Growing concern over executive pay

Income inequality has been a long-discussed issue and according to Baeten, “there is a mental shift going on.” Traditionally, boards benchmarked CEO salaries against industry peers, aiming to stay slightly above the market average to attract top talent. This practice has resulted in a continuous upward spiral in executive pay. Baeten points out that companies are now broadening their perspective, considering internal wage structures and living wages in the supply chain.

Moreover, discrepancies in CEO salaries vary significantly across regions. In the Netherlands, for example, the average CEO of an AEX-listed company earns five times more than a CEO of a small, listed firm. “Is the job of a CEO in a large firm really five times more complex than in a smaller one?” Baeten asks. The answer is no, he argues, which challenges the justification for these wide disparities.

How peer groups influence executive salaries

One of the key drivers of rising CEO pay is the benchmarking process, with companies comparing their remuneration packages to those of their peers. According to Meijs, “companies often use different peer groups,” sometimes based on industry, country, or a mix of both. The choice of peer groups can be problematic, however. Baeten warns that long-tenured CEOs often influence the selection of their own peer groups, which could lead to “gaming the system” to justify higher salaries. To counteract this, he advises boards to refine their benchmarking process and consider multiple peer groups rather than relying on a single comparison metric.

What can investors do to limit excessive pay?

Investors play a crucial role in shaping corporate governance, yet they face challenges when trying to influence executive remuneration. Meijs acknowledges that large asset managers, whose own executives earn exorbitant salaries, may not see the need to curb excessive pay at investee companies. However, responsible investors can still drive change by actively engaging with companies and their remuneration committees.

Triodos Investment Management takes a structured approach to evaluating CEO pay. “We have two different thresholds,” Meijs explains. “We assess CEO remuneration adjusted for market capitalisation, revenue, and number of employees. If a company surpasses these limits, we then analyse the CEO-to-median-employee pay ratio. If that ratio exceeds 100:1, the company enters a deep-dive evaluation stage. If remuneration structures remain unjustifiable, we exclude the company from our investment universe.”

Interestingly, Meijs notes that all companies breaching their thresholds are American, reflecting the stark contrast in executive pay practices between the US and Europe. “In Europe, on average, the CEO-to-employee pay ratio is around 40:1 and at Triodos even way less,” he says, highlighting the significant differences in remuneration philosophy.

Redefining the structure of CEO compensation

Beyond pay levels, Baeten stresses the importance of reconsidering the structure of executive compensation. He points out that an overemphasis on long-term incentives can sometimes have unintended consequences, such as a narrow focus on its share price rather than a company’s broader performance. “We found that when the long-term incentive exceeds base pay, ESG performance actually declines,” he explains.

One alternative approach is to grant CEOs a base salary with shares they cannot sell until after their tenure. “That way, shareholder value and societal value go hand in hand in the long term,” Baeten suggests. Additionally, companies should reassess the key performance indicators (KPIs) tied to executive bonuses. He warns that certain KPIs, such as sales growth and total shareholder return, tend to have a negative impact on sustainability goals.

The impact of ESG metrics on remuneration

Companies have increasingly incorporated Environmental, Social and Governance (ESG) metrics into executive compensation plans, but their effectiveness remains debatable. “We did not find a strong link between ESG metrics and improved sustainability performance,” Baeten admits. One explanation is that companies are still in the early stages of integrating ESG indicators into pay structures.

Meijs agrees, noting that many ESG targets are qualitative rather than quantitative. “After a year, companies might simply declare that their CEO has improved diversity and inclusion, awarding full bonuses without clear evidence,” he explains. Furthermore, ESG metrics are often tied to short-term bonuses rather than being part of long-term incentives. This contradicts the long-term nature of sustainability goals. “60% of companies include ESG metrics in short-term incentives, only 27% do so in long-term incentives,” Baeten points out.

Future challenges and solutions

Looking ahead, both experts believe there is still much work to be done in creating a fairer executive remuneration system. Meijs sees challenges in reducing the overall pay level but believes investors can make a significant impact on pay structures. “Pushed by their stockholders, several companies have expanded claw-back provisions and reduced stock options, which helps curbing excessive risk-taking,” he notes.

Baeten, meanwhile, highlights the need for corporate boards to take a more fundamental approach to remuneration. He suggests companies should first define how they want to pay their executives, then decide what they should be paid for, and finally, determine how much to pay. “Too many boards blindly follow market practices without critically evaluating their reward principles,” he argues.

Ultimately, transparency and accountability remain key. Investors, employees, and the public deserve clear explanations of why executives are paid what they are. As Hans Stegeman aptly concludes, “It’s about complexities, transparency, and, in the end, being able to explain your policy to investors, board members, and everyone.”