What is more effective in aligning executive interests with shareholders – incentives or ‘skin-in-the-game’?

Glass Lewis attributed remuneration structures lacking ‘skin-in-the-game’ as one of the common contributors to remuneration reports receiving strikes. The details can be found in our summary of the Glass Lewis 2024 Proxy Voting Season Review article HERE.

The first panel of our 19^th annual Remuneration and Governance Forum, co-sponsored with Glass Lewis, explored the benefits and drawbacks of at-risk remuneration as opposed to a significant shareholding (or ‘skin-in-the-game’). This article summarises director and investor views about which of the two – incentives or ownership from equity grants – is more effective in the long-term.

The debate is not settled. One panellist in last year’s Forum advocated that large, time-vested equity grants tie executives’ personal wealth with the company’s and avoids the unpredictability of market-based vesting hurdles. The 2024 Forum Panel Discussion article that suggests more executive pay through ‘skin-in-the-game’ can be found HERE. However, institutional investors in this year’s Forum indicated their preference for traditional at-risk incentives when having their say on the remuneration report.

Some panellists considered that a well-designed long-term incentive program can serve as ‘skin-in-the-game’ if done right. It was noted, however, that there is no point having a performance-based incentive unless the company has a culture of superior performance.

The importance of challenging yet attainable performance measures was emphasised, with a particular focus being those that drive long-term value are the most necessary in a long-term incentive plan. Suggestions of these types of performance measures consisted of return on equity (ROE), earnings per share (EPS), and return on invested capital (ROIC). Some panellists agreed that total shareholder return (TSR) is not the ideal measure to promote long-term alignment, citing its potential to fluctuate significantly due to a cyclical factors.

Additionally, it was acknowledged that different plans are effective at different stages of a business cycle, with panellists advocating a fit-for-purpose approach. Remuneration is often targeted when company performance is down, even if this is because of cyclical factors rather than executive performance. It is at these times that management are called on to work their hardest. A level of trust between executives, their board of directors, and the company’s shareholders that reward would remain appropriate at these critical times is necessary for retention and motivation.

For some executives, the acknowledgement of effort and performance is sometimes more important than the quantum on their remuneration.

The conversation shifted to when ‘skin-in-the-game’ would be appropriate. Panellists felt that large grants not contingent on performance would only be appropriate in select situations. Some panellists agreed that service-contingent equity grants (aka Restricted Stock Units, RSUs) can be more appropriate when dealing with executives sourced from a global talent pool, where it is more usual to receive grants of equity without performance hurdles. For global companies with primary listings on the ASX (where Australian governance standards are frequently applied), this can be frustrating, since it can be difficult to introduce RSUs without pushback.

There was no clear resolution to this issue. It seems Australian investors (at least some) expect ASX-primary-listed companies to follow Australian pay standards – notwithstanding that they are operating globally and such standards will not attract and retain foreign-resident executives.

It was agreed that large sign-on equity grants can be necessary to attract an executive to a new role if they are leaving behind their unvested incentives that do have potentially significant value.

Long term performance cycles were raised as one area where skin in the game might be useful due to the difficulty in setting performance hurdles. However, that was not accepted as being a reason not to adopt performance hurdles (but rather to select a 3 to 4 year performance period with a holding lock following that period).

It was raised that trouble with incentives generally arise when they do not pay out for multiple years. One panellist view was that if this is the case, there are likelier bigger issues than executive reward to tackle. Discussions with the audience suggests that this situation gives rise to a significant retention risk.

Other audience comments noted that non-listed companies have substantially more flexibility to design their incentive plans to align to their strategy and maximise retention. Listed companies are more hamstrung when trying to retain their top talent.

The panel noted that a very large shareholding can provide such strong alignment of executive-shareholder interests that it can combat retention issues.

A thought-provoking question posed by an audience-member asked panellists if a large shareholding would impact key decisions, for example on the dividend payout ratio.

There was consensus that the type of long-term alignment most appropriate cannot be a blanket approach. It depends on the company, its culture, where it is in its development, and where its executives are based. The panel favoured the use of performance-contingent incentives as opposed to service-contingent equity grants, except for the few select situations. The caveat being that those performance-based incentives be challenging yet realistically achievable.

To read our article covering the second panel discussion ‘Battle Scars on Boards’, see HERE.

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