Should executive pay reflect firm’s progress?

Most people agree that executive pay should reflect their firm’s progress on diversity. That’s easier to say than to do. Measuring financial performance objectively is pretty straightforward, and scoring climate credentials isn’t the headache it once was. But rewarding inclusion will necessarily be subjective. It’s unclear investors are ready to trust corporate boards to exercise such judgement given their track record of excessive generosity.
Environmental, social and governance metrics already inform executive pay plans. That’s partly because businesses are under pressure to acknowledge their wider responsibilities — think of the US Business Roundtable’s revised definition of corporate purpose, or BlackRock Inc. Chairman Larry Fink’s preoccupation with the same theme in his annual letters to corporate bosses. At the same time, there’s evidence that firms with higher ESG scores perform better as they benefit from a lower cost of capital.
Following the #MeToo and Black Lives Matter movements, this trend now dovetails with an increased emphasis on how well a company’s workforce represents wider society. Even private equity, an industry whose financial rewards are traditionally focused squarely on financial metrics, gets the idea. Carlyle Group recently divided $2 million between around 50 employees in recognition of actions that supported diversity in the buyout firm or its funds’ portfolio investments.
Policymakers are pushing on this front too. The Bank of England and the UK Financial Conduct Authority are consulting on whether to issue guidance about tying finance-sector pay to diversity and inclusion metrics. The BoE has already said it will do this for its own executive directors (without spelling out how) while a recent study by London Business School and PricewaterhouseCoopers found that around 7% of the annual bonus in executive pay for FTSE-100 financial firms is tied to diversity goals.
The snag is deciding what to incentivise and how to measure success. UK regulators say they don’t intend to prescribe exactly how firms should pay bonuses for advancing diversity.
As things stand, the approach to financial incentives in ESG is too narrowly based on quantifiable measures, largely because investors fundamentally distrust boards’ ability to evaluate pay, according to Xavier Baeten, professor of reward and sustainability at the Vlerick Business School. An all-encompassing evaluation is what’s needed. While diversity can cover everything from ethnicity and access for the disabled, the emphasis is often gender-related, such as the number of women in the senior management team, he adds.
“The challenge is you want more discretion,” says Phillippa O’Connor, head of PwC’s UK reward and employment team. “But that means shareholders need to trust the remuneration committee to exercise this appropriately.”
The backdrop is a history of boards awarding bonuses for mediocre financial performance. But setting targets purely on things that can be precisely measured isn’t the answer.

—Bloomberg