Tying Diversity Metrics To Exec Pay—A Governance ‘Best Practice’?

Almost a quarter of businesses are tying diversity goals to executive pay. Exploring how this approach might help improve a company’s diversity efforts could lead to significant benefits for all stakeholders.

It appears more companies believe that using financial incentives can help to improve diversity at America’s publicly traded companies? According to a recent report from compensation consultant Equilar, more corporations are tying executive pay to diversity metrics. The report found that of the 61 metrics Fortune 100 companies used to tie executive compensation to environmental, social and governance concerns, 23 percent were related to diversity.

By using diversity metrics to incentivize pay, it appears corporate boards are reacting to the increased interest in promoting diversity, equity and inclusion across many aspects of society. They may also be reacting to the increasing pressure from regulators, institutional shareholders and advisory firms to diversify boardrooms. This trend may also indicate that boards are recognizing that stakeholders are demanding that diversity play an important role in the company’s operations and that there will be efforts to hold company executives accountable for failing to reach certain diversity-related goals for the company. More than likely, aspects of all of those reasons are contributing to corporations tying executive pay to diversity metrics.

The Equilar report points out that in order for the incentives to be effective, companies need to “create measurable goals” that “correspond to areas of executive impact.” But doing this leads to many questions: how do you measure diversity? What power do executives at different levels have to improve diversity at a company? How much (and what type of) diversity is right for a company?

These are difficult questions for sure, but ignoring or finding ways to work around them is not the answer. How would a company attempt to work around these questions? The Equilar report offers some clues:

“Some companies will disclose that they incorporate ESG metrics into their incentive plans but not give much detail. The majority of these metrics, while taken into consideration for executive payouts, are not quantified. Often the achievement of these goals (which are frequently vague) is a matter of discretion, rather than calculation.”

By failing to disclose details about how the company intends to approach improving its diversity, and by appearing to leave executive payouts for diversity goals up to “discretion,” the board could be leaving itself open to criticism from stakeholders and regulators.  Institutional shareholders Blackrock, State Street and Vanguard have threatened to vote against directors that don’t support board diversity measures, states such as California and Washington have threatened to fine companies over diversity issues and Nasdaq has proposed delisting companies that fail to diversify their boards – so it is becoming harder for boards to escape accountability on this issue.

The Equilar report contains examples from company disclosures that can give boards ideas on how they might want to approach tying diversity goals to executive pay if they haven’t formed clearly defined policies. Boards can also engage with their largest shareholders to get an idea of what type of measures they would like to see the company adopt regarding tying diversity goals to executive compensation. Proxy advisory firms ISS and Glass Lewis also have guidance on this. Boards know this information already, so the question is how are they using it?

Boards may want to consider that not dealing with diversity issues may present real risks to the company. In addition to the threats from institutional investors, state governments and regulators previously mentioned, the company may be at risk of receiving shareholder proposals demanding aggressive moves to diversify the board and the company’s workforce; the company could be at risk of receiving backlash from consumers that view the company as being unfairly biased against underrepresented groups; business opportunities might be at risk because other companies might be reluctant to deal with a board that appears to reject diversity.

Using financial incentives to motivate executives to improve performance is practiced in other areas of corporate business, so developing incentives that work to improve diversity shouldn’t be much different. Doing this requires a commitment to diversity and requiring compliance from executives. The trend indicates that almost a quarter of businesses are tying diversity goals to executive pay, and that percentage is expected to grow. Exploring how this approach might help improve a company’s diversity efforts could lead to significant benefits for all stakeholders. If companies that tie diversity performance to executive pay are indeed seeing positive results, then maybe governance advocates should consider making it a best practice.