Is it time for a hard look at “softer” pay targets?

With so much company value tied up in reputation, social licence, integrity and sustainability, there’s growing support for basing a greater share of executive pay on meeting “non-financial” metrics that reflect these goals
By Mai Nguyen

New measures: United Airlines CEO Oscar Munoz’ (centre left) bonus pay is now linked to customer service metrics

Back in April, you may have seen a video of an older, Asian man being forcibly dragged by police off an overbooked United Airlines flight. This viral clip not only sparked horror, outrage and vows to never ever fly with the airline, it also prompted the United board to publicly announce that it would more closely link its 2017 executive compensation program to its customer service metrics. In a filing to the U.S. Securities and Exchange Commission, the board said revisions will be “tied to progress in improving the customer experience and in the necessary cultural and process change.”

The changes mean that United CEO Oscar Munoz could stand to lose US$500,000 from his annual bonus if customer satisfaction levels do not hit the company’s target. That may be chump change compared to the US$18.7 million Munoz earned last year, but in the bigger picture, the move puts United on the side of a growing camp of companies, governance experts and shareholder advocates who believe that linking at least a portion of executives’ pay to “non-financial” metrics is the way of the future. They argue it will encourage executives to act holistically and in the process more effectively mitigate risk, enhancing a company’s financial strength in the long run.

Currently, executive pay is heavily tilted towards short-term goals, with 90% of it tied to company performance under three years and largely based on earnings growth, stock performance and total shareholder return. Richard Leblanc, who teaches corporate governance and executive compensation at York University and consults leading companies, argues that pay committees should be basing pay on five- to seven-year goals that build value for the company, such as integrity, diversity and ESG conduct.

Mining and financial companies such as Cameco Corp. (TSX:CCO), Agrium Inc. (TSX:AGU) and Royal Bank of Canada (TSX:RY) have been pioneers in this field for several years, putting less emphasis on earnings-related metrics in their top executive incentives. The current momentum is fueled by consumers, millennials, investors and regulators responding to mismanagement, poor decision-making, as well as to growing restraints such as resource scarcity, climate change and economic instability. Leblanc expects to see more North American companies moving in this direction. “Seventy-five percent of a company’s value is non-financial so efforts should be made to measure them,” he says. “People behave the way they’re paid and if compensation is only tied to short-term financial goals, they may cut corners on things like employee safety, customer satisfaction and reputation.”

Not everyone is convinced, however. The typical pushback from management is that they’ve never done this before and that they don’t have the literacy or resources to effectively quantify so-called “soft” metrics. And while some indicators, like reducing carbon emissions or meeting gender diversity targets, are relatively easy to objectively measure, directors may be at a total loss when trying to quantify the worth of, say, restructuring an organization.

Institutional investors and proxy advisory firms are another hard sell. These groups like rigorous executive compensation plans that are tied to formulaic, quantitative goals that can be robustly disclosed in financial statements, says Peter Kimball, head of advisory and client services for the Institutional Shareholder Services Corporate Solutions, a unit of ISS. “Most institutions and proxy advisers don’t really care what metrics companies are using as long as those metrics can be defended and justified as important to the long-term well-being of the company and its goals of shareholder value creation,” says Kimball. “If there’s a concern that targets may be too easy or inflating executive payouts, that’s a problem and it’s especially present when we’re talking about non-financial metrics.”

ISS supports the use of ESG initiatives, but Kimball recognizes that boards will face roadblocks when it comes to defining their milestones clearly and getting their incentive programs to pass the rigour test. As he aptly puts it, “If you can’t measure it, you can’t treasure it.”

Paul Gryglewicz, a senior partner at Global Governance Advisors in Toronto, agrees, but he also says making non-financial metrics measurable and quantifiable is not an insurmountable challenge. Boards could create a scorecard based on five to six performance metrics—a mix of financial and non-financial—and determine how much weight to assign to each performance indicator. For example, an auto company could tie 70% of a CEO’s bonus to making a certain number of cars and the other 30% to slashing greenhouse gas emissions by 15%.

Gryglewicz doesn’t see a near future where most or all of an executive’s bonus will be tied to long-term metrics. “Markets haven’t responded well to that and there’s no precedent for it,” he says.

And that’s the reality of sustainability goals. Even if an executive hits those targets, the benefits may not immediately trickle down to shareholders and can result in some tension. This happened in April when TransAlta Corp. (TSX:TA) shareholders rejected a $5-million bonus handout to senior executives despite the fact that they successfully partnered with the Alberta government to phase out their coal-fired plants and move towards cleaner energy. ISS argued that compensation levels were at odds with stock performance and meant drastic cuts to dividends. “Some plans don’t show financial results for shareholders right away,” says Gryglewicz. “But what if they’re laughing by 2030, making more money and their children are living in a better environment? Should the CEO then not get rewarded?”

Shannon Rohan, director of responsible investment at the Shareholder Association for Research and Education, says this message bears repeating. “A very basic belief is that companies of the future are those that are adapting to emerging sustainability challenges,” says Rohan. “We need to recognize that we can no longer think about the bottom line exclusively, nor can we think about it in isolation. And compensation is key to incentivizing companies.”

Photography: Kevin Lamarque/Reuters

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