When executives were asked what would likely deter their board from pursuing an initiative that was expected to improve long-term value but diminish near-term financial performance, the top two factors were:
- High degree of uncertainty in the likelihood that the initiative will succeed
- A risk framework and appetite that is geared towards short-term shareholder return rather than long-term, inclusive growth
However, “lack of committed support and leadership from management” was much less of a concern for executives. This suggests companies have the willingness to pursue initiatives with longer time horizons, but need to improve their risk assessment and management capabilities to better understand long-term risk and the likelihood of success. In other words, it could allow boards to increase their risk appetite because they will have greater confidence about long-term risk-taking and the potential upside of doing so, including being able to explain it to stakeholders.
A critical function of boards has always been to understand and mitigate business risk – but the pandemic has brought that responsibility into sharp focus. Its unprecedented impact has highlighted the interconnectedness of risks and the velocity at which the landscape can change. In this environment, how can boards be sure that long-term risks – such as climate change – are appropriately forecasted and managed effectively across the organization?
Compensation schemes need a mixture of near- and long-term incentives to reward executives for generating sustainable growth. Coming up with the right mix can be challenging, but boards can consider the following guidance as a starting point to evaluate what is right for their company:
- The short game: companies can focus first on short-term plans, such as annual bonuses. This will allow them to get a feel for how the metrics are working and whether hurdle rates are reasonable. If adjustments need to be made, it is relatively easy to do this with short-term plans. Learnings from the short-term plans can then be applied to the design of long-term plans. If companies focus first on long-term compensation plans, it may be hard to course-correct if things are not working as intended.
- The long game: long-term incentive plans should be designed so that they use multi-year measurement periods. In our experience, three-year measurement periods are a common tactic. In some countries, there is increasingly an expectation that senior executives hold shares for a minimum period after they leave their firms, with two years being typical. Extending this principle to other countries can encourage executives to focus on the long-term consequences of the decisions they make.
Compensation schemes also need to alight on the right metrics, which can be challenging to both define and assess. Metrics related to ESG goals are an increasing focus. However, not all ESG metrics are relevant for all companies, and companies need to assess their strategy and determine which metrics are most relevant to them. This will vary by industry. Such metrics must be reliable if they are to influence executive remuneration, and therefore robust processes and controls will be required including board committee oversight.
Finally, there is the question of how much pay to tie to long-term measures. In most companies today, the percentage of executive pay tied to metrics that reflect long-term value is fairly modest. But, if companies are to change executive behaviour and drive long-term performance, they need to ensure that a meaningful portion of pay is at stake. Based on their experience, EY remuneration professionals believe that a range of 15-25% of pay connected to long-term metrics, with clear performance targets, would make a significant difference.
While stakeholder engagement is not a new topic, many organizations still struggle to bring the stakeholder voice to the boardroom table and really consider their feedback in decision-making. Therefore, it is worth taking another look at the building blocks that are required for effective engagement:
- As a start point, organizations need to define their key stakeholders. While there will be any number of potential stakeholders for a company, these need to be prioritized and boards need to be clear on who are the most important.
- Once stakeholders are identified, the next step is the engagement strategy. This has to take account of two factors. On the one hand, it is about getting the stakeholders onboard, to develop loyalty and buy-in. On the other, it is important that boards use the engagement to understand what is important to the stakeholders. In other words, this is about understanding their needs and how those factor into the board’s decision-making about what is required for long-term value creation.
- The engagement strategy should also be pragmatic. It may not be possible for the board to engage even with all key stakeholders, from suppliers to communities. Therefore, boards must decide who they engage with directly, and who they engage with indirectly through management.
- Finally, boards need to close the feedback loop. Getting feedback from a key stakeholder does not obligate boards to act in accordance with their viewpoint. However, there should be communication back to the stakeholder on how the feedback was considered, or else the quality of the relationship will deteriorate.
There is increasing focus on engagement between independent board members and investors. As a starting point, it would be valuable for this director group to hear more about growing investor expectations regarding long-term value and ESG principles. However, if directors are to engage more directly with investors, it is important that they buy into a long-term value/ESG approach and have a deep understanding of the subject. This will be critical to ensuring not only that boards play an effective role, but that a focus on long-term value and ESG principles is achieved across the company.