Move to link exec pay to ESG integration growing

Now in the second year of the COVID-19 pandemic, investors are raising expectations about companies' responses to highlighted ESG issues such as diversity and, increasingly, connecting that to executive compensation.

"Compensation is the ultimate governance mechanism that we have to make sure (that) companies are doing things right," said Peter Reali, New York-based managing director and head of engagement, responsible investing for Nuveen, with $1.2 trillion in assets under management.

"ESG issues are making their way into compensation conversations because shareholder proponents want it integrated into executive compensation design, to create accountability for executing on ESG commitments" and companies' responses to COVID-19, Mr. Reali said.

Robin Ferracone is CEO of Farient Advisors LLC in Pasadena, Calif., an executive compensation and corporate governance consulting firm that helps companies, large public pension funds and mutual funds review proxies and prepare votes on executive pay packages. This year, she said, "investors are really pressuring corporates to focus on ESG" particularly as COVID-19 shifts the spotlight to stakeholder issues, including employee welfare and racial and income inequality.

"Companies are now saying this is serious, and we need to seriously ask ourselves whether we should change our compensation," said Ms. Ferracone, who sees more corporate boards and even federal and state regulators paying closer attention to executive compensation.

Measures for connecting issues like workforce diversity, gender balance pay, employee engagement and retention, or health and safety to executive compensation are just starting to develop and are "all over the map," Ms. Ferracone said. So far, those metrics tend to make up about 20% of executive bonus plans, but she anticipates that more will be included in long-term incentive packages eventually.

"When you add up the investors, the corporations, the employees and the regulators, this is really a groundswell," she said.

To see how COVID-19 has advanced stakeholder interests, Farient Advisors studied how companies around the world are incorporating those interests into their executive pay plans. Analyzing data on incentives from the most recent public disclosures for companies in the U.S., Canada, Europe, U.K., Australia and Singapore, they found 67% of companies worldwide using measures on ESG, customer and community interests in incentive plans, but wide disparity by region. Australia was the leader with 87% prevalence and Europe was close behind, with the U.S. bringing up the rear at 56%.

Legal & General Investment Management Ltd. sustainable investing experts on both sides of the Atlantic can attest to that disparity.

John Hoeppner, head of U.S. stewardship and sustainable investments at Legal & General Investment Management America in Chicago, and Karoline Herms, global investment stewardship manager with the U.K. counterpart in London, deal with notably different approaches to executive pay, starting with the U.K. mandate to disclose executive pay.

Since 2016, LGIM has required U.K. companies in which it invests to not award director salary increases in excess of what was offered to the general workforce. They have also asked companies to align executive pension payments with the wider workforce's levels and even suggested increasing pension contributions for existing employees. That produced a happy result in 2020, when many U.K. companies reduced pension provisions for executive directors, and six FTSE 100 companies even increased levels for their workforces.

It is different in North America, where LGIM is working to align pay with performance. Last year, Mr. Hoeppner said, it voted against 54% of say-on-pay management proposals, many of which didn't measure performance over three years, and some that did not link long-term incentives to performance at all.

"We have quite a bit of influence in the U.K. and across Europe. We are not having influence in the U.S. market," Mr. Hoeppner said, but he does see "more watchdogs out there," including large asset managers like BlackRock Inc. and Vanguard Group Inc. that are becoming more vocal about linking stakeholder issues, executive pay and performance. "The only way to change that is if our peers are also convinced it is as big an issue as we do," he said.

Ms. Herms said she thinks it will happen, particularly if shareholder value is impacted. "As investors get less, they will be looking at pay. Companies are being judged on how they weathered COVID, how they have been treating employees and supply chains," she said. If necessary, LGIM will escalate to director votes "to make it personal," she said.

Last year, LGIM had 50% more remuneration consultations with companies on possible policy changes and additional uncertainties around the COVID-19 pandemic.

One success story came from Microsoft Corp., where LGIM collaborated on aligning pay in the tech industry and setting more formulaic financial targets for senior management pay. LGIM also won a commitment of 30% minority representation in senior management, and included diversity targets in pay decisions. Time frames were not provided.

The cautionary example of how LGIM looks at pay through a pandemic lens, especially companies that enjoyed government support or suspended dividend payments to shareholders, is International Consolidated Airlines Group SA, the parent company of British Airways and Qantas Airways. While their workforces experienced layoffs, company directors got full bonuses — and a no vote from LGIM on pay-related proposals at both airlines. The 28.4% dissenting vote should spur the remuneration committee to take action, LGIM officials believe.

"The big thing that has changed this year is, if you cut dividends, furloughed workers, had layoffs, we are going to be paying closer attention. You should not give yourself a bonus or a pay raise," Mr. Hoeppner said.

In the U.K., that message was delivered to companies "very early on in the pandemic," said Ms. Herms, who thinks that "a lot of companies are going to be careful," given that last year about one-third of shareholder votes went against proposed pay packages.

To see whether companies and shareholders are connecting ESG issues and executive incentives, governance and compensation reporting firm Equilar looked at proxy statements of Fortune 100 companies over the last year. It found that 38 of 94 companies disclosed compensation metrics tied to ESG goals. Most were for annual incentive plans, and only one company did it for a long-term incentive plan. This proxy season Equilar expects to see more quantitative disclosures, especially ones relating to culture and diversity.

"Incorporation of ESG measures into pay packages has become more and more a common metric. We are seeing more companies doing it," said John Wilson, vice president and director of corporate engagement for Calvert Research and Management in New York, with $31.8 billion under management. He and others caution that transparency is still an issue for those metrics. "We are still figuring out how meaningful it is," he said.

Investors are working to convince companies that ESG-linked executive compensation metrics are meaningful because they are material to shareholder value. "It is important to cash flow and valuations. We always try to link it back to what's good for the company, and what will make it more attractive for clients, customers, and workers," said Michelle Dunstan, global head of responsible investing at AllianceBernstein LP in New York with $697 billion under management. "We do see a lot more collaboration in the industry engaging for action on this issue," she said.

Sometimes it's a labeling problem. In its 2020 engagements, AllianceBernstein talked to 293 companies that did not disclose having ESG metrics in compensation plans, and found that 133 do include them. Still, only 96 have metrics that AllianceBernstein believes appropriately measure ESG goals.

While those discussions were fruitful, there is room for improvement when discussing ESG metrics and executive compensation, Ms. Dunstan said. "We need a better understanding of what a good metric is."

AlianceBernstein will follow up with those companies in 2021 and widen the lens to include fixed-income holdings. "Where we do not see progress, we will take the next steps," which could include negative votes, she said.

Taking a tough line on executive compensation is not new for Calvert, which voted against more than half of all pay proposals in each of the past five years, but "people are paying more attention to disparity and to CEO pay," and incorporating ESG measures into pay packages, Mr. Wilson said.

"One thing that we are really focused on is execution. Do you have the governance in place to make that happen? Companies are still working to put together their plans," he said.

"Depending on the issue, the measurement is just coming into its own now. Some (companies) are wanting to get out in front, and some are waiting to see what they are going to be told to do. I think eventually that will be an expectation," Mr. Wilson said.