NEI Investments promotes a stakeholder approach to pay – rewarding executives who create long-term sustainable value for all company stakeholders, including shareholders. We believe excessive pay is a fairness issue – and a risk to shareholder value. We are concerned that executive compensation may not take into account how people are actually motivated; that a disconnect between executive compensation and salaries at lower levels may undermine company cohesion; and that excessive pay can damage a company’s reputation with stakeholders, and contribute to income inequality, identified as a key threat to economic and social stability. One tool that has been proposed to address excessive pay is vertical comparison of the compensation of top executives to the pay of other employees. Much debate on vertical comparisons has focused on the yet-to-be-implemented CEO-to-median company worker pay ratio provision in the U.S. Dodd-Frank Act. This provision has received considerable support in the responsible investment community, and given our interest in the income inequality question, at first we were inclined to support it too. But the more we thought about it, the more sceptical we became. We found it hard to visualize integrating the metric into our pay analysis, because of significant challenges to meaningful comparison between companies in differing sectors or with radically different structures. Even worse, it was possible to imagine the lowest-paid workers being replaced by outsourced services to drive up the level of median compensation. Conversely, in higher-pay sectors such as financial services the ratio might seem relatively low, reducing the incentive to moderate executive pay and locking in a driver of income inequality.
It seemed to us that there might be more effective ways to address the issue. Other metrics and pay-capping measures attracted our interest, including the rate of increase of executive compensation compared to that of other workers, comparisons to frontline positions deemed significant in the context of the company, and maximum pay differentials between succeeding levels of the company hierarchy. We also saw the potential for entirely different approaches to reducing inequality,including addressing disparity in employee benefits such as pension provisions, and living wage initiatives to set a floor for pay of the lowest-paid workers. We decided to pursue the outcome of equitable and moderate executive compensation through our corporate engagement program – but with an open mind as to how this might be achieved.
Since 2012 we have been engaging Canada’s six biggest banks (RBC, TD, Scotiabank, BMO, CIBC and National Bank) on quantum of executive compensation. We engaged the banks as a group, not only because their executives are highly-paid, but also because in Canada they are often first movers in corporate governance innovation. We did not ask them to adopt a particular metric, but to explore the risks of setting quantum primarily by horizontal comparison with pay at peer companies, and the potential to integrate vertical comparisons. In 2013, the banks agreed to work together on this, and several disclosed in their 2014 proxy circulars that vertical comparison metrics had been provided to the compensation committee as part of the decision-making process on executive pay. According to the 2015 proxy circulars, all the banks in this dialogue have begun to use some form of vertical comparison. We will continue to ask for more detail on these metrics, the trends they reveal, and how this information influences pay – in our view, disclosure on vertical benchmarking should have the same prominence as disclosure on horizontal benchmarking, and further disclosure would also support development of good practice in this new area of pay governance. Encouragingly, the 2015 proxy circulars reveal that quantum of pay for incoming Canadian bank CEOs has been set below* that of their predecessors. The compensation is still generous, and it remains to be seen if bank pay has been curbed for the long term, but reduced use of stock options makes windfall payouts less likely, and final pension arrangements will be significantly less generous.
We have also integrated vertical comparisons into our proxy voting practice. We wanted a consistent way to determine whether to vote against a compensation plan on the basis of excessive quantum, where
it has passed all other tests (including pay-for-performance, clearly-disclosed and appropriate metrics, and pay governance good practices). We were already analyzing whether CEO pay was equitable in relation to peer companies and to other C-suite executives internally. We decided to add a new guideline on high quantum, comparing CEO compensation to the Canadian median household income – an indicator that reflected our concerns about income inequality, as it relates to the financial well-being of typical Canadian families. The median household income is a concept to which the pay of all Canadian CEOs can be compared, no matter what sector they operate in, and we can calculate the ratio ourselves, even if the company does not provide equitable compensation disclosure.
We define a high quantum “range of concern” using multiples of the most recently-available data for Canadian median household income. If CEO total compensation falls in the range of concern, we vote against unless we find evidence that the company has adopted the kind of internal equitable compensation practices that we are promoting through engagement. Our rationale is that if a company pays allemployees well, it may be playing a small part in boosting the median household income in the economy as a whole. If CEO pay exceeds the upper limit of our range of concern, we vote against. Effectively,
this sets a cap on the quantum that we will support in a given year. In 2014, we shared the draft guideline with companies where we have been in dialogue on equitable compensation. One of the banks we have been engaging, Scotiabank, saw enough merit in the CEO-to-median household income metric to adopt it within its own vertical compensation analysis.
We don’t value vertical pay comparisons for their own sake. Our purpose in promoting them is to moderate pay and address risks associated with income inequality. The wider lesson we draw is that as responsible investment practitioners, we should focus on outcomes, and not be too rigid about the tools to achieve them. If stakeholders can reach consensus that something is a real issue, there is a good chance that constructive debate about solutions will follow.
Michelle de Cordova is Director, Corporate Engagement & Public Policy at NEI Investments.
*Report reference: McDowall Associates (2015) Are the Banks Changing the Compensation of their CEOs?