Remuneration Requires New Knowledge

Remuneration Requires New Knowledge
Sustainable performance targets have an increasing impact on bonuses awarded to top executives. This brings new challenges, as emerges from the third masterclass on bonus policy held by Management Scope in collaboration with Deloitte. “Stakeholders do not hesitate to hold organizations accountable for their sustainability goals.”

In an increasing number of companies, the bonuses awarded to top executives reflect the sustainable ambitions of the strategy. Their bonus policies include both financial and non-financial performance criteria. This is work in progress, as demonstrated during the masterclass for members of remuneration committees on remuneration policy, held by Management Scope in collaboration with Deloitte. Members of the remuneration committees (or RemCos) of various stock exchange-quoted companies attended online. Three specialists in the field of European legislation and regulations, corporate governance and communication brought them up to speed on the latest developments. The inclusion of sustainability targets in strategy and bonus policy is a tricky business and regularly presents directors and remuneration committees with dilemmas. Aspects such as selecting the correct indicators and their measurability need to be factored in. This requires new knowledge on the part of directors and the RemCo. In addition, this knowledge helps to avoid reputational risks, because proposed bonuses for directors are increasingly being voted down at shareholders' meetings.

Consolidation in Standards
Many companies want to include sustainability indicators in their strategy and bonus policy. Vanessa Otto-Mentz, Risk & Advisory Partner and Sustainability Lead at Deloitte notes that in doing so, companies struggle to select the most appropriate indicators, as the range of standards is vast. “The range is changing due to consolidation and the metrics in the various standards are showing more and more similarities. The good news is that it will eventually become easier to navigate this landscape. We expect that within five years, there will be a single global sustainability standard.”
Until then, organizations should carefully select a sustainability standard that aligns with their strategy, their organization and their sector, and select associated KPIs that are used to measure and assess performance. But make sure you carefully select the information that you share, as it is difficult to have to backtrack on sustainability goals that the organization cannot meet but have already been publicly announced.
Selecting the right KPIs is easier for some organizations than others, notes one of the RemCo chairs present. “Climate-related KPIs are much more concrete for an oil company than for a software company. It is about defining what is important for your organization and your stakeholders in terms of sustainability,” says Otto-Mentz. She stresses that the importance of non-financial KPIs is set to increase. “Think about it carefully. Whereas, until a few years ago, many stakeholders took the information on sustainable performance for granted, this is now closely monitored. Stakeholders do not hesitate to hold organizations accountable for the selected sustainability goals.”

Dual Materiality
Otto-Mentz sees a major shift taking place within companies – from a focus solely on financial goals to dual materiality. Materiality is a measure that determines whether a sustainable goal is significant to a company. It helps companies establish their environmental, social and governance (ESG) risks and opportunities. In the current era, it is not only the climate risks on the sustainability of the company or the company itself that are referred to as “material”, but also the other way around, that is, the impact a company itself has on the climate. This is what we mean by “dual materiality”. Otto-Mentz says, “Business activities have an impact on the world. Organizations and regulators have to take an increasing responsibility for that impact.”

Learn From Accountants
Otto-Mentz highlights the need to define what is important to your organization and stakeholders. Members of the RemCo who want to use sustainability KPIs to shape their bonus policy can benefit from the working methods used by accountants. By means of position papers and policy documents, they clarify how decisions are made. They need to be transparent about how the organization addresses sustainability issues. Good bonus policy always begins with a strategy and a structure that encourage the desired sustainable behavior. This forms the basis for decisions regarding directors’ bonuses and means that bonuses can be explained to stakeholders more easily.

Ambiguity of Long-Term Value Creation
Companies are expected to act sustainably and put an increased focus on long-term value creation. In addition to profit, non-financial goals such as sustainability are top priorities. However, what long-term value creation exactly entails is often unclear, says Mijntje Lückerath-Rovers, Professor of Corporate Governance at Tilburg University, TIAS School for Business and Society. “It is a widely used buzzword; everyone has a rough idea of what it means, but they do not know what it means exactly.” The revised corporate governance code explicitly mentions the term but does not provide a definition. The code stipulates that director bonus policies should support long-term value creation.
In her research, Lückerath-Rovers noticed that many directors and Supervisory Board members find the concept of ‘long-term value creation’ to be a vague one. This is slowly changing, partly because of the unambiguous standards Otto-Mentz discussed, but she also envisages a key role for Supervisory Board members. “They are precisely the ones who can clarify what long-term value creation is. Directors and Supervisory Board members must be able to explain what long-term value creation means for their specific company and for all their stakeholders.”

Stakeholder Interests
The mission and core values of the company are key to any value creation model. In concrete terms, this involves making a distinction between economic and social value creation, and within that between internal and external value creation. That simple but effective matrix helps Supervisory Board members consider stakeholder interests. Internal economic value creation focuses on how the company adds financial value in its own business operations. “For example, by adapting a business model or implementing a reorganization that results in higher profits over time, you will have a potentially positive impact on shareholders but a negative impact on employees.”
Lückerath-Rovers emphasizes that Supervisory Board members must make considerations in this regard. An example of internal social value creation is improving working conditions for employees. The necessary investments may initially be at the expense of lower returns for the shareholder, but the company will perform better in the long term because people enjoy working there. External social value creation includes broader social issues such as product quality and doing business sustainably.
Such a matrix helps to determine which stakeholders benefits from the value created by the organization. Even more importantly, according to Lückerath-Rovers, it helps to answer the question whether sufficient value is being created for all stakeholders. She says there is still a lot of progress to be made. Take the study of the effect of long-term performance targets on the various stakeholders, for instance. “Over 62% of performance objectives focus on financial returns for shareholders. 20% relate to the continuity of corporate objectives. Only 18% of objectives focus on value creation for clients and employees.”

Best practices
The corporate governance code stipulates that bonus policies should support long-term value creation. Lückerath-Rovers acknowledges that this is a challenge for Supervisory Board members in practice. Take the AEX-listed company that includes various non-financial objectives in its strategy, only to have those objectives reflected in the bonus policy to a limited extent. In the remuneration report, only 20% of the variable bonus relates to sustainability. In practice, the percentage is even lower – the organizations use the scope offered by the bonus policy to adjust this percentage.
Although some companies still have a long way to go, fortunately there are also best practices available. Lückerath-Rovers says, “Within the AEX, there are four companies that consistently factor financial and non-financial KPIs into directors' bonuses. AkzoNobel, Besi, NN Group and Philips are real trendsetters. They include long-term value creation in both their strategy and bonus policy.”

Attention to Proposed Bonuses
Stakeholders are taking more interest in the directors’ bonuses. Frans van der Grint from Confidant Partners has noticed that the Supervisory Board is having increasing difficulty obtaining shareholder approval of proposed bonuses. At shareholder’ meetings of AEX companies last year, there were 43 controversial voting items on the agendas, with over 20% of votes cast against the proposed bonuses. Of those proposed bonuses, no fewer than 44% related to directors’ bonuses. Van der Grint says it is an urgent issue: “The majority of stock exchange-quoted companies must update their bonus policies by 2024.”

Van der Grint sees that Supervisory Board members and certainly RemCo chairs are becoming more concerned about this trend. And rightly so – shareholders and other stakeholders are taking an increasingly critical view of directors’ bonuses. Although only the shareholders have voting rights, other stakeholders do have an influence, especially at companies that face incidents. Van der Grint says, “The RemCo bases its bonus policy on long-term value creation. However, controversy surrounding directors’ bonuses is often related to short-term incidents such as reorganizations, fraud and environmental conditions. Everyone knows that the bonuses of directors working for Nederlandse Spoorwegen (NS, the principal passenger railway operator in the Netherlands) are scrutinized during snowy weather conditions.” RemCos need to ask themselves how they should address the major impact of this kind of short-term incident on long-term bonus policy.

Public Sentiment
According to Van der Grint, it does not help when public sentiment is barely factored into bonus policy. “As a RemCo chair, ask yourself who you have to explain the bonus policy to. It is usually only one or two stakeholder groups that the Supervisory Board probes, often shareholders and analysts.” But it is precisely in those controversial situations that other stakeholders such as trade unions and politicians establish public sentiment.
The Supervisory Board members present indicated that they increasingly factor public sentiment into their decisions, encouraged by proxy advisors, the voting consultancies. They assess whether the RemCo has sufficiently incorporated market sentiment into its bonus policy by contacting various stakeholders. Companies that factor ESG criteria into their strategy cannot avoid assessing public sentiment either. Also from a reputation management perspective – of which there are many examples – the Supervisory Board members allow the opinions of all relevant stakeholders to be considered.

Attention to the Pay Gap
Van der Grint says that the pay gap is factored into the decision-making process on directors' bonuses in the RemCo. The pay gap is the ratio that represents the difference between the income of the CEO and the income of the average employee. The corporate governance code requires stock exchange-quoted companies to publish these internal pay ratios, but the question remains as to whether Supervisory Board members focus on them enough. “After all, stakeholders do focus on them. For example, trade union FNV is managing to draw more attention to the Dutch version of the British Fat Cat Day – the day when CEOs have earned as much as their employees earn in an entire year.” The media present a confronting conclusion: top executives earn in just a short time what an employee earns in a year.
The Supervisory Board members present recognize the dilemmas. According to some, the pay gap cannot be closed in the short term. However, making it transparent certainly promotes discussions about the bonus structure applied throughout the company in terms of paying out more bonuses to employees, for example. Necessary increases in pay in the war for talent also reduce the pay gap. This is an ongoing process that absolutely deserves more attention in the future.

This article was published in Management Scope 03 2022.