CEO Compensation in the News? No Surprise, but Clarity Needed

Posted by Chris Kelley on Jun 8, 2017 4:52:07 PM

Each year around this time, mainstream media outlets jump into the fray to chime in about executive compensation. Always a good whipping post, the pay packages for Chief Executive Officers (CEO) get a lot of attention when companies file their annual proxies.

One challenge executive compensation professionals face as a result of the media coverage is that there isn’t a solid understanding for the terminology and the mechanics of executive pay packages.  A recent example of the sensational hype stems from a post on Forbes website by Tim Worstall.  This was an opinion piece in response to Gretchen Morgenson article in the New York Times.  Tim Worstall’s headline was a real eye-catcher…” An Interesting Error In Equilar's Calculations Of CEO Pay” and his piece was attempting to highlight an error in that CEO pay is being overestimated.  However, Gretchen Morgenson’s article attempts to shine a light on a perceived disconnect between pay and performance, without recognition of the “error” in the calculations.

So What’s the Problem?

Primarily it’s one of timing. Much of what companies are reporting in their proxy filings now are the pay decisions made in the first quarter of the prior year. So, it’s not so much of a problem, per se, but more of an opportunity.  The more transparent corporate disclosures and media’s role in highlighting executive compensation both can improve the accountability corporations have in making sure there is legitimacy to the remuneration packages awarded to senior leaders. Compensation professionals (and their consultant advisors) are keenly aware that they need to get it ‘right’.  Their work is going to be aired for all to see and it had better be accurate and effective…meaning it drives business results.

The opportunity we see is to ensure there is fair representation of the executive compensation terminology and plan mechanics. Investors and the community at-large should indeed get riled up when executive compensation is out-of-whack, but let’s make sure people have the right information before picking up the pitchforks.  Here are some of the key terms and concepts that would help clarify the communications on executive pay:

  • Pay Mix
  • Long-Term Incentive Vehicles
  • Timing of Awards
  • Realizable Pay

Executive Pay Mix

It’s worth mentioning that when describing increases to CEO pay, we’re primarily looking at changes in total CEO-Pay-Mix-S&P100.pngcompensation.  Why?  Because the mix of pay for CEO’s is so heavily skewed towards long-term incentive that changes to base salary are hardly noticeable.  The pie chart here uses data from our CG Pro software and shows the mix of CEO pay for the S&P 100 companies.  Base salary accounts for only 10% of the total compensation package for at least half of the companies, whereas long-term incentives (stock awards and option awards) combine for 58% of the pie.  Effectively, all the fanfare about changes to executive pay should be focused on changes to equity awards.  In fact, the median base salary for this group of executives has remained unchanged between 2015 – 2016.

Long-Term Incentive Vehicles

With the clear majority of the reported compensation coming from long-term incentives (LTI), we think it’s important to understand more details about those awards. Again, using our CG Pro software to analyze the S&P 100 companies, we can see that companies are frequently using multiple LTI vehicles, most commonly 2 – 3.

 CEO-LTI-Vehicle-Mix-S&P100.png

Each of those LTI vehicles has different triggers for when the award converts from a hypothetical value reported in the proxy filing into actual cash that the executive can deposit into their bank account.  And, the different vehicles are designed to serve different objectives.  For example,

  • Restricted Stock – typically a time-vest award designed to promote executive retention
  • Stock Option – also referred to as share appreciation vehicles, these awards promote enhancing share price
  • Performance Share – the lion’s share of the LTI award at most companies, these vehicles are designed to achieve specific performance goals

We increasingly see companies using Performance Share plans more as this is perceived as the best way to ensure alignment between pay and performance.  Gretchen Morgenson accurately reports that the majority of companies in their sample of the 200 highest paid CEO’s use Total Shareholder Returns (TSR) as a measure of performance.  In our sample of the S&P 100 companies, we see approximately 57.1% using TSR as a measure.

What’s not explained in the New York Times article is that the vast majority (90%) of those plans are Relative TSR plans (rTSR). A seemingly minor point, but the significance of a rTSR plan is that performance goals are established in a way that the performance goals are set ‘relative’ to a set peer group of companies or perhaps an industry index. The article points to Exxon Mobil and alludes to how their performance share plan benefited by the escalating value of oil market and how that propelled their stock.  The Exxon Mobil performance plan though is a rTSR plan and their performance is measured against their primary competitors who operate in the same industry and would have had the same benefits of rising commodity prices.

Using a relative plan is one way to help organizations protect against windfalls where executive pay rises simply as a result of a fortunate turn in the stock market. Another trend we are seeing is that companies are now using multiple measures of performance. For example, the performance measures could be rTSR and Return on Capital which combines elements of both relative and absolute performance.

Timing of Awards

The New York Times article title is “The Trump Effect on C.E.O. Pay” and the whole premise is that executive compensation disclosures are showing how executives are seeing a rise in their pay because of the unexpected lift the stock market has enjoyed since the November elections. The challenge we see with that hypothesis is that the timing is off.  The information most companies disclose in proxy filings in early 2017 reflect payments and awards that they made in the prior fiscal year. 

  • Base Salary – amount of salary paid during fiscal year 2016. In most cases, that amount was set at the beginning of the 2016 fiscal year
  • Short-Term Incentive – amount paid in 2017, but based on performance results against the prior fiscal year performance objectives set at the start of 2016. This has the potential to reflect a Trump effect, but very few companies use TSR or stock price in their short-term incentive plan so the impact of a Trump Effect is minimal at best
  • Long-Term Incentive – awards granted in most cases in early 2016, these awards won’t be vested for several more years, meaning any 2016 Trump effect is small and as noted above many are relative TSR plans

Realizable Pay

In Tim Worstall’s post, he rightly calls out the fact that all the pay disclosures that people are focusing on from the annual proxy statements are the ‘book value’ that the companies are required to report but that these amounts can ‘pan out to be worth nothing at all’.  What’s not right about his post is that he refers to this as an error in the calculations.  They are not errors. The information is reported accurately from the proxy, to the best of our knowledge, but rather it’s the wrong analysis.

The information companies are required to publish in their Summary Compensation Tables are consistently defined so that it is possible to look easily across companies and understand the value of what each company is awarding to its top five executives each year.

What’s not required currently for disclosure in the proxy, is any analysis of what is actually being earned by the executives over the multi-year time horizon.  This type of earned pay analysis is referred to as Realizable Pay.  While it is not a required reporting topic, we found that 11%  of the S&P 100 companies voluntarily include some statement about their realizable pay analysis in their proxy.

Two of our executive compensation consultants, Richard Harris and Tom Williams, have published a more detailed analysis of realized and realizable pay where they looked at reporting trends over a four-year period. 

CEO pay is certainly a hot topic in the media every year after proxy filing season. The detail companies disclose about their executive pay practices demonstrates for investors the strength of the corporate governance practices they have in place. Journalists are playing an important role in summarizing and highlighting newsworthy items from those disclosures for the benefit of their readers. We applaud those efforts to promote transparency – but hope we can help sharpen the focus through a better understanding of the terminology and mechanics of executive pay.

Realized and Realizable Pay Analysis 

 

Topics: Executive Compensation

Chris Kelley

Posted by Chris Kelley

Chris is a Director of Survey Product Management and is actively involved in the design and administration of a portfolio of salary surveys for Aon Hewitt. Chris previously spent over 20 years working in compensation / HR and he is an adjunct faculty member for WorldatWork where he has taught Market Pricing for over 10 years.