ESG Club feature – Executive pay


the company, market sentiment, and, especially if it is a large payout, potential reputational risks. These cannot be ignored. “Ultimately, it is the committee’s responsibility to persuade us that a pay award is justified,” Herms says. LGIM doesn’t have a threshold for how much a company pays its senior leaders. A pay deal being linked to long-term sustain- able performance is more important. “We look at the structure of pay and how it aligns with the experience of the workforce, of the shareholders and wider society,” Herms says. Although useful, the ratio of how much the chief executive is paid compared to that of an average employee can be confusing. “We accept that comparability is difficult across different com- panies and sectors. It is not a red flag for us,” Herms says. When assessing if an executive’s pay is extravagant, comparing the pay structure to a reasonable peer group could help. “If a company pays its executives to a degree we deem excessive rela- tive to their peers, we may have an issue with that,” Dervan says. “You need to incentivise executives to remain with the company, but success is defined potentially differently by different par- ties,” Dervan says.


Cash or paper?


The structure of the pay package also needs to be considered. A large bonus may seem extravagant, but it could only be paid if the company hits certain targets. An executive receiving a $1m cash bonus, for example, is likely to be a different proposition from receiving the equivalent in shares. “We might have better tolerance for payments made in equity as opposed to cash if those equity awards are tied to strong operational hurdles. Achieving that equity payout could significantly enhance share- holder value,” Dervan says.


It is not just a question of why an executive is being paid so much, but how, or when, it is paid. “Is it purely in their salary, where they just need to sit in their seat to earn pay, or tied to strong financial or operational metrics that could result in unlocking shareholder value?” Dervan says. “We are long-term investors; therefore, we want pay packages weighted towards three-to-five-year periods,” Dervan says. “We want to incentivise outperformance against a peer group and we want to


incentivise alignment with shareholders


through equity ownership, so we want [pay packages] weighted more towards equity compensation than cash,” Dervan says. “We want robust challenging metrics over the longer term,” Dervan says.


The right metrics You want metrics that incentivise fundamental outper- formance. Return on invested capital is such a measurement, which is weighted towards not just equity, but performance-re- lated equity.


32 | portfolio institutional | September 2023 | Issue 126 Different strokes


It is difficult to compare the responsibilities of the directors to those of the wider workforce. “Directors are having to walk a bit of a tightrope here,” Herms says. “Different risk and responsibility levels are rewarded differently. “Executives are employees of a company and work on behalf of shareholders and other stakeholders, from the workforce to the supply chain,” Herms says. “For that they are generally quite well paid. They get a salary, a bonus and participate in share incentives.”


The wrong incentives can certainly threaten long- term value.


Peter Dervan, Manulife Investment Management


“You need to incentivise executives, but you need to do it in a responsible and reasonable way through a responsible and rea- sonable use of shareholder investor capital,” Dervan says. “The wrong incentives can certainly threaten long-term value,” Dervan says. “That is why we work with companies to encour- age the right metrics and the right incentives that seek to drive outperformance over the long term. “You could have a good year of performance, but is that worth a significant increase in pay? We want to incentivise perfor- mance against the long term,” Dervan says.


“It may not be enough just to look at stock performance. It is great if the stock price goes up, but we pick companies for a reason. We pick them because we expect them to outperform the market,” Dervan says. He doesn’t want executives benefiting from just riding the market. “Some people could point to a share price going up over the last year, but if everybody’s share price went up you have performed thanks to macro tailwinds. Nothing funda- mentally has changed at the company,” Dervan says. “A revenue target could encourage executives to empire build, to just go after acquisition after acquisition without measuring the success of any post-merger synergies,” Dervan says. “The right metrics, like return on invested capital, can help balance that.”


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