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March 02, 2005
Carrots and Sweets: Tying Executive Remuneration to Extra-Financial Performance Indicators
    by William Baue

A report from Henderson Global Investors and Universities Superannuation Scheme finds incentives for extra-financial performance tied to short-term instead of long-term indicators.


Carrots dangled from sticks provide incentive for donkeys to plow fields, while promises of sweets can keep kids engaged in constructive activities (instead of bickering) for hours. Business institutionalizes these carrots and sweets systems of incentives by tying executive and director remuneration to financial performance indicators, most commonly total shareholder return and earnings per share. However, increasing evidence links long-term financial performance to extra-financial indicators, such as customer and employee satisfaction and environment, health, and safety (EHS) issues, suggesting that strong performance on these issues should also be incentivized.

A report released last week by UK-based Henderson Global Investors and Universities Superannuation Scheme (USS) found that UK companies are starting to link compensation to extra-financial indicators. However, it found that the short term bias of companies still holds sway, as these incentive plans tend to cover the short term instead of the long term, when extra-financial performance takes hold. The study also concluded that there is a lack of transparency on executive compensation.

Rob Lake, Henderson's head of corporate engagement, and Daniel Summerfield, responsible investment adviser at USS, examined remuneration reports for directors of companies in the FTSE100 and a small number of others. They focused on director compensation because it is subject to annual shareowner approval in the UK.

"We found that extra-financial factors are being linked almost exclusively to short-term incentive schemes," said Messrs. Lake and Summerfield. " Three of [the companies studied]--BHP Billiton [ticker: BHP], BT [BT.L], and Scottish and Southern Energy [SSE.L]--increase the potential reward for annual extra-financial performance through share-based deferred bonus schemes."

"However, none of the companies studied here links extra-financial performance to long-term incentive schemes (LTI) that are not tied to the annual bonus," they continued.

Although they do not suggest reasons why, this exclusion of far-sighted incentives seems counterintuitive, as extra-financials tend to have a long-term horizon for affecting financial performance. Perhaps corporate nearsightedness, namely the obsession with short-term financial performance, helps explain the current situation.

The authors found the weight placed on extra-financial performance in determining annual bonus awards ranged between ten percent and one third at the companies reviewed. The number of extra-financial measures assessed range from one to ten.

"Some companies use only one: customer satisfaction at BT and Vodafone [VOD.L]," state the authors in the report. "BHP Billiton and Shell [RD] use four corporate measures (as distinct from measures of personal performance) . . . [and each] of Shell's four measures in turn breaks down into sub-measures."

"At the time of writing, in November 2004, Shell is reviewing its system," they continue. "Rio Tinto [RTP] uses corporate safety performance, as well as a number of extra-financial personal performance measures."

The authors also highlight the importance of measurement, verification, and benchmarking of the extra-financial indicators being used to determine compensation, so as to ensure that bonuses are based on actual performance in the extra-financial realm. Even more importantly, the authors stress the importance of transparency and disclosure so investors can evaluate the degree to which the remuneration system aligns with shareowner value.

"The review of Remuneration Reports conducted as part of the research for this paper showed there is currently little detailed disclosure on the performance measures used for short-term incentives whether those measures are financial or extra-financial," write the authors.

This lack of disclosure is occurring despite the fact that the Association of British Insurers (ABI) Guidelines on Executive Remuneration, the primary UK guidance on the issue, specifically call for disclosure of the parameters used to determine compensation. In addition, the ABI Disclosure Guidelines on Socially Responsible Investment call for disclosure on how compensation is linked to social, environmental, and ethical issues--in other words, extra-financial issues.

The new UK regulations requiring greater disclosure of social and environmental issues in companies' Operating and Financial Review (OFR) will likely drive increased transparency on linkages between compensation and extra-financial issues.

Investors on this side of the pond are also scrutinizing compensation. For example, a shareowner resolution filed at Halliburton (HAL) asks the company to link executive compensation to performance on social and environmental (as well as financial) criteria. Another resolution addresses employee issues, asking companies to limit CEO compensation to no more than 100 times the amount paid to non-managerial employees. This resolution is filed at a Black & Decker (BDK), International Paper (IP), Lockheed Martin (LMT), and United Technologies (UTX), as well as a number of financial service companies, such as Citigroup (C) and Marsh & McClellan (MMC).

 

 
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