Morgan Stanley IM: Executive pay - “Show me the incentive and I will show you the outcome”

And we take the compensation process seriously, with our proprietary Pay X-Ray scoring system and established principles based on 20 years of talking to companies about executive pay.

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Modern capitalism suffers from the “principal-agent problem”, given the differing interests of the owners of assets versus the corporate executives who manage them. The executive pay industry, with its complex packages of bonuses and performance shares, has evolved to try to align the interests of the two parties.

The pay industry has certainly succeeded in increasing the rewards for chief executive officers, who the Economic Policy Institute claims are now paid 344 times as much as a typical worker, in contrast to 1965 when they only earned 21 times as much.¹ We would argue that there is still progress to be made in making sure that this extra executive compensation is matched by improved alignment.

As long-term investors, we want the companies our clients own to have pay plans in place that encourage longer-term thinking over short-term opportunism. After all, we agree with Charlie Munger’s claim that incentives drive outcomes. Our fear is that the wrong incentives, for instance excessive focus on earnings per share (EPS), can encourage management to take decisions that boost profits in the short run at the expense of their companies’ ability to compound over the long run. This may be a consumer company cutting advertising, or a firm making large acquisitions that, while “accretive”, i.e., boosting short-term EPS, deploy a large amount of capital at low returns. By contrast, when compensation is managed effectively, it aligns key decision-makers’ behaviours with the company’s objectives, encouraging better performance and long-term returns to shareholders.

As a result, we take the process very seriously, using our proprietary Pay X-Ray scoring framework to evaluate pay schemes, engaging with boards to improve them and voting against them where we are unhappy with the structures. Our attempts to effect change on pay schemes for the benefit of shareholders is helped by our well-resourced team and concentrated long-term holdings in the companies we cover. This allows us to invest the effort and time required to improve pay schemes, and to get the access to boards to make our case. We have recorded successes, often after years of discussions, proving that perseverance can pay off. After all, we have been talking to companies about how they incentivise their executives for over 20 years, long before the concept of environmental, social and governance (ESG) investing came to the fore.

¹ Source: Economic Policy Institute report on CEO pay in 2022. Published 21 September 2023.

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