Companies tying senior executive pay to shareholder return is the most effective governance and financial arrangement for corporations, according to a report by investment manager Schroders.
The argument, framed within the context of what produces the best governance, is written by Jessica Ground, global head of stewardship, and Marc Hassler, sustainable investment analyst at Schroders, and highlights that CEO pay/shareholder return alignment helps companies to achieve improved upside or reduced downside in their financial performance.
The report states: ‘Few governance debates have consumed as much energy, time and controversy as that on pay. With the exception of Australia, we have long been proponents of linking executive pay to total shareholder return.
‘While we acknowledge that this has its shortcomings – in particular, the risk that it can lift all boats in a rising tide and the share price is not totally in management’s control – we like its simplicity and the alignment with shareholders it creates. Our analysis provides an evidence base to support this over other structures such as net asset value and dividend growth.’
The report switches the role and focus of governance: ‘Shareholder alignment guarantees fair treatment of shareholders, effective board structures and alignment of stakeholder interests. Indicators within these three categories are included only if they show evidence of leading to an improved upside or reduced downside in a company’s financial performance. We are not focusing on good governance as an end in itself, but as something that leads to enhanced long-term investment returns.
‘This leads to a structure that first identifies indicators that are expected as a result of good corporate governance and filtering them based on their relation to financial performance and risk characteristics.’
In this way, the research questions the nature of good governance and how it is assessed: ‘For something so important, there is little agreement on what ‘good’ is. For example, the UK is often seen as a leader in corporate governance and has recently celebrated the 25th anniversary of its Corporate Governance Code – the first in the world.
‘[But] that did not stop Carillion, a major listed company, going into liquidation in 2017 following some serious corporate governance failures. Similarly, it has not meant the UK has outperformed other developed markets; indeed it has lagged the US, whose corporate governance code is conspicuous by its absence.
‘Academic and professional results on what manifests as good corporate governance are mixed at best and often much too context-specific to provide a general understanding. They rely on a tick-box approach that identifies the right policies, but are inadequate when assessing the quality of less easily observable issues.
‘Policymakers do not always help the debate by promoting endless rounds of new and improved codes, which imply that corporate governance is all about getting the correct formula. While codes evolve, the core issue they are solving remains the same: how to build sustainable and successful companies.’
Codes alone for Ground and Hassler, therefore, are not enough to guarantee good governance outcomes. ‘The very fact that codes evolve over time, with new innovations like board evaluation, diversity and stakeholder focus coming in during the most recent rounds, demonstrates that governance is sometimes difficult to codify.
‘Indeed, many codes are built around the principle of comply or explain, but the message many companies take away [from that] is comply or die, especially as corporate governance indices rise. There is a risk that in assessing corporate governance solely on inputs only encourages boards to turn their focus to window dressing rather than the business of good governance.’
