Business leaders are under increasing pressure to design financial incentives in ways that reflect companies’ broader societal responsibilities while also creating long-term value for investors and other stakeholders as executive compensation soars back to pre-COVID-19 levels and the pay gap between chief executives and employees widens.
When it comes to environmental, social, and governance (ESG) factors, executive compensation plans have historically encouraged short-term profit maximization. According to consultants SemlerBrossy, that is beginning to change, with the percentage of S&P 500 businesses including ESG goals in their CEO bonus plans increasing from 57% in 2021 to 70% in 2018.
Compensation for top executives: striking a balance between the two
The difficulty for these companies is to find a happy medium between long-term sustainability and short-term profits. For example, reducing greenhouse gas emissions may increase expenses and slow growth in the short term, but this is far outweighed by the cost of inaction.
A company’s fiduciary duty extends to its shareholders and other interested parties. When will investors and the board finally have enough of a CEO’s poor performance? The catastrophic downfall of former Danone CEO Emmanuel Faber illustrates the dangers.
Faber declared he had “toppled the statue” of the late free-market economist Milton Friedman when he transformed the company’s legal status to codify its social purpose. After Danone’s investors criticized the company’s poor share performance relative to its competitors, Faber was fired nine months later.
In an effort to appease their investors, many C-suite executives delay making the bets that might allow businesses to address society’s long-term concerns. But they feel pushed in different directions. Other stakeholders (customers, staff, regulators) also put pressure on many organizations to prioritize values other than financial gain.
Since CEO compensation has a significant impact on executive behavior, it would benefit companies and society if companies adopted a more well-rounded set of goals, incentives, and accountability systems.The non-profit organization Reward Value has proposed three principles for ethical compensation at the World Economic Forum.
Benchmarking performance
Executive remuneration depends on financial performance. We believe corporations should widen their performance targets to incorporate long-term stakeholder value.
The Long-Term Investor Value Appropriation (LIVA) approach calculates shareholder value creation or destruction using share price data.
LIVA shows actual cash returns from share price increase, share buybacks, and dividend payouts, less the opportunity cost of investing in a company.For instance, if you bought $10,000 worth of Apple shares in 1984 when it released its first Mac computer, you would be $3.8 million richer today.Thus, Apple’s LIVA throughout this period is $3.8 million.
Non-financial performance is difficult to measure due to a lack of accurate data.The Impact Weighted Accounts (IWA) framework values a company’s societal impact, such as carbon emissions. Financial and non-financial performance can be compared more directly. Long-term stakeholder value creation can be measured using the IWA and LIVA frameworks.
Performance-based pay
To embed such performance data into CEO compensation plans, define KPIs that are relevant to the enterprise, such as an airline’s environmental footprint or a mining company’s worker health and safety.This gives the C-suite a financial incentive to safeguard stakeholders.
However, the compensation model must contain fixed annual salary and a longer-term incentive.Most compensation packages have “absolute goals” that executives must meet to receive their bonus. However, these milestones usually last a year. The average time horizon for relative performance bonuses is three years.
Too often, short-term compensation plans allow executives to “game” their pay, hurting shareholders.Executives may defer payments or R&D investments until after their incentive to meet cash flow targets.
Short-term ambitions may conflict with long-term goals to address serious social issues like the climate problem, which former Bank of England governor Mark Carney called a “tragedy of the horizon.” This implies most leaders won’t see global warming’s repercussions.
To combat short-termism, extend bonus vesting beyond the executive’s tenure. After the crisis, leading bankers practiced this. That would free executives from annual performance expectations and reward them for long-term wealth development.
Implementing greener pay plans
You’ll need strong corporate governance to implement these new targets.How involved should stakeholders be? A wider representation on remuneration committees would assist guarantee that ESG considerations are not just integrated into pay plans but also protected and defended.Executives may also be discouraged from using their company influence to place their favorite candidates on pay committees.
If a major social or environmental issue arises, a “clawback” clause can be utilized to reclaim pay or cancel future payments. We think such a provision is crucial in an age of greenwashing.
In addition to climate concerns, firms should explore how CEO pay may advance equity goals.
Bonuses for lower epidemic objectives have boosted executive pay in the past year. However, that may conflict with the premise that companies should improve society. The boss-worker compensation ratio is important. The ratio increased to 1:81 in the FTSE 100 last year from 1:59 in 2020, according to Deloitte.To align compensation with equality, companies must prevent the gap from widening.