Short-Termism in Executive Pay

On the 27th of February, Guerdon Associates and CGI Glass Lewis hosted their 18th annual Remuneration and Governance Forum, with a panel focusing on short-termism in Australian executive pay.

This summary highlights the insights of the panel on aligning executives’ behaviour with long-term interests.

While it was acknowledged that remuneration practices have improved over the years – for instance, with the introduction of the two-strikes rule improving stakeholder engagement – transparency and trust remain critical obstacles in determining remuneration; namely, companies’ transparency on pay, and trust between directors and shareholders. The panel noted that trust may be low, necessitating improved transparency as a counterweight.

Remuneration is a driver behind executive behaviour over which boards hold sway. Total Shareholder Returns (TSR) are a common LTI vesting measure, since they measure the ultimate outcome of interest (i.e., share price) in determining adequate incentives. However, TSR-based vesting measures require comparison against corporate peers, and in a small market such as Australia where there are fewer players, it is a challenging task to find an appropriate peer group of sufficient size. This has caused executives to view relative TSR measures as being “lottery-like” and outside of their control; a particular concern for all-or-nothing vesting hurdles, which are highly commonplace among Australian companies. By implication, relative TSR measures fail at influencing behaviours to improve long term performance.

Some members of the panel argued that most investors tend to be influenced primarily by the short-term, whereas directors more frequently have a long-term orientation. Much of the short-termism prevalent among Australian companies may therefore be attributable to boards’ appeasement of shareholder interests.

A facet in designing variable remuneration plans is determining the appropriate split between STI and LTI. The determination of an adequate STI-and-LTI split reflects a balancing act between short-term and long-term interests: company performance and shareholder returns in the near-term, as well as sustained performance and profitability in the long-term.

The discussion highlighted that a 50% split might, at first glance, seem balanced for the incentive structure. However, executives (and people in general) tend to devalue deferred awards the longer they are deferred beyond a rational assessment of economic value. Due to this bias (termed “hyperbolic discounting”), half-and-half incentive splits are in fact representative of a short-term orientation, despite involving a balanced economic allocation of reward. Some argued that a balanced incentive structure would therefore involve more LTI than STI, to counterbalance the hyperbolic discounting of deferrals, and that the appropriate split would differ depending upon each company’s particular context.

Some members of the panel criticised the rigidity of Australian regulations, which constrain boards from tailoring remuneration plans to company-specific needs. Despite shareholders’ dissatisfaction with rampant short-termism, a short-term focus does not always reflect a misguided strategy: some businesses, like fast fashion, might even benefit from a primarily short-term incentive structure. This exemplified why a one-size-fits-all approach to incentive frameworks imposed by investor guidelines is not always appropriate.

In addition to balancing short- and long-term incentives for context, the panel highlighted the importance of balancing financial and non-financial vesting measures within incentive elements. Companies often use balanced scorecards (i.e., with a balanced mix of financial and non-financial metrics) for STI plans, but non-financial measures are seldom used in LTI plans. Non-financial metrics are typically more opaque than financial metrics, rendering them more difficult to be independently verified. Since non-financial measures are often incorporated into STI plans, companies may run the risk of doubling-up if such measures were also ultimately rewarded via LTI plans. Moreover, it is conventionally reasoned that everything ultimately shows up in the share price; this line of reasoning would imply that only market-based vesting measures (most commonly, the TSR) are necessary for LTI scorecards, together with annual assessments for malus/clawback.

The panel concluded their discussion with a brainstorming session, in which each panellist proposed a single change that can be made to cultivate healthier executive pay. One panellist advocated for large, time-vested, guaranteed stock grants not contingent upon performance (i.e., service rights). This ensures that executives have adequate skin-in-the-game by aligning their personal wealth with company stock, without the unpredictability of market-based vesting hurdles in conventional LTI plans. Another panellist echoed the sentiment that equity grants would constitute the most straightforward approach, while noting that grants may have to be tailored to each executive on a case-by-case basis, due to the different individual circumstances and interests of each executive.

In summary, a multitude of factors – including conflicts of interest, issues of trust and transparency, difficulties in determining STI-and-LTI splits and vesting measures, as well as regulatory complexity – may all be at play in rendering short-termism in pay so widespread.

CGI Glass Lewis deemed short-termism to be one of the main contributors to this year’s anomalous voting trends, as detailed HERE. For our article covering the panel on voluntary and advisory resolutions, see HERE.

© Guerdon Associates 2024
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