awards are based on, leading to discussions that have essentially become a referendum on what companies are doing to make money and how they apply those returns.
Executive compensation is not only about rewarding and retaining hardworking individuals. It’s also about corporate transparency and accountability. One key reason companies are in the public market in the first place is to raise money from investors. Therefore, if they’re not satisfying those investors, then they’re not fulfilling a critical duty of a public company. Boards of directors have become astutely aware of this as they continue to put greater attention and consideration into pay incentives that maximize profits to support investment in the company’s employees, products and services, while offering a return for the stakeholders as well.
According to a recent Equilar report, Executive Long-Term Incentive Plans, in the past five years, relative total shareholder return (rTSR) has been the most popular metric employed and has also increased the most in prevalence. From 2016 to 2020, the percentage of Equilar 500 companies awarding performance compensation to named executive officers (NEOs) increased from 47.0% to 56.3%.
There’s a good reason for this, as shareholder pressure in one way or another over the past decade has played a key role in corporate governance. As institutional investors became concerned that their long-term positions in the market would be undermined if quarterly earnings had an outsized influence on corporate leaders, long-term incentive plans (LTIPs) became the norm, with rTSR as a leading metric.
If a majority of companies are utilizing rTSR as a means to empower their executives to consider the company as a holistic investment, there is also a reason it’s not the only metric tied to long-term compensation. The ability for executives to keep focused on the task at hand, acting and reacting to day-to-day challenges while maintaining balance with a long-term vision, is the hallmark of an effective leader, and ultimately a successful company.
Following rTSR, return on capital (ROC) metrics are the most common performance indicators tied to executive LTIPs, and they are increasing in prevalence as well. In 2020, 39.3% of Equilar 500 companies utilized this metric, up from 36.1% in 2016. This is an important indicator that companies are evaluating executive performance not only in reference to the whole, which is often influenced by market factors outside of executives’ control, but also the sum of its parts.
Environmental, social and governance (ESG) issues have been among the most commonly discussed topics in corporate governance in recent years. The largest institutional investors have consistently engaged their portfolio companies both publicly and privately to address concerns about ESG. Meanwhile, companies have chosen to disclose far more information about their efforts in response, and the SEC and other governing bodies have concurrently enacted or explored new disclosure rules around human capital resources, diversity and environmental factors.
The events of the past year only served to amplify these trends. According to the Edelman Trust Barometer Special Report: Institutional Investors, 69% of U.S. investors said that social factors were integral to their investment strategy, a 15 percentage point gain in 2020, catapulting it to becoming the most important factor and also bringing it on equal footing compared to environmental at 61% and governance at 68% (Figure 2). More specifically, 69% of U.S. investors also said they believe that linking executive compensation to ESG impacts trust in a company—a 17 percentage point increase from 2019.
This is where pay for performance and shareholder engagement meet, as long-term vision, reflected through ESG strategy, connects with financial performance and market value creation. Boards of directors send a powerful message to stakeholders and executives alike about company values and priorities through incentives structured around ESG goals.
However, non-financial metrics have not (yet) become particularly popular as part of executive compensation packages, at least not for long-term incentive plans. According to the Equilar analysis on executive LTIPs, only about 3% of the Equilar 500 disclosed such metrics as a determinant for awarding executive equity.
“While there has yet to be a wave of adoption of [non-financial] metrics in determining compensation, there is an uptick in serious discussion about them,” Kathryn Neel, Managing Partner for Semler Brossy, said in a 2020 interview with Corporate Board Member. “[Board directors] are talking in the compensation committee about corporate strategy and key indicators of success, and directors are being asked by investors how they defend not having those metrics.”
A recent article from Pay Governance, “The Role of Non-Financial Metrics in Annual Incentive Programs,” was published following the onset of the COVID-19 pandemic, noting that this tide may be turning.
“Prioritizing and rewarding the achievement of critical, non-financial objectives in the short run may ultimately lead to improved financial performance in the long run,” the authors noted. “It may also provide companies with a first step toward articulating a long-term sustainability strategy, which is increasingly important to a number of investors who believe that focusing solely on near-term bottom-line results may be inappropriate given the growing awareness surrounding the value of non-traditional measures of performance.”
69% of U.S. investors say linking executive compensation to ESG target performance impacts trust in a company “a great deal.” Source: Edelman Trust Barometer 2020
The largest companies are on the leading edge of this trend. According to a recent Equilar analysis among the Fortune 100, 38 companies disclosed 53 separate compensation metrics that were tied to ESG goals, most of which corresponded to annual incentive plans (only one company incorporated an ESG metric into its long-term incentive plan).
While the actual metrics companies are using vary widely, Equilar organized ESG metrics into seven categories: culture, diversity, environmental, general ESG, human capital, safety and other. Most commonly, companies tied compensation to goals related to culture and diversity. Together, these categories accounted for 20 of all ESG metrics disclosed (Figure 3).
The challenge lies in creating measurable goals that correspond to areas of executive impact. Some companies disclose that they incorporate ESG metrics into their incentive plans but do not give much detail, while others give more detailed descriptions of the specific goals and how they measure performance in relation to them.
These issues will only amplify under the current political environment and continue to evolve. For example, Joseph Hall of Davis Polk told The New York Times that a Democrat-led Congress will likely push the SEC to adopt many of the disclosure requirements under consideration, tying them to specific metrics that make comparisons easier.
Meanwhile, The Wall Street Journal reported that Allison Herren Lee, as acting SEC Chairwoman, criticized recent SEC amendments affecting climate change, citing a September 2020 statement in which she said that “these actions collectively put a thumb on the scale for management in the balance of power between companies and their owners [since] climate change, worker safety [and] racial injustice have never been more important to long-term value.”
In March 2021, Herren Lee issued a statement inviting public comment on climate change disclosures, which was open until June. In particular, it includes a question that asks: “What are the advantages and disadvantages of requiring disclosure concerning the connection between executive or employee compensation?”
This question—related not only to climate change but also to human capital management and diversity—will be at the center of the executive compensation debate in 2021 and beyond, expected only to intensify.
In modern America, there has been a strong movement behind the idea that the free market has significant responsibility to influence and lead societal change. The biggest question is to what degree stakeholders are truly sharing in the market’s good fortune through more equitable treatment in the workplace, opportunities for advancement in a more diverse workforce or a healthier environment.
This is the debate that public companies find themselves in the middle of as we move forward. For executive pay, there has been at least one point of agreement: There is no better way to award compensation than through metrics that drive actions and outcomes reflecting company and stakeholder values. The discussion continues around what those values should be.
If this fails to become more transparent, companies risk the ability for stakeholders to understand how executive pay is structured, leading to a continued focus on gross dollar amounts and consternation over the quantum of pay. Meanwhile, the reward is a more inclusive role for public companies in the world outside of financial statements and stock exchanges, enabling and incentivizing leaders to take a more active part in driving the change their companies have the power to influence.
Dan Marcec is Senior Editor at Equilar and Associate Editor for C-Suite. Erin Lehr, Research Specialist for Equilar, also contributed to this article.