Equity-based compensation in the form of stock options and restricted stock grants remains a popular means of diversifying employee pay packages. For CEOs and other named executive officers (NEOs), equity awards commonly account for the majority of total compensation, while rank-and-file managers typically realize a smaller proportion of total pay in equity. Nevertheless, the multitude of equity vehicles, vesting schedules and performance conditions allow companies to take a dynamic approach to cost and talent management as well as alignment of equity incentives with shareholder interest.
At a broad level, the prevalence of options grants declined over the last decade due to expensing requirements and investor concerns. Because proxy advisors do not consider options to be performance-based, and that options make a greater contribution to share dilution than restricted stock, some companies have shifted away from awarding options with an eye toward strong Say on Pay and equity plan support from shareholders.
Although options are dependent on stock-price appreciation, they are not inherently goal-based, and restricted stock grants made contingent on hitting performance targets have incrementally taken their place for senior managers. Performance stock grants have largely become a “check-the-box” exercise for large-cap boards. More than 80% of the 500 largest (by revenue) public companies in the United States (Equilar 5001) granted performance-based awards to their NEOs in fiscal 2016, according to the Equilar report Equity Compensation Trends, published with commentary partner E*TRADE Financial Corporate Services, Inc. (Graph 1).
There may be other factors at play in the trend away from options and toward restricted stock and performance awards.
“Stock options offer the potential for higher returns than restricted stock, but they can also wind up worthless in down markets, potentially for extended periods of time as stock prices recover,” noted E*TRADE in its commentary for the report. “A tumultuous 2015 for many sectors, perhaps due in part to political uncertainty and the potential impact on overall market performance in 2016, may have had some compensation committees rethinking their granting strategies. For example, in the highly competitive technology sector, where attracting, retaining, and motivating employees is a continuous effort, some companies may have elected to increase the grant value of restricted stock and decrease option grants.”
Once the compensation committee commits to granting stock-based awards contingent on hitting predetermined goals, determining the ideal overall pay mix may remain a challenge. About 65% of the average Equilar 500 CEO’s total compensation was granted as equity in fiscal 2016, though the mix of equity, or long-term incentives (LTI), shifted since 2012. In 2016, 60% of CEOs received over half of LTI value in performance awards, a 17 percentage point increase in just a four year period (Graph 2).
The remaining portion of the LTI mix remains highly variable, with about an equal number of companies pairing performance LTI with options, restricted stock or both. With proxy advisory firms preferring that companies grant at least half of LTI in the form of performance awards to their CEOs, the market has largely responded in favor of such practice, even as the grant-date value of equity awards outpaces the growth of annual cash awards. The median base salary for Equilar 500 CEOs climbed 10.6% between 2012 and 2016, when stock awards increased 43.5% in value at the median.
The shift in LTI mix is true for mid- and small-cap companies as well.
“Based on our proprietary data, the gradual increase of perfomance-based equity began soon after the passage of the Dodd-Frank Act in 2010, which, among other things, provided shareholders with more transparency into executive pay,” wrote E*TRADE. “While adoption of this type of equity compensation began slowly, it continues to increase year over year for mid- and large-cap companies and at measurable rates for small-cap companies. Our proprietary data show increases of 28% in large cap, 26% in mid cap, and 31% in small cap.”
The decision to award performance LTI and its overall standing in the total compensation mix only serves to trigger the often complex process of designing the specific award structures. Boards must understand the performance areas that will drive company strategy, goals and shareholder value.
Ultimately, shareholders have the right to voice a non-binding opinion on the overall structure of the company’s executive compensation program at the annual shareholder meeting in the form of Say on Pay votes. Say on Pay and the influence of proxy advisors has largely been credited with driving the usage of relative total shareholder return (rTSR) as a metric. RTSR comes with benefits and challenges. On the one hand, goal setting is simplified to pegging payout opportunities to percentile rankings within a peer group. On the other hand, rTSR suffers from “line of sight” challenges, whereby executives may lack the ability to directly influence stock price and dividends over a three-year period.
Nonetheless, half of CEOs at Equilar 500 companies who received performance awards in 2016 saw rTSR tied to their award’s payout—up from 43% in 2012. Leveraging rTSR in LTI awards displays wide variability across sectors, where three-quarters of CEOs at utilities companies received an rTSR award—most of any sector—compared to one-quarter of CEOs at services companies. Despite disparate practices in rTSR use, greater than 92% of companies in every sector received at least 70% support for their most recent Say on Pay proposals, excepting basic materials companies (Graph 3).
The 70% mark is viewed as a “bright line” test, due to additional scrutiny from proxy advisors and investors should support dip into the 60s or below. It should be noted that most compensation committees view Say on Pay support less than 90% as a warning from shareholders to reevaluate the pay and performance alignment resulting from executive compensation packages.
Although rTSR grew to prominence since Say on Pay votes began in 2011, the prevalence of use flattened at around 50% between 2015 and 2016 as compensation committees looked to other metrics to both provide line of sight to executives and drive strategy and value. This rethinking of TSR meant alternative choices were increasingly valid. Case in point, the second most common LTI metric, return on capital (ROC)—inclusive of return on invested capital (ROIC) and return on equity (ROE)—increased in prevalence by seven percentage points since 2012 to reach 35% of Equilar 500 companies in fiscal 2016. The ability of senior management to ensure returns on capital exceed the costs reflects their skills to execute strategically over longer time horizons. Research by Rivel Research Group and the Stanford Graduate School of Business indicates the investor view that ROC is a superior metric to link CEO pay and long-term company performance. Use of ROC, like rTSR, varies by sector, with financial firms leading all others at 55% prevalence when measured by inclusion of all LTI awards to any named executive officer (Graph 4).
Still, individual companies may reject the market trends as inapplicable, instead focusing on internal metrics. Boards that have difficulty setting longer-term goals with the necessary rigor often choose yearly goal-setting for financial metrics included in executive LTI awards.
Solutions on a case-by-case basis vary, and E*TRADE noted that “based on our proprietary data, non-financial business goals remain the highest performance-based metric type at 72% for mid- and large-cap companies, followed by TSR at 36%, and earnings at 32%.2 TSR use increased with companies administered by E*TRADE from year-end 2016 to June 2017, but many companies are designing plans that implement a secondary metric, evaluated annually, to drive specific business line performance. (In 2017, the average number of metrics used by companies administered by E*TRADE is just over two.)
“From this data, it is clear that compensation committees remain focused on setting transparent and realistic metrics that are aligned with shareholders values while motivating executives to produce results on business-critical goals.”
Since 2011, Say on Pay, proxy advisors and shareholders drove boards to link more LTI awards to predetermined goals and increasingly so as measured by rTSR. As the prevalence of rTSR flattens due to concerns that managers require more direct control over performance measures, alternatives such as ROC have come to the fore for a great many companies. With Say on Pay support at an all-time high in 2017, expect the focus on metric selection and rigor in goal-setting to sharpen.
1Equilar 500 comprises the 500 largest U.S. public companies (by revenue), and is weighted by sector.
2Data collected from the E*TRADE Financial Corporate Services, Inc. Equity Edge Online® platform as of June 30, 2017.
Matthew Goforth is a senior governance advisor at Equilar. He can be reached at firstname.lastname@example.org.