Seven principles for pay for performance

As the SEC continues to contemplate what its final rules on pay for performance disclosures in executive compensation will be, Robin Ferracone, CEO of executive compensation consulting firm Farient Advisors, says companies should consider using some basic principles for defining pay when developing their pay-for-performance models this proxy season. Those principles are outlined in a report, ‘Pay definitions: what works best in pay for performance analysis’, released last November.

While these principles are not all new, Ferracone argues that they could provide much-needed guidance for shareholders to use when comparing pay and performance. In fact, ‘we are suggesting that the principles be the standard,’ she asserts (see Seven principles for pay-for-performance standards, below). There is wide disagreement on what works best, however, as individual companies are making decisions on pay based on what works for them, and then trying to explain their rationale to shareholders in the compensation discussion and analysis section of their proxy statements.

‘Corporate secretaries and corporate counsel would be well served to think about the principles with which they want to report pay for performance alignment, try to have some consistency from year to year, try to make it easy for the investors to follow it and make it easy for the investors to derive the calculations based on the reporting of the amount earned,’ advises Ferracone, who also provides other insight on how compensation may be viewed during the 2013 proxy season in this interview with Corporate Secretary. 

Do you have a view on what ISS may decide to do regarding pay for performance this proxy season?

ISS is sticking to a grant-date value definition. What it’s going to do for large companies is basically say that if the grant-date value doesn’t show pay-for-performance alignment, it will do a second test for you, and it’s going to use something similar to performance-adjusted compensation. ISS is calling it realizable compensation, but what’s really going on in its definition is that it is using the ‘in the money’ or ‘out of the money’ value for the option just like we are… The principle of what it is doing is the same as performance-adjusted compensation, so I was delighted to hear that it is moving in that direction as a way to further test alignment – and that it has realized that grant-date value doesn’t necessarily tell the full story.

Is that approach significantly better?

I think so. It is moving in that direction, but the question is going to be how fast and how far it moves. ISS has put its toe in the water by saying it’s going to do a qualitative analysis of performance-adjusted value. If that works out well for it this year, my guess is it may start leaning on that more heavily. But that’s just my guess – it hasn’t said that and no one told me that.

What about Glass Lewis? How will it handle pay for performance?

Glass Lewis is aligned with Equilar, and Equilar uses realizable compensation. The problem is the embedded value of the option is the methodology there, and it is a real problematic methodology, so I don’t know how it is going to handle that. While I have yet to confirm this, I think Glass Lewis is now making an effort to get the actual number of performance shares earned; that would be an improvement and another actual point of conversion among the platforms. 

Do you think we will see pay limits in the future? 

I don’t see a cap on equity-based compensation. Certainly there is a cap on the number of shares somebody might get – there are a variety of caps out there already. Lots of times there is an individual cap on how many grants somebody can get. There might also be a two-times target cap on how many performance shares someone might get relative to the target.

We’re not seeing any caps on the equity values. Part of the reason for that is if my equity value ran up and it was 10 times what it was at the beginning of the performance period and I got a big payday, well, the investors got that payday too. Usually when investors get that type of a payday, they will feel things kind of worked out for everybody.

What else should companies consider when writing disclosures on pay this year? 

I think it’s helpful to be very clear what you are using your pay definitions for. For example, if you want to illustrate your pay-for-performance alignment, we think pay definitions that adhere to these principles on performance-adjusted compensation (see Seven principles for pay-for-performance standards, below) is a good way to go. If you are trying to set target compensation for somebody, the grant-date value definition is a good way to go. If companies are clear about what they are trying to use that pay definition for and how they are calculating it, that is extremely helpful. 

Next I would caution companies not to switch definitions from year to year based on what’s going to look most beneficial for them. I think shareholders will get impatient after a few years of that. Companies should stick with some things they think will endure and tell the real story about whether pay and performance really did align or not.

Is there anything else corporate secretaries can do to make pay disclosures better?

The disclosure rules are going to have to help investors look at pay-for-performance alignment, and what corporate secretaries can do is actually make that accessible in terms of the information. In the years performance shares vest, corporate secretaries can say, ‘Here’s how many shares vested for all the key executives and officers and what they were worth’ so investors have it right there at their fingertips. If companies would do that voluntarily, that would earn them kudos in terms of being transparent with investors. 

Seven principles for pay-for-performance standards

Farient Advisors suggests that any company creating standards for pay for performance adhere to a number of principles, such as these:

1. Data should be shown over the long term (for example, at least three full three-year rolling cycles). This longitudinal analysis will help companies and investors smooth annual fluctuations or distortions in pay for performance, without overreacting to one-year swings.

2. All elements of compensation should be valued after performance has happened, not at grant date.

3. The time horizon of the pay components should match the horizon of the performance measured.

4. The pay definition should put the various long-term incentives (LTIs) vehicles on comparable footing. If a method favors one vehicle over another, then pay and performance comparisons will be distorted.

5. The pay definition should make it easy to compare actual pay across companies. For example, the realizable compensation definition, as described above, will favor companies that issue stock options over companies that use other forms of LTIs because using embedded value understates the value of stock options relative to other LTIs. In addition, realized compensation will overstate compensation for CEOs when large, lumpy stock option exercises are made.

6. The pay-and-performance discussion should cover total compensation, including salary, short-term incentives, long-term incentives and the value of benefits and perquisites, so that pay mix does not distort the analysis of pay and performance.

7. The data should be readily available and easily replicated by third parties.

In evaluating the various pay definitions against these standards, performance-adjusted compensation comes closest to meeting the criteria for pay and performance analyses.