Are ESG-Supportive Institutions Addressing Income Inequality, The ‘Other’ Big Risk?

“I think it’s such a strange thing,

Giving me concern.

Half the world it got nothing,

The other half got money to burn.”

– “Luxury(Jagger/Richards), from the 1974 album It’s Only Rock ‘N Roll by The Rolling Stones

Investment firms of all shapes and sizes have been busy creating investment vehicles known as ESG-focused funds that in the last several years have attracted billions upon billions of dollars from investors looking to profit from companies that are seeking to address environmental, social, and governance matters in a constructive manner. No doubt some of the interest in ESG investing is due to the growing recognition of the existential risks posed by climate change and the need to address these issues in a timely manner. The many extreme climate events in the last few years show that we don’t need to watch movies like The Day After Tomorrow (2004) or the recent climate-change allegory Don’t Look Up (2021) to imagine the risks facing the planet.

While these funds target a range of ESG issues, most ESG-focused funds currently devote the majority of their attention to the environmental (“E”) part of the ESG triad. They often justify their investment in companies that seek to address environmental issues based on the theory that climate change poses a fundamental risk, in varying degrees, to all companies, which ultimately increases a company’s cost of capital. By embracing environmental policies that lessen these risks, so the theory goes, a company’s cost of capital would decline and the theoretical value of such company would increase.

It is thus very disconcerting to see income inequality, which has been understood for a long time to pose another significant risk to stability, growing even wider in the face of this surge of money ostensibly dedicated to achieving positive ESG outcomes. To wit, it was nearly 50 years ago that The Rolling Stones, in the above-cited verse from their outstanding 1974 song “Luxury,” noted with prophetic insight the manifestation of income inequality, an issue that has become more pronounced in recent years.

To illustrate the extent of this disparity, consider that according to recent IRS data compiled from individual returns, the top 1% of Americans had an annual income of about $540,000, which is over 12 times the median annual income of about $43,600, and according to the Fed’s most recent Survey of Consumer Finances, the net worth of the top 1% of households in the United States was approximately $11.1 million, over 91 times the median U.S. household net worth of approximately $121,700. This concentration of wealth has grown significantly over time, as according to recent research from The Federal Reserve, the top 1% of U.S. households now holds 31.3% of this country’s wealth, up substantially from 22.7% in 1989. Ponder this concentration of wealth and consider that a 2021 Fed survey indicates that 32% of all U.S. adults would not have the cash to be able to cover an unexpected expense of $400.

While there are various reasons why income and wealth inequality have exploded in the United States, the stratospheric pay awarded to members of the executive suite of public companies is believed to be one key factor. For example, see a report detailing CEO pay from the Economic Policy Institute dated 10/4/22, which provides extensive supporting data and notes: “[T]he escalation of CEO compensation, and of executive compensation more generally, has fueled the growth of top 1% and top 0.1% incomes, generating widespread inequality.”

More specifically, according to data from “Executive Paywatch” on the AFL-CIO website, the CEOs of S&P 500 companies received $16.7 million in average total compensation in 2022, which amounted to an average of 272 times that of what the median worker was paid at such companies. This represents a staggering increase of 518% versus a similar statistic from 1989, when, according to the aforementioned report from the Economic Policy Institute, CEOs at the largest 350 U.S. firms were “only” granted average compensation valued at approximately 44 times that of the average worker.

Not coincidentally, this skyrocketing executive compensation directly correlates with the massive growth of institutional investing, or the “fundification” of people’s investment dollars and retirement savings. According to the Investment Company Institute, 47.9% of U.S. households, amounting to over 108 million individuals in the United States, had invested in U.S.-registered funds in 2021. The end result of this fundification can be seen from data in a June 2022 paper by Jonathan Lewellen and Katharina Lewellen from the Tuck School of Business at Dartmouth College entitled “The ownership structure of U.S. corporations,” which notes that the percentage of all U.S. stocks held by institutional investors had grown to 73.7% as of 2017, up from 29% in 1980 as cited in a previous paper, reflecting a dramatic increase over the last several decades.

For nearly 20 years, the SEC has required that institutional investors disclose how they vote the shares of the companies which they own, including their votes on corporate pay packages known as “say-on-pay” votes, which are advisory votes on a company’s most highly-compensated executives that shareholders must periodically cast. Unfortunately, these voting records leave much to be desired. The organization As You Sow has for several years published a comprehensive and highly-insightful report on this topic, whose title in its trenchant brevity says it all: “The 100 Most Overpaid CEOs: Are Fund Managers Asleep at the Wheel?” The latest As You Sow report from February of 2023 seeks to explain it thusly: “The most overpaid CEO pay packages are approved by boards, elected by you – the investor – and the asset managers who hold their stocks in mutual funds and ETFs.”

Among other items, this latest As You Sow report highlights the voting practices of “The Big Three” index fund managers in terms of say-on-pay, namely BlackRock, Vanguard, and State Street, whose funds are believed to hold, when aggregated, more than 20% of the shares of S&P 500 companies. According to As You Sow, the largest U.S.-based fund manager, BlackRock, voted against only 5.7% of S&P 500 CEO pay packages submitted for approval by shareholders in 2022; Vanguard, the next largest U.S.-based fund manager, voted against only 4.8% of CEO pay packages at S&P 500 companies in 2022; and State Street abstained or voted against 9.6% of S&P 500 CEO pay packages in 2022. Or, to put it another way, some of the very largest institutional investors in the United States voted to approve well over 90% of the pay packages granted to the CEOs of S&P 500 companies in 2022. Contrast this general posture of acquiescence with that of many shareholder activist funds, who often strenuously (and usually rightfully) rail against excessive compensation awarded to the senior executives of public companies.

More broadly, another report, by Semler Brossy, noted that in 2022, the number of S&P 500 companies that “failed” their say-on-pay vote (meaning less than 50% of shareholders voted to approve a company’s executive compensation plan) was a mere 4.7%, and that the compensation plans at S&P 500 companies received overall support from 87.2% of shareholders on average.

The above serves to illustrate that, with all of the investment dollars allocated to professionally managed mutual funds and ETFs, an overwhelming percentage of these funds voted to approve of pay policies ultimately resulting in S&P 500 CEOs making an average of 272 times that made by the median worker in 2022. This seems to be quite at odds with the public, ESG-conscious image cultivated by many institutional investment organizations, particularly when considering the risks that income inequality can pose to stability. It would be helpful for these investors to consider the existential concerns voiced by a growing number of people regarding the danger that inequality poses to a functioning society. We don’t need much imagination to envision a country torn apart by a swelling mass of people suffering from the ill effects of inequality.

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