Investors, proxy advisors, employees, the media and other audiences continue to show intense interest in executive compensation, particularly that of the CEO. While some focus on absolute levels of pay, most focus on how pay aligns with various measures of performance.
Perceived disconnects or misalignment between pay and performance are the most frequent driver of poor or even failing Say on Pay votes. If such concerns remain inadequately addressed, these can lead to negative scrutiny of boards and the compensation committees that approved these pay programs.
As a guiding concept, the importance of explaining pay for performance is clear. In practice, it gets more complicated. Definitions of pay include summary compensation table pay (often referred to as “SEC pay”), and various forms of realizable or realized pay. Definitions of performance include total shareholder return (TSR), whether absolute or relative to one or more peer groups or market indices; financial metrics (e.g., income, revenue, EPS, cash flow, return on capital or other industry-specific metrics); as well as achievement of strategic or operating goals.
In recent years, we have seen companies use virtually every permutation of these varied pay and performance definitions to demonstrate pay for performance alignment. However, companies are not the only ones telling their executive compensation story, and they are competing with other messengers that may obscure communications to their shareholders.
1. Companies. An increasing percentage of companies is discussing pay for performance in their proxies, and a smaller but also increasing percentage of companies is including one or more pay for performance graphs in their proxies. (Graphs 1 & 2)
2. Proxy Advisors. Both ISS and Glass Lewis compare CEO pay to peer company TSR, one difference being ISS employs GICS/industry group peers while Glass Lewis uses Equilar Market Peers, an algorithm that objectively determines peer groups by matching companies based on who they choose as their peers, and who chooses them as peers.
3. Investors. Each year more institutional investors, many of whom subscribe to one or both major proxy advisory services, also run their own pay for performance analyses, often using Equilar or other third-party data. This past year, RR Donnelley, Equilar and Stanford University jointly surveyed 64 institutional investors, with a combined $17 trillion in assets under management. These investors indicated that two of the top three topics of interest to them are pay for performance alignment and performance metrics. The third main topic is director independence—though that is not exclusively related to executive pay, many investors scrutinize compensation committees based on how their pay decisions align with company performance.
4. The U.S. Securities and Exchange Commission (SEC). In April 2015, the SEC proposed a new rule which, if and when approved, would require companies to show the relationship over a period of years between the pay of certain senior-level executives and the company’s TSR. Each company would also be required to compare, over the same period of time, its TSR with that of a company-selected peer group. Given the potential new rules on the horizon, it is quite possible that 2017 proxies will feature yet another way to demonstrate alignment of pay versus performance.
Context matters. Many of the proxy voters and governance heads at the largest institutional investors report that inclusion of some industry and business context at the beginning of the proxy is helpful to them. Some have even referred to this as a “mini CD&A.” Consider these readers to be governance generalists who have limited time and resources to research companies or their IR stories, as opposed to the portfolio managers responsible for making the ultimate buy/sell decisions. Despite this, these voters still want to vote in a thoughtful manner. To assist them in doing so, each year we are seeing more companies provide critical industry/business context in their proxies, whether in robust CEO and/or board chair cover letters, in proxy summaries or in the CD&A.
Explain how pay supports strategy. As you review your selection and disclosure of performance metrics, you may also want to review your company’s past IR messaging that influenced the initial investment decision. If IR disclosures identify certain value drivers, yet performance metrics in the proxy do not seem in sync with or supportive of these value drivers, investors may conclude “you told us X is important, yet you appear to be paying for Y.” Beyond disclosing metrics, companies should indicate why certain metrics are selected and why they are appropriate and incent the behaviors intended to drive shareholder value.
Compensation explained “at a glance.” Compensation is an admittedly complex and multi-layered topic, with its key elements typically described in detail over 10 to 15 pages of narrative in the CD&A. Not every reader is looking for the same information, and a layered or cascading approach, which goes from broadest overview to full detail, may be useful.
We are also seeing more companies employ one-page elements of compensation tables, identifying each principal pay element, its rationale/purpose, how this type of pay is earned (including any specific performance metrics), and even page references indicating where each element is subsequently discussed at length. The key is to make the proxy easily accessible and digestible for a broad range of readers.
Text versus graphic/visual presentation. Important information contained in sections of dense text can easily be overlooked. By definition, visual treatments draw the reader’s eye and are more likely to be located and digested. For instance, if you are describing a process, perhaps this information should take the form of a timeline. If you are listing peer companies or best practices, tabular or checklist formats may be most desirable. Similarly, call-out boxes, graphs, shading (for emphasis) and other design elements can further draw the reader to whatever content you consider most important.
While non-binding in nature, Say on Pay votes are not inconsequential. In addition, meeting SEC proxy disclosure requirements does not automatically mean you are meeting the informational needs and expectations of a majority of your investors. A good practice is to review not only the proxies of the governance leader companies that constantly innovate, but also of your peer companies.
While proxies are growing in terms of word length, with some of this additional length attributable to expanding SEC requirements, for many companies much of the added length comes from the all-important context or story-telling—the “why” in addition to the “what” of your company’s story. This additional context is critical in helping investors better understand the environment in which you operate, which in turn helps them to make more thoughtful, company-specific voting decisions.