Large Investors Beginning to Put Executive Pay in the Bullseye

July 6, 2018

Passive money managers, finding wins on ESG, turn to say on pay. What boards need to do.

By Joseph Daou, Barry Sullivan, and Seamus O’Toole

Passive money managers are having an impact on how boards think about, and engage with shareholders on environmental, social, and governance (“ESG”) issues. Now they’re focused on taking a stronger stance on executive pay.

Given these managers’ significant influence, boards would be well served to proactively review their shareholder engagement approaches and pay design.

While they are not equipped to engage to the same degree as their more active counter parts, they have expanded their governance teams, expressed stronger perspectives and increased their engagement, particularly in ESG matters.

For example:

  • BlackRock’s CEO Larry Fink has called for companies to focus on more than just financial performance and be mindful of their impact to society and all stakeholders — including shareholders, employees, customers and communities.
  • State Street made a big push in 2017 on the topic of gender diversity by threatening “no” votes for nominating and governance chairs if “intentional steps” aren’t taken towards board diversity (and making good on that threat for 400 companies).
  • BlackRock, State Street and Vanguard have upped their willingness to vote on environmental and social proposals last year, basically doubling the number of yearly votes made in 2017, compared to each year from 2011 to 2016. (Semler Brossy analysis via Proxy Insight).

These passive money managers have had a significant influence.

Eight environmental and social proposals have received greater than 50% support in 2018, compared to 16 in the previous seven years combined. In perhaps the highest profile example, ExxonMobil is now reporting its efforts to mitigate rising temperatures, following a 2017 shareholder proposal that passed because of support from passive money managers.

As passive money managers continue to more aggressively exert their influence, we are seeing them take stronger stances on executive pay matters:

  • The head of corporate governance at State Street said they intend to abstain from say-o-pay votes when “on the fence” with a pay program (rather than not voting at all or simply voting for).
  • BlackRock and State Street, who voted “for” 97% of the time on say on pay in 2011, dropped their rate of support to 91% in 2017 — still high, but a marked decline (Semler Brossy analysis via Proxy Insight).
  • The new CEO pay ratio disclosure presents a natural extension from a core ESG topic of income inequality directly into executive pay matters.
  • The Investor Stewardship Group — a collective of investors that includes the largest passive investors and manages a combined $22 trillion in assets — emphasize alignment of incentive pay with long-term strategy by calling on boards to develop and continuously reevaluate their incentive programs’ effectiveness.

So, what are public companies and their boards to do in the face of this mounting pressure? Gone are the days when these money managers could be counted on to support management proposals.

Going forward, companies and their boards need to prepare for and engage with passive managers, similar to how they prepare for activist/active money managers. This overarching need carries through to the design and administration of executive pay programs, as well as the external messaging of pay outcomes and calls for a plan of action.

Continue to tell your story. Communicate the rationale for all executive pay decisions, and how each ties back to business performance and strategy. Where programs deviate from market norms, explain why the alternative approach is better for the company.

Review pay programs regularly. Evaluate pay programs, working to ensure continuing effectiveness relative to business and organizational needs, and appropriate responsiveness to investor interests and priorities. Disclose sufficiently and anticipate criticisms and vulnerabilities.

Engage directly with shareholders. Know your investor base and priorities before engaging. Demonstrate responsiveness to feedback. Ongoing outreach may prove even more effective with passive money managers than with activists, given the longer-term orientation, generally, among passive managers. Furthermore, companies may consider shaking things up to align with passive money manager ideology. Specific operating instructions include:

Review your long-term incentive vehicles. The rise of passive investing may mean stock prices become increasingly correlated and therefore less dependent on individual company performance. Consider revisiting and evaluating the use of relative total shareholder return in performance plans (if you use it) to be sure it still makes sense as a litmus for outperformance. Similarly, traditional service-based equity — that links rewards solely to share price — may need to be rebalanced with more performance-sensitive equity as a way to incentivize participants to continue operating at a high level. As such, consider introducing performance conditions apart from share price and/or increase the weight of performance-based equity.

Take a longer-term orientation. Consider structuring programs to reflect passive managers’ longer-term orientation. For example, consider larger equity grants that vest over an extended timeframe (e.g., five to seven years, in place of today’s standard three-year approach). Consider stepping away from overlapping performance periods (e.g., a new three-year performance period begins every year), opting instead for end-to-end cycles in an effort to increase participant focus on long-term results. Stock options, which have largely gone extinct, might make good sense to reintroduce as their term to exercise (oftentimes 10 years) provides natural long-term alignment. Further, upping ownership requirements for key executives and board members can underscore the long-term owner orientation.

Monitor compensation equality and fairness. As CEO pay ratio and gender pay equity garner more and more attention, boards have an opportunity to set the tone to ensure these issues are appropriately prioritized. We are already seeing many compensation committees’ expanding their roles and charters to cover broader topics, including pay equality, culture, talent development and succession planning.

Introduce non-traditional pay metrics. Double down on ESG-attendant commitments, making clear what matters and why. Doing so can enhance a company’s reputation, generate political capital with regulators, introduce potential cost savings through reduced inputs, and create new product and service offerings. Consider whether direct measurement and incentives are helpful signals, both internally and externally, in support of those ESG commitments.

Today and in light of the rise of passive investing, those investor needs and priorities are shifting for many companies. Consider the “operating instructions” above as helpful prompts for your next review.

Finally, while market data is an important input to pay design and decisions, it is not determinative on its own. Increasingly today, investors are focused on long-term strategy as the priority, and it is okay to step away from the herd when connecting your pay programs to your long-term strategy.