Simplify Executive Pay By Focusing on Stock Ownership, Says New Study

Executive pay is too focused on short-term targets, overly complicated, and unreasonably homogenized, according to a new paper by non-profit FCLT Global (stated mission: drive long-term value creation for a sustainable economy). 

The answer (according to FCLT): companies, investors and proxy advisors should reduce focus on TSR, peer groups and short-term incentives and instead concentrate on “direct stock ownership by executives, with long-term holding periods.” The paper makes some good points, such as:

• Say on pay is ineffective -  and disclosures, though lengthy, aren’t always helpful to investors (the authors cite Pay Versus Performance as an example).
  
  
• Say on pay gives proxy advisors too much power, causes investors to “punish innovation” and rewards reliance on said proxy advisors.
  
  
• “Use of external consultants” for pay design tends to increase homogeneity of pay plans, as consultants are forced to recommend the “same models to almost all clients.”
  
  
•  Reliance on one-year TSR as a performance measure, by companies or by investors, leads to short-term thinking and does not align with sustainable value creation.

So how do we do it? Unfortunately, here the paper falls somewhat short. While acknowledging that the suggestion of stakeholders like Norges Bank and CII to eliminate performance shares entirely (or even move to performance periods of longer than three years) is unlikely to happen, the authors don’t seem to have a clear idea of what companies should do instead. Many of the suggestions are things companies already do: avoid one-time grants as much as possible, implement share ownership guidelines, require mandatory holding periods. Perhaps more interesting are the suggestions for investors:

• Clarify proxy voting policies so companies know exactly what leads to support or rejection of Say on Pay, other than relative performance to peers.
  
  
• Require mandatory holding periods or share retention policies, especially with longer horizons.
  
  
• Encourage direct share grants to create an ownership mindset in leaders.
  
  
• Look beyond TSR and financial metrics to pay duration (a metric reflecting vesting periods and time horizons of different pay components) and wealth sensitivity (the incentive effect of changes in an executive’s total wealth holdings based on stock price).

Path Forward. The report concludes with a list of do’s and don’ts for Compensation Committees, investors and proxy advisors alike. Some ideas seem possible (consider continued rather than accelerated vesting of outstanding stock upon retirement) while others are more challenging (require share retention beyond termination). Although unlikely to change current practice, it is interesting that despite any obvious alternatives, the debate continues around whether performance-based incentives actually align with long-term shareholder value.