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CEO Pay

Part 2. The Basics of Executive Compensation Design

One of the most significant responsibilities of compensation committees is to establish CEO compensation packages. In our experience, committees work hard to strike a balance between the need to offer attractive compensation opportunities and the need to appease potential critics.

Employees and the press often criticize CEO pay for being too high in an absolute sense or relative to the pay levels of the typical worker. Shareholders and shareholder advisory firms tend to focus their criticism on the pay-for-performance relationship. For them, the primary concern is whether the CEO’s pay is appropriate in the context of the company’s performance. They will raise concerns when the CEO’s pay appears to increase or stay the same while the company’s performance declines. They also may criticize the committee or board if they find that its CEO is paid more than industry peers while the company has failed to outperform those peers. Institutional shareholders will look beyond the amount of pay to criticize the forms of pay. Was too much of the CEO’s pay delivered in salary or cash compensation relative to equity? Did the CEO receive too much pay that did not move with performance (e.g., perquisites and retirement benefits)? Was the CEO’s long-term incentive plan too conservative (e.g., mostly restricted stock) or too risky (e.g., mostly stock options)?

With all the criticism of CEO pay, it may seem impossible to create a “bulletproof” CEO pay program. While that is probably true, a well-thought-out process for addressing CEO pay can help to limit the amount of criticism directed at compensation.

Process

The chair of the compensation committee normally takes the lead in overseeing CEO pay. Management may actively participate in much of the committee’s work, but it is rarely involved in setting CEO pay. For CEO pay decisions, the committee chair will rely more heavily on the input of its compensation consultant to understand market compensation levels and pay practices. However, the ultimate decision on CEO compensation lies with the committee as a whole.

In most cases, the timing of the committee’s decision on CEO pay is aligned with the timing of pay decisions for other executive officers. The key difference is that any recommendations that are specific to the CEO (e.g., target pay levels, actual incentive payouts, etc.) are typically discussed by the committee in the executive session without members of management present. The materials are most often prepared by the committee’s compensation consultant with input from the compensation committee chair. The consultant can facilitate the decisions on pay by informing the committee of competitive CEO compensation according to market data, the company’s compensation philosophy, as well as the company’s and CEO’s performance.

The following key steps in regard to CEO compensation should be taken at three distinct points through the annual pay cycle:

  1. Beginning of the year – Establish compensation package and relevant performance objectives:
    • Establish target pay levels for the CEO (e.g., base salary, target bonus, target cash compensation, long-term incentive grant value, target total direct compensation)
    • Assess competitiveness of current pay levels relative to peer group target compensation levels
    • Assess current pay levels relative to compensation philosophy (e.g., how positioned vs. target pay positioning)
    • Determine whether to increase CEO’s target pay opportunity based on current compensation positioning
    • Identify whether the committee’s perspective on the CEO’s sustained performance would serve as the basis for adjusting CEO target pay levels up or down
    • Establish CEO’s individual and strategic performance objectives for the year (often done with input from the full board of directors)
  2. Year’s end – Determine annual and long-term incentive payouts in view of performance:
    • Assess company’s performance relative to annual and long-term incentive plan objectives
    • Assess CEO’s performance relative to individual and strategic objectives
    • Determine CEO annual incentive payout, potentially adjusting size of payout based on committee’s assessment of CEO’s performance
    • Approve long-term incentive payouts for the CEO
    • Anticipate outcomes of ISS and/or Glass Lewis CEO pay-for-performance tests based on anticipated proxy statement disclosure of CEO compensation
  3. After year’s end – Assess competitiveness of CEO’s compensation relative to peers:
    • Assess actual CEO pay for fiscal year relative to actual pay among peers
    • Assess actual performance on key measures relative to peers
    • Assess percentile pay relative to peers vs. percentile performance relative to peers (see diagram below)

A robust process for assessing the pay-for-performance relationship is a critical part of whether the committee fulfills its responsibilities effectively. Our preferred approach is discussed in the following section.

A formal review of the CEO’s pay levels relative to peers, as well as an assessment of how financial performance compares to the same sample of companies, is a valuable tool to test whether the company’s actual pay practices are consistent with the pay philosophy. This is also an important indicator of whether the financial goals established for the company contain sufficient rigor.

The diagram shown below summarizes the results of the pay-for-performance assessment. Four quadrants are displayed with the upper-right quadrant showing the sweet spot: above-median performance and above-median pay relative to peers. The diagonal lines mark the 25th and 75th percentiles on each axis. In most instances, a position within these bounds is desirable.

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Many committees are becoming more sophisticated in how they view the pay-for-performance relationship and are looking at pay and performance over a three- to five-year period in order to base the majority of CEO compensation on long-term performance. When looking at compensation over a multi-year time frame, committees often shift their focus from the grant value of long-term incentives to the “realizable” value of long-term incentives. Realizable pay can be calculated in several ways, but in all its variations, the key difference is that the long-term incentives are revalued at the end of the period under review to capture the most critical driver of CEO compensation levels: changes in a company’s stock price since the grant date.

Below are several approaches to assessing the CEO pay-for-performance relationship:

  • Absolute Assessments:
    • Change in SCT pay vs. change in TSR over a 1–3-year period
    • Change in realizable pay vs. change in TSR over a 3–5-year period
    • Change in realized pay vs. TSR over CEO tenure
  • Relative Assessments:
    • Compensation percentile vs. performance percentile
    • Compensation may be defined as SCT pay, SCT pay excluding change in pension value and all other compensation, realizable pay, or realized pay.
    • Performance is frequently based on TSR but can be based on financial performance on key metrics that are important to the committee.

ISS Approach:

As a key component of its recommendations to institutional shareholders on how they should vote on management Say on Pay proposals, ISS assesses CEO pay using three quantitative tests:

  • Relative Degree of Alignment: This test compares the percentile rank of the company on the three-year average SCT pay of the CEO relative to peer group CEOs against the three-year total shareholder return percentile ranking relative to the peer group. If the pay percentile ranking is well ahead of the TSR performance percentile ranking, ISS may have concerns.
  • Multiple of Median: This test assesses the relationship between the one-year SCT pay of the CEO and the median SCT pay of peer group CEOs. If the company’s pay is well above the median of the peer group (e.g., more than 2x), ISS may have concerns.
  • Pay-TSR Alignment: This test compares the trend rate in a company’s CEO’s total compensation with the value of a $100 investment (in the company) over the prior five-year period. If the pay trend is not aligned with the TSR trend, ISS may have concerns.

Many committees will review simulations of ISS’s quantitative pay-for-performance tests in advance of filing proxy materials to understand if they are likely to receive a negative recommendation on Say on Pay. If a company raises concerns on the quantitative tests of performance, ISS will evaluate numerous qualitative aspects of the company’s compensation program before determining its recommendation.

Glass Lewis Approach:

Similar to ISS, Glass Lewis conducts a quantitative assessment of the relationship between pay and performance. The Glass Lewis performance assessment looks beyond TSR to include financial measures of performance. Similar to ISS, pay is defined as SCT pay. Glass Lewis will assign companies an A–F rating based on the degree of alignment in the pay-for-performance relationship. Companies with an “A” rating have a performance percentile above their pay percentile; companies with a “C” rating have aligned pay and performance percentiles; companies with an “F” rating have a pay percentile above their performance percentile. Glass Lewis will evaluate the pay-for-performance relationship for the CEO and all other named executive officers (NEOs) disclosed in the proxy statement.

Key Questions for Committee Members to Ask:

  • How well do the CEO’s actual pay levels align with the company’s performance relative to peers over one-year periods and over longer periods? Have we heard any comments?
  • Does the actual pay reflect the leadership and strategic stewardship of the company?
  • Do we expect ISS or Glass Lewis to raise concerns about the CEO’s compensation?
  • Do any committee members have any concerns about the compensation program for the CEO?
  • Have we received any shareholder proposals that touch on CEO compensation? Any publicity?

Realized and Realizable Pay

Many companies have concluded that the required Summary Compensation Table (SCT) disclosure of executive pay levels is ineffective for purposes of comparing pay and performance. The key limitation of SCT pay is that it mixes actual payments to executives (e.g., salary, bonus payouts, long-term cash plan payouts) and pay opportunities that will vest and be earned over time (e.g., the grant date fair values of stock options, restricted stock, and performance share awards). Since equity-based pay is such a large portion of CEO pay, it is the most critical form of pay to examine when looking at the pay and performance relationship. If we look at SCT pay, then we are missing how the pay and performance relationship plays out over time for the most significant part of CEO pay.

To correct for this serious shortcoming of SCT pay, most compensation committees will also evaluate the realized pay of the CEO over time, as well as the realizable pay. Realized pay is akin to the “take home” pay for the CEO and is similar to W-2 gross income. It includes the CEO’s base salary, short-term and long-term cash incentive payouts for a given year, the value realized upon stock option exercises, the value realized upon the vesting of restricted stock, and performance share plan payouts. Some analyses will also include the value of other forms of compensation for a given year (e.g., perquisite values, pension contributions).

Realizable pay is the potential value that an executive could realize at a point in time if the executive “cashed in” on all outstanding long-term incentives granted over a period of time, plus the salary and bonus paid to the executive over that period. Realizable pay has become popular because it demonstrates how the potential pay an executive could earn changes over time with movements in the stock price. It is generally easier to use for comparisons across companies, because it is less dependent on the timing of executive stock option exercise decisions and the timing of equity vesting than realized pay. Many compensation committees make it a practice to review realizable pay on a relative basis compared to peers and a small minority of companies have begun to include the results of these comparisons in their proxy statements.

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