The Long-term Impact of Corporate Compensation Models

As the conversation around executive pay grows louder, several possible solutions have arisen. The U.S. Congress now requires that companies reveal the ratio of their CEOs’ pay to that of their median employee. Some boards have begun tying CEO pay more concretely to the company’s financial performance – which has proven a difficult task. As a result, companies with poor returns often still give their executives sizable pay packages.

The economic crisis brought on by the novel coronavirus comes on the heels of a record-breaking year for executive compensation globally. A significant number of CEOs will be paid much less in 2020 than in years past, whether it be in solidarity with their employees or otherwise. But viewing the issue strictly in dollars and cents oversimplifies the issue – what lies beneath is whether or not compensation truly reflects a company’s long-term success, and whether it actually incentivizes decision-making that is in the company’s long-term interests.

Parallel to this growing spotlight, FCLTGlobal Members  identified long-term CEO compensation provisions as  an important  lever to encourage a longer-term focus in business and investment decision-making. The issue was explored further at our 2020 Summit, where participants broadly agreed existing compensation plan design focuses executives more on the short term, but recognized it is difficult to design compensation that would create a longer-term focus. In response, FCLTGlobal will research new ways in which short-term, status-quo compensation practices can be restructured  to enhance long-term value creation.

There is a growing body of work that already raises serious doubt about the extent to which current executive pay packages are associated with long-term corporate performance.

According to research from MSCI, more than three-fifths of MSCI USA Index constituents had cumulative 10-year realized CEO pay totals that were poorly aligned with the company’s 10-year total shareholder return performance:

10-Year Total Shareholder Return vs. 10-Year Cumulative Realized Pay

(10-year TSR as of Dec. 31, 2015 vs. 10-year cumulative total realized CEO pay as reported in 2007-2016 proxy statements, reflecting a one-year lag in reporting. Source: MSCI ESG Research)

Equilar research demonstrates how executives’ performance metrics are setting short-term incentives, with three years being the most common performance period. Based on the results of the 2015 Dow Jones Sustainability Index assessment, RobecoSAM observed that only 18% of the 1,845 companies assessed demonstrated clear evidence of CEO incentives that were longer than three years.

This issue has also garnered attention from academics. Alex Edmans at the London Business School contends that compensation reform plans should focus on “growing the pie” for the benefit of all stakeholders rather than on hitting short-term performance targets. “Growing the pie” approaches will create more value than “splitting the pie” differently, according to Edmans.

Recent work from Robert  Pozen  and S.P. Kothari (MIT Sloan School of Management) demonstrates how the complexity of status-quo compensation packages make it difficult for investors and compensation committees to comprehend executive compensation. If directors and investors cannot comprehend the compensation packages they evaluate, designing these packages for the long-term will be especially difficult.

There are elements beyond the scope of finance that also factor into the CEO pay dilemma. Behavioral agency theory raises questions about whether compensation plans with longer durations may in fact influence executives toward shorter-term behavior because recipients discount it so significantly and feel it to be so uncertain. This form of renumeration may be viewed as “house money,” rather than management’s own compensation, potentially providing less of an incentive than originally intended. There are other common behavioral tendencies, commonly found in professional settings, that may also influence the perception of long-term compensation – these will be explored in conjunction with our future work on the topic.

Companies’ specific circumstances further muddle the current state of play, but also create the promise of longer-term pay practice.

One element of circumstance – that will be of particular focus in our future study – is the variety of rubrics investors and compensation committees must use to design and evaluate compensation plans. At this stage, we have identified at least four distinct sets of criteria currently in use. Despite varying features and components, each  aims  to motivate executives to maintain a more long-term approach to their business. 

Type	Definition	Reference
Performance- based compensation	CEO is paid based on their  ability to meet pre-determined performance measures	See CPP Investments’ example on “Paying Only for  Skill, a Practical Approach”
Ownership- based compensation	CEO is required to invest a meaningful part of his or her remuneration in company shares	See Norges, “Remuneration of the CEO: An Asset-manager Perspective” (01/2017)
Base/Fixed salary	CEO is paid an agreed-upon fixed salary, independent of performance	See PGGM, “Remuneration Guideline for Portfolio  Companies”
Intrinsic pay	Significant portion of CEO remuneration is paid in non-financial rewards	See PGGM, “Remuneration Guideline for Portfolio  Companies”

Long-term companies also refer to their own strategies in order to shape the goals and objectives of their executives – FCLTGlobal’s Straight Talk for the Long Term highlights 10 elements of this approach. A notable example is Unilever; in 2017, it restructured its compensation planning in order to align with the long-term strategy. Furthermore, board directors and investors have various historical and regional experiences that inform their choices about how compensation can influence long-term executive behavior in their circumstances. We plan to use these different approaches to inform our research and arrive at new, globally relevant solutions.

FCLTGlobal expects that tailoring changes to compensation provisions can address these circumstances, incorporate insights from behavioral economics, and produce a practical, impactful, and broadly–applicable tool for designing and evaluating pay in a longer-term way. 

The objective of this work is to pinpoint provisions that are useful for any organization’s compensation planning and that can be put in place independent of any regulatory change that may occur. It is our hope that investors, boards, and executives will view new provisions as balanced and capable of driving real, tangible impact.

If you have insights relevant to compensation, or any questions about our work, please contact [email protected].