Executive compensation design has evolved considerably over the past decade. In particular, the introduction of Say on Pay in 2011—the mandatory shareholder advisory vote on executive compensation—has heightened the degree to which shareholders hold corporate boards accountable for executive pay decisions. Balancing a response to external pressures and their duty to attract and retain quality leadership, boards have initiated strategies to reward executives for their direct influence on both company performance and shareholder value creation.
Resulting from these trends, pay-for-performance strategies have altered long-term incentive (LTI) design for top C-suite executives. For example, over 82% of Equilar 500 CEOs received a performance grant in fiscal year 2016, and the percentage of Equilar 500 CEOs receiving at least half of their long-term incentive values based on performance awards increased from 33.3% to 60.8% from fiscal years 2012 to 2016 (Graph 1). Meanwhile, the prevalence of time-vesting stock option grants among Equilar 500 CEOs fell over 10 percentage points in that time frame.
The costs of achieving pay-for-performance balance are potentially high, and the benefits of optimizing LTI design are potentially great for executives and investors. As a result, boards have implemented processes to maximize these benefits. To design a single LTI award for its CEO, a compensation committee must consider then select appropriate performance metrics; decide the amount of influence a given metric should exert on the final award payout (its “weighting”); set minimum, target and maximum goals for each metric; and finally map those goals to payouts. This process has become a year-round endeavor and is taken lightly by neither boards nor corporate shareholders.
“Executive compensation remains a high-profile and sensitive issue for companies, and the required public Say on Pay vote and codifications of voting guidelines by governance groups may make it more difficult for companies to experiment with unique plan designs,” said Kelly Geerts, Director of Advanced Solutions at E*TRADE Financial Corporate Services Inc., in commentary for the recent Equilar report, Executive Long-Term Incentive Plans. “As a result, we continue to see companies rely on standard performance metrics while adjusting the mix of targets and weighting within overall compensation.”
One benefit to performance awards historically has been the ability for companies to deduct compensation in excess of $1 million from corporate taxes. In 1993, the amount of compensation that corporations could deduct from their taxable income was capped at $1 million for select executive officers (the CEO and the three highest-paid officers, excluding the CFO). The then-fresh change to the tax code came with a loophole. If the compensation was considered performance-based, it was exempt from the rule and could be deducted—even if the executive received compensation in excess of the $1 million limit.
In December 2017, the bill originally known as the Tax Cuts and Jobs Act was signed into law and, among other changes, ended the performance-based exemption to IRC Section 162(m).
At face value—especially given recent trends toward performance pay in executive compensation—the reduction in tax-deductible compensation is significant. Equilar found that Russell 3000 companies had been eligible for a total of $92 billion in tax deductions under this provision and would have included an addition $13 billion if CFOs had been included under 162(m) (Graph 2).
On a per-company basis, the value of deductible compensation widely varied based on size. Because larger companies are more likely to offer performance-based equity awards to their executives (and those awards are likely to be larger given higher-valued shares), total deductible pay increased in direct proportion to market cap by a considerable margin (Graph 3).
Despite the absence of these potential tax credits, we shouldn’t expect to see performance-based compensation going anywhere any time soon. As an example, Netflix made waves in the executive compensation world shortly after the Tax Cuts and Jobs Act went into place, announcing that it would shift all of its bonuses to cash compensation. There was speculation initially that many companies would follow suit, but it turned out—at least so far—this was an anomaly, not a trend.
“It’s helpful to keep in mind when you’re talking about 162(m) changes that an increase in cash or time-based compensation could be a red herring,” said Nathan O’Connor, Managing Director at Equity Methods, during a recent Equilar-hosted webinar. “Companies do not grant performance equity to get a tax deduction. They do so because shareholders really want strong performance.”
In other words, no matter what happens with tax deductibility, the momentum of tying pay to performance is much bigger.
With pay-for-performance trends likely to continue on their current track, the question then becomes how compensation is structured and eventually paid out. And while there are some common best practices, there’s also a lot of flexibility available to corporate boards when making these decisions that will ultimately benefit their shareholders. Over the past decade, executive compensation has become more closely tied to corporate performance goals, in contrast to “pay-for-pulse” strategies that would award CEOs solely on keeping their jobs. Time-based awards remain an important balancing agent for executive pay packages, but the bulk of stock awards are now provided with payout only occurring when specific performance goals are met.
Viewed through the lens of creating shareholder value, the design of executive long-term LTI awards has shifted to prominently feature total shareholder return (TSR). This is often measured relative to comparator companies (relative TSR, or RTSR) as a performance metric to determine payout levels of incentive awards.
In fiscal 2012, 43.4% of Equilar 500 CEOs received performance LTI tied to relative TSR performance, a figure that rose to 52.0% in 2016. Still, the growth curve of TSR usage flattened in more recent years relative to the early days of Say on Pay, and boards began to diversify incentive plans to include additional performance metrics, such as return on capital (ROC). Indeed, 36.1% of Equilar 500 companies provided compensation awards dependent on this metric in 2016, up from 30.0% in 2012. Earnings per share (EPS), the third-most-common metric reported in the Equilar study, remained flat over the five-year period.
In her commentary for the report, E*TRADE’s Geerts noted that market swings, industry-related circumstances and the life stage of peer companies can affect relative TSR. Therefore, boards of directors have introduced other metrics to balance executive incentive plans.
“By including ROC as a metric in executive compensation, the executive is encouraged to make thoughtful decisions on corporate investments, which in the long term may deliver strong financial results for the company and its shareholders,” said Geerts.
Market volatility has been elevated in early 2018, Geerts noted. Since many companies align TSR and RTSR awards to prices measured based on calendar-year performance, the recent large short-term stock price movements occurred close to the start and end of performance measurement periods. Especially for companies using a pure TSR metric, short-term movements in the stock market may drive excessively high or excessively reduced payouts, at times, when the stock price movements are unrelated to corporate performance.
“RTSR metrics can help lessen the impact of market-wide movements when peers move in the same direction, but these metrics are still inherently volatile and can drive payouts that are disjointed from long-term goals,” Geerts added.
As a result, companies often pair metrics together in order to provide better line of sight on certain goals—like return on capital, for example—that can in turn drive shareholder return. A separate analysis of individual CEO incentive plans in the Equilar report confirmed the fact that TSR is often aligned with other metrics in order to support multiple goals to receive a certain award.
Exactly one-third of CEO incentive awards featuring TSR were fully dependent on that metric. By comparison, TSR was weighted to influence half of an award’s payout nearly 40% of the time. ROC and earnings per share (EPS) similarly were offered in conjunction with another metric a majority of the time. Each of these metrics was offered in a variety of award weightings across Equilar 100 CEO incentive plans, Equilar found.
Ultimately, incentive plans are often as diverse as each company and the goals of each individual executive. As a result, even if a pay package follows “best practices” and earns a passing Say on Pay vote, that doesn’t mean it shouldn’t be closely examined each year. And situations often change—a CEO leaves for a new position or retires, or the market dictates that performance goals be reevaluated. When these scenarios do occur, a close, ongoing relationship with shareholders is critical to ensuring those transitions go smoothly.
“Boards want an open line of communication to shareholders on an ongoing basis on executive compensation, and it’s tough to do that if they’re not listening carefully to solicit feedback,” said O’Connor. “At the same time, any time you are changing awards, executives must have good line of sight into the process. Sometimes that means having heart-to-heart conversations with key recipients explaining that the company is under scrutiny today in a way that it wasn’t five to 10 years ago. Among all these competing concerns, boards are trying to find that nice medium between executive incentives and shareholder gains. That’s part of the reason dual market- and performance-condition awards have really grown in popularity.”
Dan Marcec is the Director of Content at Equilar and the Editor-in-Chief of C-Suite magazine.