ESG materiality | Analyzing the growing role of ESG factors in executive compensation

Katherine Collins, CFA, MTS, Head of Sustainable Investing, 08/24/23

In a potentially positive trend for investors, the number of companies incorporating ESG metrics in their executive compensation plans has been growing.

In a new research paper, Management incentive compensation: Trends, observations, and value to fundamental research, we explore the importance of assessing management incentives, the characteristics that can inform incentive plan analysis, trends in how compensation plans have evolved over time, and considerations of emerging issues.

Understanding corporate incentive pay structures helps investors to assess the alignment of management compensation with shareholder and stakeholder interests and to better understand motivations that drive management decision-making. In our research, we highlight a number of individual company examples to bring these issues to life within a specific context. By examining the structures of long-term and short-term incentive plans, we believe that investors can gain insights into strategic priorities that drive long-term financial performance.

Our research conclusions note the following points:

  • Management incentive compensation has evolved over time.
    It has become more performance based. In 2020, 94% of S&P 500 companies utilized performance-based share plans. It involves more metrics today, going beyond total shareholder return and incorporating more ESG metrics. The level of CEO compensation has also grown, with average realized pay of CEOs reaching $25 million in 2020. This represents an 8% compound annual growth rate over 11 years.
  • Putnam's analysis focuses on understanding the structure and composition of incentive plans.
    Effective plan structures have relatively longer time horizons, a performance basis, reasonable compensation levels, and clear, consistent terms, in Putnam's view. Performance metrics that are well composed are business relevant, appropriately ambitious, and financially material.
  • Business-relevant ESG metrics in incentive plans can potentially be additive, when done in a way that emphasizes key attributes of relevance, additionality, specificity, and ambition. The number of companies in the S&P 500 Index that use ESG metrics in incentive compensation plans has more than doubled over the past decade. Companies held in Putnam's sustainable portfolios are also incorporating ESG-linked compensation plans more often than in the past. We highlight some examples in the paper.
  • Improving governance and incentive data can help us better understand motivations for executives and top-level management.
    There is growing data available on average CEO pay relative to median worker pay, on broader employee ownership models, and on the effectiveness of stock-based compensation models. We are interested in new ways of assessing stakeholder alignment and new approaches that foster strong long-term performance, some of which are featured in the report.

Well-crafted incentive programs, in our view, can align management teams with the long-term performance interests of shareholders and relevant stakeholders.

The importance of holistic analysis

For investors to gain a comprehensive understanding of management incentives, it is essential to combine this research with a company-specific understanding of other governance elements, including management team composition and expertise, track record, and strategic business context. As fundamental investors, our goal at Putnam is not to label incentive plans as "good" or "bad," but rather to gain insights into the motivations influencing corporate leadership's actions and the potential impact on long-term financial returns. By combining this analysis with our ongoing fundamental, sustainability, and valuation-based research, we can make more fully informed investment decisions for our clients.

link to report

* Based on HOLT data and Putnam analysis.