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- [00:01]
Kurt Nickish
You're listening to Is Business Broken, A podcast from the Merotra Institute for Business Markets and Society at Boston University Questrom School of Business. I'm Kurt Nickish. Last week we kicked off a three part series on executive compensation. Today we're diving further into the voice that shareholders have in how executives are paid, including big institutional shareholders. What does that relationship look like between investors and companies and how does this affect CEO pay? Our guests today are Bob McCormick, he is the Executive Director at the Council of Institutional Investors, or cii. And Charlie Tharp, professor of the Practice at Boston University Questrom School of Business. Bob, thanks for being here. My pleasure, Charlie. It's great to have you back.
- [00:58]
Bob McCormick
My pleasure.
- [00:58]
Kurt Nickish
Thank you, Charlie. In that first episode we talked about executive compensation. How it's gotten so complex, how it's gotten so high and the reasons for that. And we also learned that there's no cap on executive pay and that largely shareholders approve of compensation packages as they're structured today. So today we're going to learn about institutional investors, a really influential group of shareholders and their role in this issue. How big are they? How much ownership of public stocks do they have?
- [01:34]
Charlie Tharp
Yeah, I can tell you that our members who are the public pensions have about $5 trillion under management. When we add in our members who are asset managers, that's another $60 trillion. So if you look at the largest investors of BlackRock, State Street, Vanguard Fidelity, that alone is probably close to $35 trillion, which the numbers are kind of stiffening.
- [02:01]
Kurt Nickish
Yeah, yeah, no kidding. And what percentage of public ownership are we talking about here then?
- [02:08]
Charlie Tharp
Well, there's some estimates that at least the big three, in some studies, the big passive index funds, I've seen studies that show they own between say 20 and 25% of the S&P 500 or even broader indices like the Russell 3000.
- [02:23]
Kurt Nickish
Wow.
- [02:23]
Charlie Tharp
In general, I would say, however, institutional investors probably own 70 to 80% of most public companies with the balance owned by retail or individual investors like you and me.
- [02:35]
Kurt Nickish
Right. If I have a 401k or a 403b, those institutional investors own, own my stock and are representing me. That's kind of phenomenal. They're huge shareholders. They essentially own most of these companies.
- [02:50]
Charlie Tharp
Yeah. I mean, particularly those that the index funds, in effect, you know, their investment thesis is to own the market.
- [02:57]
Kurt Nickish
I mean, you would think that they have just an enormous amount of influence over executive compensation. Is that fair to say?
- [03:05]
Charlie Tharp
Yeah. So in particular, with the advent of say on pay, which is a non binding vote on executive Compensation that we've had in place for over 10 years now. It has created the opportunity for shills to voice their opinion on the executive compensation program. And if companies see a weak vote, so to speak, then they'll usually reach out to the sherlocks and figure out what was driving that vote. And often the companies will feel some obligation to respond to those concerns. It could be about the performance nature of their long term compensation program, which is often inequity. We've seen a gradual move towards more and more performance based aspects in those programs away from time based. And this, these are kind of generalizations, but that has kind of been one specific impact, what we call engagements, that is meetings in between the companies and the investors, particularly on compensation.
- [03:58]
Kurt Nickish
I mean, so Bob, your organization is sort of a trade group that coordinates efforts and policy among all of those members, all of those institutional investors, works on best practices, et cetera. It's almost like they're so big, it's almost like they're policymakers deciding how something is done across the economy. It's almost as influential as regulators, it sounds like.
- [04:23]
Charlie Tharp
Yeah, but they don't always agree. They may feel that in some cases options are a great sacred compensation tool for certain emerging companies or tech or biotech, where the cash flows may be more limited initially, whereas others may favor purely time based awards that pay out over a longer period of time. So even though they, you write in terms of the size of their position gives them significant influence because they don't always agree. Companies need to digest what they're hearing and respond accordingly. And that's really the role of the board as fiduciaries is to be cognizant of what chillers are thinking and respond accordingly. It can be a bit of a challenge if the board is hearing different things from different shareholders.
- [05:07]
Kurt Nickish
Charlie, we discussed last week how the Dodd Frank act requires public companies to hold non binding shareholder votes on executive compensation. You know, you said that shareholders seldom vote against the board's recommendation. Does the same go for institutional investors then? Basically, yeah.
- [05:24]
Bob McCormick
In fact, with institutional investors, companies are very conscious of having what Bob referred to as engagement and outreach to their institutional invest investors. They don't want to be surprised that when they issue their proxy statement, they hear that an investor, especially a large investor, has problems with the design of their compensation program. And just to put a finer point on the ownership, as I look at proxies, the ownership by any individual institutional investor for most big companies is probably in the 5 to 10% range. And so they'll have you know, maybe 10 companies that might own 30 to 40% of their companies, maybe 50% and those they will pay the most attention to and make sure that they're having regular engagement and really benefiting from their perspective on not only compensation but other issues that come up in the company. But just another fine point on that, they can't really tell any of the investors what they're thinking about doing. They can only talk about what's already been publicly disclosed. So the dialogue is really one of teeing up an issue and companies listening because they can't tell one investor what they don't tell all investors. They would have to have that as a public disclosure. So it's usually a listening tour on part of companies.
- [06:54]
Kurt Nickish
Why engage? What are they afraid of? If they don't take those wishes and concerns of institutional investors seriously, if they.
- [07:04]
Bob McCormick
Don'T at least pay attention to the views, they could lose a say on pay vote. Although it's non binding, directors pay a lot of attention to that vote. And secondly, you know, directors rent their reputations to companies and if they're standing for election and they get a very low vote from shareholders to be reelected, and most boards elect all directors each year, they don't have staggered boards anymore where only a few of the directors up. So. So there's also a bit of reputation, personal reputation that is important to them.
- [07:36]
Charlie Tharp
Yeah, I was going to say on the engagement front you may say, geez, the proxy statement's 100 pages long and there's 45 pages of CDNA. Like what more information can a company provide? Right. But it is amazing the nuances you glean from an engagement. Having served as investor and advisor to investor and help companies prepare for the engagements. It's some of those nuances that really tip the scales in terms of investor being able to support the program. Either a trust in the compensation committee members if they've met with them, or understanding how challenging performance metric is. And that's an important point because when an investor looks at a proxy statement, they'll see what they call a summary compensation table and it breaks down the salary, the annual bonus and then long term compensation. Well, the long term compensation is usually a form of equity and the valuation of that is based on a, a Black Scholes or other estimate which could be wildly inflated because of the inputs. And also, most importantly, some of those awards may never actually vest because if they're tied to performance criteria, the criteria are not met. That means the executive actually doesn't receive any of that award or much smaller portion than it may appear at first blush. So by having those engagements, it helps the investor making the voting decision understand how challenging those performance metrics are. And they also want to know how is those performance metrics tied to the strategy that comes Take the long term strategy. So all these opportunities to have more dialogue, it's really management's the companies and boards favor because it eliminates any potential misunderstanding on the part of investors when they actually go to make their voting decision and think about, well geez, how do I value this compensation program and how difficult is it to achieve some of these objectives?
- [09:25]
Kurt Nickish
Yeah, so we're discussing this whole process of engagement around this one question of executive compensation. How does that conversation go? Like what are investors thinking about as they look at a proposal and what are companies kind of factoring in and how does that conversation go?
- [09:45]
Charlie Tharp
So the main point is compensation can be very complicated. However, it's also very transparent because you can see the numbers. And then what most investors really start with is are the compensation program amounts commensurate with the performance. Pay for performance is kind of the fundamental thing that shareholders are really striving to understand and how does that actually work? So when they see high levels of compensation but really good performance, they're not going to be concerned. It's really where they see that big disconnect which is a very large payment or continued large payments, particularly if they're discretionary in the form of a bonus however, but the company is struggling in terms of their own performance. That's really what where investors sort of.
- [10:27]
Kurt Nickish
Initially look at and break that tension out a little bit. Like what can happen in that situation? Because it seems, you know, just on the surface it could seem unwarranted that there's a bonus like that, but it, but it might be justified.
- [10:39]
Charlie Tharp
Absolutely. So then the next step is that bonus may be tied to very challenging performance metrics. And therefore Shillers may say well this is a bit of a stretch to reach these targets. I'm going to support this program recognizing that if these targets are met, then we'll all do well, including the, you know, the shares you held. But the second part of the analysis is, all right, you look at the time between pay and performance, but then the next pivot is to the structure of the program. And if they feel that even if this a potential disconnect between the pain performance, if the structure looks really strong, meaning very long term performance period tied to those challenging performance metrics I talked about that they may feel like the structure strengths make up for potentially a weaker tie between pay and performance and therefore we should support it.
- [11:27]
Kurt Nickish
Are there provisions that, I don't know, companies love and investors hate, or investors love and companies hate? Like I just wonder how far apart this marriage has to come together.
- [11:39]
Charlie Tharp
Yeah, I mean a couple examples of that is where there's a lot of discretion built into compensation programs. Investors really want to understand how that's how that's used. Are there any performance aspects to that? Are there any guardrails around that? So like a purely discretionary program usually raises some red flags.
- [11:56]
Kurt Nickish
Gotcha. And then what displeases companies in this process?
- [12:00]
Charlie Tharp
I would say that companies get frustrated when they expects sharelists, one size fits all approach. If they say, well, we have a program that doesn't fit neatly within a set of policies, particularly the proxy advisors policies, which they use a bit of a, use as a bit of a proxy pun intended for how investors think, although it's not necessarily completely accurate. And they want to design a program that actually makes sense for the company, but they feel constrained by having to meet these external standards. So that, that can be really frustrating for companies. And again, that's where the engagement can help. They may have a program that is very different than most companies. So for example, this equity program is solely time based in the form of 10 year vesting stock. So it doesn't have any performance characteristics to it. So most investors would sort of initially give that a red flag. We don't like this because it doesn't have any performance aspects to it. However, that opportunity for the company to engage and explain to investors how successful this has been for the company makes them very long term. It actually invests to after the executive leaves the company. So it promotes good succession planning. It's those situations where a company needs to kind of make a case, so to speak, for why their program is designed in the way it is. And, and for the board, you know, it's their role to design a good compensation program. And I think they get annoyed when they design a really good program they found to be effective and shareholders don't see it as matching what they're typically looking for. And that's where that dialogue can really help.
- [13:36]
Kurt Nickish
So how much does public opinion or media scrutiny play in shaping how institutional investors manage executive pay? I mean, we heard last week from Charlie that, you know, largely shareholder support executive compensation packages and they kind of think they're justified at the levels that they're at, largely just based off of how they've voted. But a lot of the public thinks that CEOs are paid too much. So I just wonder how much media scrutiny, public opinion sways institutional investors and their ownership say in how companies are run.
- [14:15]
Charlie Tharp
I would say the public reporting and sort of public sentiment has very little impact on investors views. The people making the voting decisions are very experienced on these issues and they are comparing thousands of companies. So it's not as if they're going to be made aware of a level of compensation or type of compensation that they might not have otherwise been aware of. And in some cases the numbers used are like headline numbers, the summary comp table, but they might not actually be what the executive ultimately receives and the sophisticated investors can appreciate that and therefore they might not be swayed initially by a high number that may never actually be paid.
- [14:58]
Kurt Nickish
Charlie, you were nodding there.
- [15:00]
Bob McCormick
Yeah, I think the institutional investors I've interacted with is they kind of look to the board to make those sort of decisions based upon competitive data and what they've disclosed in terms of the process for how they do decide the level of, in terms of peer groups, in terms of the mix of short term and long term. So I think institutional investors are probably as less concerned, unless of course it were just way, way off the chart. Although there was a pretty high shareholder approval of Elon Musk's pay. But having said that, I think they focus more on the structure and things like take ESG or DEI subset of ESG that, you know, it's a small part of pay. But sometimes pay isn't so much about incentives as much as it's about communication. And to include those sort of metrics is a way for companies to communicate to investors and really the public at large that it's important, and it's so important they're willing to put part of their senior management's pay on that issue.
- [16:08]
Kurt Nickish
There's a really interesting dynamic here that you're, you're explaining between institutional investors and company management and boards. What are some trends in the ways that institutional investors are looking at compensation? Like what are some of the growing realizations in best practices and some of the emerging things that you think we'll be seeing more of in the years to come?
- [16:34]
Charlie Tharp
Well, I've talked to some of our full members and associate members usually and asset managers. And there's some initial rethinking of how long term equity works. Historically there was a strong push to have at least a three year performance period. At least a majority of the long term equity should be performance based as sort of a baseline. I think there's a reevaluation now as to Whether that is really appropriate for every company and it leads to more towards a potentially more, I know, case by case or pragmatic approach of while that may be a good approach, it's not the right approach for every single company and therefore a time based approach for certain companies and maybe very long term developing projects maybe as appropriate or even more appropriate surely performance based award. And I think therefore it calls for more flexibility in implementing policies when you're looking at design of particularly long term equity.
- [17:35]
Kurt Nickish
So this is one place where over with the experience of years and more research into how these compensation packages have actually performed as positive incentives, institutional investors are trying to tweak them more in those ways to be more productive.
- [17:55]
Charlie Tharp
Yeah, I mean, one of the challenges for investors is that they are following literally thousands of companies so they can only spend so much time on each company. So what is happening is when they are able to triage and filter out the companies that may look like outliers, they're spending more time with those companies rather than. So rather than spend like a little bit of time with a lot of companies, they're spending more time with a smaller subset.
- [18:18]
Kurt Nickish
And these are the really successful ones or the poorly performing ones.
- [18:23]
Charlie Tharp
It is those that are either poorly performing or may have raised red flags based on some of the initial filters Charlie was talking about. So it may be that they want to look more closely at what is driving some of those red flags and they may ultimately be satisfied that yeah, this, this makes sense for this company, but it gives them the opportunity to kind of roll up their sleeves and drill down deeper into the issue rather than rely on a more cursory review of, you know, thousands of companies that can focus their efforts on a few hundred and really get to know the companies.
- [18:54]
Kurt Nickish
Ever gotcha. So a bit of a conforming influence there.
- [18:58]
Bob McCormick
Yeah. It's interesting too because the common approach is a three year performance based equity award as an example. But if you think of certain industries, take pharmaceuticals, how long it takes to go from a compound to a potential receptor to testing it in animals, up to people and all that, seven years maybe. If you look at an extraction oil company as an example, you dig a hole in the ocean or in land and then how long before it ends up in someone's gas tank? So for many companies, their sort of product cycle and their production cycle probably doesn't fit well with a short term three year cycle. The other is there are certain industries that are very cyclical. Caterpillar, John Deere, construction equipment companies. And to think of three years is probably a pretty short term for them. So tailoring, sort of the, the time horizon of compensation and the performance that would produce it is going to vary by company. And you know, different companies have different ways of creating competitive advantage. Some are really in terms of intellectual property, some are in terms of quick turnaround of product introduction like software or, or fashion or something. So having one size fits all, which is very convenient for analyzing companies quickly may not make a lot of sense in terms of how pay can help reinforce strategy and the appropriate cycle over which to measure true performance.
- [20:38]
Charlie Tharp
To just elaborate that one, if you're say AI, three years is a lifetime, it's way too long to evaluate the companies. So there's I think a recognition, a more pragmatic, realistic approach is to look at each company and better sense of what makes sense for that company. And it requires the company to provide some disclosure about why they've chosen a certain performance period or a performance metric or performance vehicle. Again, that gets back to the disclosure and ultimately to help kind of flesh out thinking.
- [21:12]
Kurt Nickish
I mean, anybody who's listening to this, hoping that there was going to be significant downward pressure on executive compensation is getting more of a picture of the dynamic pay packages that are trying to be shaped in the most productive ways. It sounds like institutional investors are influencing these pay packages in ways that are optimized but aren't really significantly changing the overall amount or bringing what some people see as exorbitant pay packages down. Is that fair? And just how, how do institutionals justify that, I guess?
- [21:48]
Charlie Tharp
Well, I think with the advent of cp, most investors didn't see as a means to, you know, rein in excessive executive compensation. They saw it as a means to improve disclosure and structure of compensation programs. So and I think that has been successful certainly in the significantly better discussion of compensation programs, design, selection of features, et cetera. And the structures have really improved in terms of providing more of a closer tie to strategy. But for most investors, I don't think there was an expectation these steps would lead to lowering executive compensation. They were more kind of realistic that that was not, not really going to happen.
- [22:31]
Bob McCormick
Yeah, I think the, perhaps the people who wrote some of these rules, the politicians, you know, that were maybe some of the motivation of Dodd Frank, some of the provisions like the pay ratio, maybe they thought it would have an impact of lowering pay as with many competitive markets. And as Bob pointed out, the CEO pay market is incredibly transparent. It is very competitive for the top talent. And when there's an opening in a large company, it's quite A search to get someone that can really shepherd, especially a company that needs a turnaround. And so, you know, merely disclosing pay won't make it go down because most companies have to compete for talent in a very transparent market. And that tends to mean you're not too far off of what the median is of what similarly sized industry competitors pay.
- [23:26]
Kurt Nickish
Bob, what's the biggest misconception that people have about institutional investors and their role on executive compensation?
- [23:34]
Charlie Tharp
That investors are monolithic in their views, even within a certain type of investor, that is index versus active versus public pension, there's a significant range of views. And companies that tend to assume that they've talked to one investor or one type of investor, they speak for large group investors will be surprised to learn that that is not the case and therefore they really need to talk to a broader group of their investors.
- [23:59]
Kurt Nickish
And Charlie.
- [24:00]
Bob McCormick
Yeah, no, I echo that. And the engagement I've had with investors, you, you know, they focus on very different things. And like ESG as an example, historically that's been viewed through the lens of risk, that this introduces a risk in my portfolio if they're polluting the Hudson river, if they're bearing chemicals or something. And now it's a mix of that plus the sort of image of the company in the eyes of consumers, in the eyes of other investors, in the eyes of potential employees, especially some of the graduates coming out of school are very focused on social issues. So I think there's this blend not only between investors, but it's changed over time, too. There's been an evolution of how investors think not only about pay, but some of the positions that companies take.
- [24:52]
Kurt Nickish
Well, Bob and Charlie, this has been really helpful and illuminating. Thanks for coming on the show to talk about it.
- [24:59]
Charlie Tharp
Thanks for the invitation.
- [25:00]
Bob McCormick
Yeah, thanks for doing this.
- [25:07]
Kurt Nickish
That's Bob McCormick and Charlie Tharp. Next week, we continue our conversation on executive compensation and dive into what we're learning from the latest research. To what extent are CEOs being compensated for lucky events just because they happen to be running the right company at the right time? Have executive pay packages gotten too complex at this point? And is CEO compensation encouraging the right kind of risk taking? Do they get rewarded for those? That's next week. To get that episode and more, please follow the show on Apple, Podcasts, Spotify or wherever you listen. Thanks for listening to Is Business Broken? I'm Kurt Nickish.