Arthur J. Gallagher discusses Study of 2014 Short- and Long-Term Incentive Design Criterion

In order to investigate what (and how much) is being reported in annual proxy statements about executive pay packages and how incentive pay is designed, Arthur J. Gallagher & Co.’s Human Resources & Compensation Consulting Practice (formerly James F. Reda & Associates a Division of Gallagher Benefit Services, Inc.), has conducted a study of the 2015 annual proxy statement disclosures for 200 of the top U.S. companies (based on revenue and market capitalization). This is the seventh consecutive year we have conducted this in-depth analysis for the top-200 public companies.

It has been almost five years since the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was signed into law. 2015 has been an active year in the SEC’s implementation effort of this Act. The final version of the controversial CEO pay ratio disclosure rules were released on August 18, 2015.

The CEO pay ratio now joins two other provisions related to executive compensation that have already been implemented to date (Say-On-Pay (“SOP”) and Say-When-On-Pay “SWOP”). A majority of companies have their executive compensation reviewed each year (e.g., SWOP of one year). The five-year SOP history is as follows:

• The inaugural year for SOP and say-when–on-pay, just 44 companies (1.4% of companies with SOP proposals) failed to receive majority shareholder support. On average, companies received 91% favorable votes for SOP proposals. An analysis by Institutional Shareholder Services (“ISS”) indicated nearly three-quarters of the failed votes were due to pay-for-performance issues.
• 61 companies (2.6% of companies) failed the SOP vote.
• 70 companies (2.5%) failed.
• 66 companies (1.9%) and
• Through mid-October 2015, 62 companies (2.3%) failed SOP which is back up to 2012 and 2013 SOP failure levels. The leading factors causing SOP failures continue to be the pay-for-performance relation, the rigor of performance goals, and problematic pay practices, according to ISS.

In addition to finalizing the CEO pay ratio disclosure, the SEC released three anticipated rule proposals in 2015: (i) hedging policy disclosures (February 19, 2015), (ii) pay vs. performance disclosures (April 29, 2015) and {iii) compensation recoupment (i.e., clawback) policies (July 1, 2015). The final rules for these proposals will impact board process and oversight by focusing more on corporate performance and fairness to employees and shareholders, the structure of executive incentives and overall executive pay mix,

The only remaining Dodd-Frank compensation issue not addressed by the SEC is the disclosure of the rationale for the chairman and CEO roles. That is, explain why the Chairman and CEO roles are separated or held by the same person. The SEC currently does not anticipate providing guidance for this provision of the Act.

With SOP now entrenched in the psyche of compensation committees along with ISS’s annually evolving standards, improving disclosure of measures used, the values associated with those measures, and how they can be expected to drive performance should continue to be a priority for all public companies. The SEC requires that in their annual proxy statements, companies disclose the specifics of their executive compensation policies in clear language for investors. This requirement has developed from the assertion by the SEC that if executive compensation performance targets are central to a company’s decision-making process, these targets must be disclosed to investors. ISS is also explicit in the need for “robustness of disclosure”, as this is a component of their qualitative assessment of SOP proposals.

Most public companies have redesigned their incentive programs over the last several years to ensure there is a link between performance achievement for the company and executive, and performance achievement for shareholders. Indeed, we continue to see increases in the use of performance-vested grants as a means for more closely linking pay to performance. A disconnect stemming from faulty incentive design could expose an executive and the board of directors to unwelcome scrutiny from shareholders and the general public.

Short-Term Incentive Plans

• Of those companies with bonus or short-term incentive plans:
  • Eighty-five percent (85%) used at least one financial measure.
    • Fifty percent (50%) used non-financial measures, usually in combination with financial measures, and
    • Forty percent (40%) included specific individual objectives.
  • The remaining 15% of companies used discretion-no formula determination.
  • In all, sixty-three percent (63%) used discretion in part or whole in 2014.
• Performance goals are being ratcheted up year over year. For companies using the same financial measure(s) from 2013 to 2014, the median target goals in 2013 were set at 4.2% above prior year and 2.7% above prior year actual results.
• EPS is the most commonly used single measure in 2014 as thirty-nine percent (39%) use this measure. Overall, income and profit continue to be most common performance measures (93% of STIPs).
• Eighty-two percent (82%) of STIPs include multiple financial performance measures in 2014, an increase from 68% in 2010. To break it down further, in 2014, 34% of STIPs included two measures, 30% included three measures, and 18% used four or more performance measures.
• Forty-two percent (42%) of STIPs begin to payout for any positive (greater than zero) result. The next most common threshold payout set at 50% of target (29% of companies). The most common maximum payout continues to be 200% (65% of companies).
• Use of umbrella plans continues to increase (64% of companies in 2014 as compared with 59% in 2013, 57% in 2012 and 50% in 2011) as more companies incorporate discretionary/non-formulaic goals in their STIPs that will qualify as tax deductible payments under IRC 162(m).

Long-Term Incentives

• Performance-based awards continue to increase in both prevalence and value with the opposite occurring for stock options/SARs. Performance-based awards are used by ninety-five percent (95%) of organizations and represent 57% of the average total grant-date value provided; on the other hand, stock options/SARs which are used by 63% of companies account for 25% of the average total LTI value.
• Most companies (71%) with an LTIP used two or more measures in 2014, up from 54% in 2009. This is likely a response to SEC concerns about the risks associated with single performance measures, especially if the same measure is used in both the STIP and LTIP.
• TSR, income measures, and capital efficiency ratios continue to be the most commonly used long-term incentive measures in 2013.
  • One hundred and two (102) companies (54% of LTIPs) with long term incentive plans used relative TSR, up from 91 companies (49% of LTIPs) in 2013 and eighty-four companies (also 49% of LTIPs) in 2012. The increase in the number of companies using performance-vested equity and TSR is being driven by ISS policies, including the Relative Degree of Alignment quantitative test and performance mix standards. In addition, the use of relative TSR obviates the need to determine long-term goals. Of the 102 companies using TSR, 17 companies used relative TSR modifiers as part of the overall LTIP.
  • Seventy-seven percent (77%) of long term incentive plans with relative performance measure used TSR, down from 81% in 2013.
  • EPS and other income measures were used in 49% of LTIPs in 2014 as compared with 55% for TSR. Capital efficiency measures were included in 46% of LTIPs
• Maximum payouts were most often capped at 200% of target (63%), followed by 23% of companies capping the payout at 150%. The most common threshold payout is set at 50% of target (39% prevalence), followed by 0% which is used by 22% of companies. All but 4% of the remaining companies begin payouts between 0% and 50%.
• Threshold and maximum levels, for the most part, are set to be symmetrical around the target whether the goal is absolute or relative. A closer examination of specific threshold and maximum pairs revealed that 57% of pairs were relatively symmetrical.

The preceding post is based on a study prepared by Arthur J. Gallagher & Co., which is available here.