More shareholders are saying “no” to excessive pay packages, but there’s still plenty of work to be done. We offer food for thought as proxy season winds down.
We can’t help but notice this proxy season that investors are showing an increasing willingness to shoot down executive pay packages. We believe the pandemic is crystallizing the problem of inequitable pay at a faster rate than may otherwise have been the case, as examples of companies seeking to game the system (at the expense of their employees) make headlines.
The Financial Times reports that shareholder support for U.S. corporate pay packages dropped notably this year. Support for pay packages among S&P 500 firms fell to an average of 87% as of April 29, down 3 percentage points from 2020 and 2019, and down 4 points from 2016 to 2018. What’s more, citing Morgan Stanley, the FT article says “most companies that failed pay votes underperformed the S&P 500 and their sector peers” from 2017 to 2019. To put this in perspective, NEI’s voting record for say-on-pay last year was essentially the opposite. We voted against 86% of the compensation proposals we reviewed. In short, we like where the trend is going, but there is still a long way to go.
Tackling the difficult and complex issue of excessive compensation is among NEI’s priorities. How much is too much? How can the seemingly unstoppable increases in sky-high compensation packages be curbed? What are the best options for re-allocating executive pay? (We have some ideas.) What are the risks if we do not act now? Because make no mistake—the potential for deep and lasting societal wounds due to the inequitable distribution of wealth is real, as we’ve seen, and the threat looms larger with every unchecked pay increase.
Consider this report from the Institute for Policy Studies, which pulls no punches even in the headline: Pandemic Pay Plunder: Low-Wage Workers Lost Hours, Jobs, and Lives. Their Employers Bent the Rules – to Pump up CEO Paychecks. The report found that 51 of the 100 S&P 500 firms with the lowest median worker wage revised their pay rules in 2020, so that median worker pay fell 2%, while CEO pay rose—by 29%. What’s more, the report notes that 16 of those companies lost money in 2020. Yet they had the highest average CEO pay, at US$17.5 million. We strongly recommend reading the full report.
Who wants to go first?
We have found in our conversations with companies that management is often aware of the need to revise their pay structures. This makes sense. We have observed that some companies are willing—if not eager—to transition to a purpose-driven model that incorporates a multi-stakeholder approach, and in fact, a few of those companies are making solid headway. We are seeing progress on human rights policies, greater rigour around measuring and mitigating environmental impact, and action toward improving diversity and inclusion, among other things. Pay packages, however, remain a challenge.
Companies have shared with us that the main reason they are reluctant to be a first mover on restructuring pay is because (presumably) it would negatively impact retention and make them less competitive. Our stance is that a company ought to be able to offer more than financial reward to attract top talent, and that financial compensation should not be so heavily emphasized. In fact, we suspect companies would be surprised by the degree to which a more equitable pay structure could work as a competitive advantage, with the potential to boost corporate reputation and improve retention among employees (assuming some portion of re-allocated CEO pay goes to wage increases, benefits, training, community programs, scholarships, et cetera).
The status quo must be changed, because the status quo is only making things worse. The risk is largely an economic one; wealth disparity leads to slower growth, polarization and political risk—all of which makes for a more volatile society where public policy efforts to address key challenges like education and the environment become even more difficult. We recognize this is a big ship to turn, which makes it all the more important companies take action now.
From horizontal to vertical benchmarking
We recommend companies begin by augmenting their horizontal benchmarking exercise with vertical benchmarking. In addition to asking, How much do our top executives get paid compared to the top execs of our competitors?, they should ask, How much do our top execs get paid in relation to the rest of our employees? This would promote better internal pay equity. Securities law in the U.S. requires companies to disclose the ratio of CEO compensation to the median compensation of their employees. The rule has only been in effect since 2017 and, in the words of the Securities and Exchange Commission, companies are allowed “substantial flexibility” in the calculation of the ratio.
The rule is a good start, but all that “flexibility” carries its own risks. Namely, the potential exists to game the system by, for example, outsourcing your lowest paid work, thus lowering your ratio without touching CEO pay. It also creates a different playing field for industries where salaries are relatively high, such as the technology industry, versus industries that rely on front line staff, such as retailers and grocery stores. (See again the Institute for Policy Studies report mentioned above for examples of companies bending the rules.)
If we want to address the systemic challenge of income inequality we need to go further. We should extend the comparison to include a broader swath of society. Companies could ask, How much does our CEO get paid in relation to median household income? NEI has been using a multiple of median household income as a barometer for what is acceptable for the last 7 years. When the ratio is higher than a certain multiple, we vote against the pay package, and if it egregiously high, we vote against the entire compensation committee. In other words, we’ve placed an absolute cap on compensation as a way to start chipping away at this problem. It’s worth pointing out that a few of the companies we are talking to are open to our approach, and some Canadian banks are beginning to incorporate median household income in their analysis.
Time to take action
We invite likeminded institutional investors to consider a set of key questions as they vote their remaining proxies and as they develop their stance on executive compensation, starting with this fundamental gut-check: Are you comfortable with how much money CEOs are being paid compared to the vast majority of workers?
- Is there merit to setting an absolute cap on executive pay regardless of company performance to address the systemic risks of income inequality?
- Has the financial impact of the pandemic been shared equitably among executives and other employees?
- Should we be demanding the use of vertical metrics alongside (or instead of) horizontal metrics when benchmarking executive pay?
- Is there a more meaningful impact that can be spread among a larger group of stakeholders (especially employees) if executive pay is redirected to other places?
- How can investors better promote inclusion of ESG metrics in compensation packages, and what would we include that would curb the growing inequality?
As investors, we have a crucial role to play in getting this done. After all, investors are the ones who pushed corporations to tie their pay packages to stock performance in the first place, back in the early ’90s. The responsibility to help bring all stakeholders into the fold—not just C-suite executives and shareholders—lies in large part with us.
At NEI, our next step following proxy voting season is to reassess the effectiveness of our absolute cap approach and start to dig into other ways to address income inequality. We certainly do not think we have landed on the perfect solution, but we must start somewhere. To that end, we hope to bring investors together later this year to workshop solutions. If you are an institutional investor who is tackling this issue, we would very much like to hear from you.
As the saying goes, together we can do it.