by Cydney Posner
Comp Committees appear to have gotten the message when it comes to executive pay for performance. As discussed in this article in the WSJ, executive compensation “is increasingly linked to performance,” but investors are now asking whether the bar for performance targets is set too low to be effective. Are companies just paying lip service to the concept?
The WSJ analysis showed that median pay for CEOs of companies in the S&P 500 reached “a post-recession high,” and that about 60% of that pay was derived from equity awards, “most of which [were] tied to performance targets.” While performance bonuses are familiar elements of pay, tying equity awards to performance metrics—such as EPS, operating profit, total shareholder return or specific operating goals—is a relatively recent phenomenon.
But has the prevalence of performance metrics had the effect (whether or not intended) of lifting executive compensation? According to the article, based on ISS data, for about two-thirds of CEOs of companies in the S&P 500, overall pay “over the past three years proved higher than initial targets….That is typically because performance triggers raised the number of shares CEOs received, or stock gains lifted the value of the original grant. On average, compensation was 16% higher than the target.” In addition, for 2016, about half of the CEOs of the S&P 500 received cash incentives above the performance target payout levels, averaging 46% higher, while only 150 of these companies were paid bonuses below target. Examples cited in the article included using the same earnings growth target year after year—notwithstanding forecasts from analysts suggesting much higher earnings growth—paving the way for executives to consistently exceed the target and earn the maximum, and making up the difference with other components of compensation when one component of pay fell short because targets were not met.
SideBar: At least one recent study has shown that—enthusiasm of compensation consultants, boards, proxy advisory firms and institutional holders for pay tied to performance aside—performance-based pay does not necessarily pay off as expected. A 2016 study by corporate-governance research firm MSCI showed that, over the long term, there was a significant misalignment between CEO pay and stock-price performance. The study looked at CEO pay relative to total shareholder return for around 800 CEOs at more than 400 large- and mid-sized U.S. companies over a decade (2006 to 2015). For the companies surveyed, the study found, on average, that CEO pay and performance had an inverse relationship; according to the WSJ, “MSCI found that $100 invested in the 20% of companies with the highest-paid CEOs would have grown to $265 over 10 years. The same amount invested in the companies with the lowest-paid CEOs would have grown to $367.” The WSJ concluded that the study “results call into question a fundamental tenet of modern CEO pay: the idea that significant slugs of stock options or restricted stock, especially when the size of the award is also tied to company performance in other ways, helps drive better company performance, which in turn will improve results for shareholders. Fortune, reporting on the same study, indicated that MSCI also attributed the “misalignment, in part, [to] the Securities and Exchange Commission’s disclosure rules that focus on annual reporting instead of long-term results. It suggests that a CEO’s cumulative pay and performance data over his or her entire tenure should also be taken into account to reduce reliance on figures that only consider the short-term.” The WSJ reported that the study authors recommended that the SEC modify its disclosure requirements to show “cumulative incentive pay over long periods, to help illustrate a CEO’s pay relative to longer-term performance.” (See this PubCo post.)
And sometimes, the WSJ contends, pay may be exceeding performance targets because those targets are set at levels that are, shall we say, not exactly challenging. According to the head of analytics at ISS, in some cases, “’the company is setting goals they think the CEO is going to clear….It’s a tip-off to investors.’” The article reports that, based on a 2016 analysis, ISS concluded that about 186 of the Fortune 500 expected that the equity awards granted to their CEOs would pay out above target, 122 at target and 150 below target.
SideBar: In a recent essay in the Harvard Business Review, two academics contend that performance-based pay for CEOs makes absolutely no sense: research on incentives and motivation suggests that the nature of a CEO’s work is unsuited to performance-based pay. Moreover, “performance-based pay can actually have dangerous outcomes for companies that implement it.” According to the academics, research has shown that, while performance-based pay works well for routine tasks, the types of work performed by CEOs are typically not routine; performance-related incentives, the authors argue, are actually “detrimental when the [task] is not standard and requires creativity.” Where innovative, non-standard solutions were needed or learning was required, research “results showed that a large percentage of variable pay hurt performance.” Why not, they propose, pay top executives a fixed salary only? (See this PubCo post.) Similarly, as discussed in this PubCo post, a New Yorker columnist concurs with the contention that performance pay does not really work for CEOs because the types of tasks that a CEO performs, such as deep analysis or creative problem solving, are typically not susceptible to performance incentives: “paying someone ten million dollars isn’t going to make that person more creative or smarter.’” In addition, the argument goes, performance is often tied to goals that CEOs don’t really control, like stock price (see this PubCo post and this news brief.)
The head of corporate governance for a major institutional investor expressed his concern that, sometimes, the bar is set “too low, allowing CEOs to earn ‘premium payouts in the absence of compelling performance relative to the market.’’’ In selecting metrics and setting targets, comp committees “must juggle a range of factors,” taking into account the preferences of investors and proxy advisers, as well as the recommendations of consultants.’’ However, he said, “‘[i]t has to be the right measure and the right achievement level.”’
SideBar: According to a recent report from Equilar, an executive compensation and corporate governance data firm, “relative total shareholder return” continues to be the most common performance measure used in long-term incentive plans for CEOs among S&P 500 companies. However, after years of increasing prevalence among companies in this group, use of rTSR flattened out in 2015 as a performance metric for CEO pay. At the same time, use of return on capital and earnings per share as performance metrics each “saw a bump,” the related press release indicated. Why the flattening? Could the break in TSR’s ascent reflect recent criticism of the “tyranny of TSR”? For example, a study in 2015 showed no real correlation between use of TSR and improvements in company performance. According to Equilar, companies now often employ more than one metric when using rTSR. For companies in the S&P 100, Equilar “found that more often than not, rTSR was included alongside at least one other metric to achieve performance awards. The study found that 35.9% of the time rTSR appeared in CEO incentive plans, meeting target goal accounted for half of the payout. (See this PubCo post and this PubCo post.)
Some have also taken issue with the typical three-year time horizon used for long-term incentives. As discussed in this PubCo post, two consultants have even contended that the usual time horizon has the “potential to be dangerous,” especially where the performance measure is relative TSR, because the “payouts to executives may reward short- to mid-term stock price volatility rather than sustained long-term TSR performance.” Recognizing that the ideal of a “truly long-term performance period like 10 years or 7 years, which also more closely corresponds to the life cycle of business strategies” is impractical, the consultants suggested that comp committees “think about a performance period of five years or even four years, which may provide a better balance between executives’ reluctance to wait to receive compensation and shareholders’ concerns that equity awards should reward long-term value creation.”