How to Pay a Bonus for Something You Can't Measure
(Bloomberg Opinion) -- Most people agree that executive pay should reflect their firm’s progress on diversity. That’s easier to say than to do. Measuring financial performance objectively is pretty straightforward, and scoring climate credentials isn’t the headache it once was. But rewarding inclusion will necessarily be subjective. It’s unclear investors are ready to trust corporate boards to exercise such judgement given their track record of excessive generosity.
Environmental, social and governance metrics already inform executive pay plans. That’s partly because businesses are under pressure to acknowledge their wider responsibilities — think of the U.S. Business Roundtable’s revised definition of corporate purpose, or BlackRock Inc. Chairman Larry Fink’s preoccupation with the same theme in his annual letters to corporate bosses. At the same time, there’s evidence that firms with higher ESG scores perform better as they benefit from a lower cost of capital.
Following the #MeToo and Black Lives Matter movements, this trend now dovetails with an increased emphasis on how well a company’s workforce represents wider society. Even private equity, an industry whose financial rewards are traditionally focused squarely on financial metrics, gets the idea. Carlyle Group recently divided $2 million between around 50 employees in recognition of actions that supported diversity in the buyout firm or its funds’ portfolio investments.
Policymakers are pushing on this front too. The Bank of England and the U.K. Financial Conduct Authority are consulting on whether to issue guidance about tying finance-sector pay to diversity and inclusion metrics. The BoE has already said it will do this for its own executive directors (without spelling out how) while a recent study by London Business School and PricewaterhouseCoopers found that around 7% of the annual bonus in executive pay for FTSE-100 financial firms is tied to diversity goals.
The snag is deciding what to incentivize and how to measure success. U.K. regulators say they don’t intend to prescribe exactly how firms should pay bonuses for advancing diversity.
As things stand, the approach to financial incentives in ESG is too narrowly based on quantifiable measures, largely because investors fundamentally distrust boards’ ability to evaluate pay, according to Xavier Baeten, professor of reward and sustainability at the Vlerick Business School. An all-encompassing evaluation is what's needed. While diversity can cover everything from ethnicity, LBGTQ rights and access for the disabled, the emphasis is often gender-related, such as the number of women in the senior management team, he adds.
“The challenge is you want more discretion,” says Phillippa O’Connor, head of PwC’s U.K. reward and employment team. “But that means shareholders need to trust the remuneration committee to exercise this appropriately.”
The backdrop is a history of boards awarding bonuses for mediocre financial performance. But setting targets purely on things that can be precisely measured isn’t the answer. A company may rightly consider addressing gender- and ethnicity-based imbalances in its junior workforce, only to realize that its gender or ethnicity pay gap would worsen (until it hopefully improves).
It’s inevitable that assessment must be largely subjective and against a mix of qualitative and quantitative inputs. For senior executives, the realistic approach is for the board to start by considering the company’s overall sustainability goals, diversity included, and form a view as to how the leadership has performed against them.
This is more likely to encourage changes that improve processes — such as ensuring recruitment is handled objectively and measuring staff progress throughout the firm — that make a lasting difference. Dutch lighting business Signify NV allocates 25% of executive directors’ long-term bonus to sustainability. The quantum is “at the discretion of the supervisory board” after considering a range of factors.
Carlyle’s recent awards are relevant here. They weren’t part of annual performance related pay; the recipients came from a long list nominated by peers. The only criteria was “going above and beyond.” It sounds woolly, but the lack of specificity captured a range of serendipitous actions, including surrendering a seat on a portfolio company’s board to boost its diversity. For private equity, making a payment tied to individual conduct, rather than the exit price of a deal, is a welcome innovation.
Improving diversity in corporations starts with establishing the right incentives at the top. That will require investors to cut some slack to board members who set executive pay — frequently the villains of the shareholder voting season. If this leads to a shift away from crude formulas to more intelligent judgements in bonuses more generally, all the better.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.
©2021 Bloomberg L.P.