Compensation disclosures have grown significantly over the last decade (mostly for the better), and they continue to evolve with the ongoing engagement between companies and shareholders. Certain compensation practices are known for raising investor concerns, leading to difficult conversations between investors and boards and higher levels of investor opposition of executive pay programs. But beyond outright egregious practices, a careful review of the diverse set of compensation programs available may reveal some compensation practices that do not appear as significantly concerning but can raise pointed questions about a compensation program’s alignment with shareholders’ interests.
We call these potential transgressions the venial sins of executive compensation, and they are based on opinions and observations formed after several years of experience reviewing executive compensation disclosures and discussing compensation practices with investors. None of these opinions reflect an official ISS position or a preview of upcoming ISS voting policy, but they are meant to highlight potential risks related to otherwise sound incentive structures, as observed by the author.
Why seven venial sins? Well, we’ve already catalogued the seven deadly sins. More than four years ago, we began to collect the most commonly cited factors (other than simple ones, such as eye-popping pay quantum and severe pay-for-performance misalignment) contributing to headwinds in shareholder say-on-pay votes (typically support levels of less than 80 percent of votes cast). Although some of these factors have changed at the margin since 2014, most of the themes have remained surprisingly consistent. These seven themes – the seven “mortal sins” of executive compensation – that are most often associated with adverse vote outcomes include (in no particular order):
- An unresponsive or ineffective compensation committee;
- The granting of significant “special” awards without explanation or justification;
- Escalatory pay benchmarking practices, including “aspirational” peer groups and above-median targeting;
- Poor disclosure of performance metrics and goal mechanics;
- Lack of rigor on incentive targets;
- Multiple payouts on similar performance metrics; and
- Employment agreement issues, such as renewed excise tax gross-ups or guaranteed multi-year awards.
But these aren’t the only problems that we see with executive compensation. What follows is a list of seven “venial” sins – meaning, they don’t always (or even often) result in adverse voting outcomes, but we are finding that they are increasingly under scrutiny by institutional investors. Again, in no particular order:
1. Placing excessive focus on TSR-based awards
For years, companies and their third-party advisors have used total shareholder return (TSR) as a metric in compensation programs. There are a variety of ways to incorporate TSR in the compensation program: base relative TSR metrics (the most common by far), Market Stock Units (MSUs), simple stock price targets, and more. Companies and their advisors sometimes justify the use of TSR as a way to “satisfy investors and their proxy advisors” (although ISS never endorsed this metric and has quite emphatically stated being agnostic about metric selection going back to at least 2012). No matter the TSR award type, it may have some significant issues:
- Point-to-point TSR measures over most executive compensation timeframes are more reflective of changing investor optimism than actual delivered performance. TSR is best measured over the long-term – often measured in decades, rather than the three-year performance period in an LTIP cycle. The varying placing of companies during business cycles over a three-year LTIP cycle and the point-to-point nature of most measurement techniques make a relative TSR measure more of a lottery ticket than a performance measure.
- Relative TSR awards may be interpreted as a “punt” on the part of the compensation committee. Selecting the right metrics and establishing meaningful goals is hard – there’s no doubt about it. But many companies claim that they implement a TSR program because projecting three years of financial data is simply too difficult for them; relative TSR solves that need by not requiring any projection. But boards should have the means and ability to create such projections, especially if these measures will help establish meaningful goals.
- TSR is a levered measure. In a bull market environment – which we’ve seen over the past 10 years – more financial leverage leads to higher returns; often companies with poorer fundamental performance but higher levels of leverage earn higher TSR than a similar company with lower leverage but stronger fundamental performance. However, when the market corrects, the situation will change significantly.
- TSR awards do not give managers or investors clear line of sight. It’s hard for a CEO to get up in the morning and focus on “making more TSR.” A CEOs job description should not include “stock price cheerleader-in-chief” as the main focus. Many investors agree that CEOs should focus on resource allocation and productivity, and excessive emphasis on TSR may distract from those priorities.
- TSR awards can reward the executive multiple times for the same shareholder wealth creation. Many alternative fund managers (hedge funds or private equity) have a concept of a “high watermark” in their fee structures; they are only paid once on value creation for their own investors. But we don’t often see similar safeguards in TSR-based executive compensation awards. That opens the potential for executives to be rewarded multiple times for creating the same shareholder wealth; the energy industry over the past four years has seen many such cases.
Many investors do recognize that having a relative metric in a compensation program is useful to encourage executives to look both outward and inward to assess their performance. And, even if we acknowledge that “cheerleader-in-chief” for the company’s stock price may be an important part of the CEO’s job, it should perhaps be encouraged more modestly. Some companies have chosen to use relative TSR as a modifier, adjusting LTIP payments up or down a moderate amount – say plus or minus twenty percent – as a way to accomplish these two aims. That may be a great way to incorporate TSR into a compensation program without motivating excessive focus. Certainly, there are many other ways to solve this issue that are just as effective.
2. Complicating the compensation program with too many metrics
Proxy advisors and investment professionals are reasonably sophisticated consumers of compensation data. They understand that modifier metrics, hurdle metrics, high watermarks, and other non-traditional structures can add value to a program. But there are some compensation programs that seem to take things to extremes. To illustrate, let’s focus on the number of metrics of short-term incentive programs as an imperfect proxy for program complexity.
According to ISS Incentive Labs data, among S&P 1500 companies, the median number of metrics used in a short-term incentive plan is four, with the middle 50 percent of companies using between two and five metrics. In general, these aren’t highly complex programs; even at the 75th percentile, where there are five metrics in operation, the program is generally understandable, and investors can easily grasp the interactions among metrics in most cases. Perhaps more importantly, executives can focus management attention on improving those key metrics; there’s clear line of sight to what the board wants management to prioritize.
But some companies take metrics to an extreme. There are some companies that have more than 50 metrics in their short-term programs (set aside an afternoon and go through the programs at Consolidated Edison or Pinnacle West Capital, for instance) – and many more companies have at least 15 metrics. When you ask the CEO to focus on everything (or, at least, too many things), you face the risk of losing the CEO’s focus on the things that are most important.
Ninety percent of S&P 1500 companies include eight or fewer metrics in their short-term program. If a company employs more than eight metrics in their STIP, the program may be worth a closer look. One may at least look for a rationale as to why fewer metrics cannot be used.
On the long-term side, the median number of metrics used (including modifiers and hurdles) is three, with the middle 50 percent of companies using between two and four metrics. Only 10 percent of companies use six or more metrics – although we see some companies using significantly more than that.
3. Seeming to allow management and consultants to drive the executive compensation agenda and program
Investors are not naïve. They know that deep executive compensation expertise is not a skillset that often appears on a board’s director search criteria. Consequently, there’s a lot of reliance on third-party advisors to design, benchmark, pressure-test, and disclose executive compensation programs. But what’s essential is to have firm and effective boardroom oversight over these processes.
How does this practice become apparent? Well, one way is through shareholder engagement. Investors report that, in some engagements, companies bring along their compensation consultants or members of management to explain the compensation program, even though they have members of the compensation committee present in the room.
That’s not to say that management and consultants don’t play a vital role in the executive compensation process – they do, and there is nothing inappropriate with management and consultants playing a significant role in the process. But when the compensation program evolves to the point that compensation committee members have difficulty articulating the program’s strategy, mechanics (not including the technical details that are beyond the board’s remit, of course), and connection to company strategy, there’s a problem.
Some proxy statements do an exceptionally good job of articulating the committee’s involvement in the process, and, oftentimes, engagements with directors at those companies confirm the committee’s understanding and direction of the program. However, far too many proxies leave the division of duties and the altitude of the committee’s engagement in the compensation process to the reader’s imagination – and, as some investors report, engagement meetings seem to confirm these suspicions.
4. Blurring the line between retentive pay components and incentive pay components
One of the seven deadly sins is the “special grant“ – often called a retention grant. Certainly, that’s an issue – but, at least in years when the formulas haven’t failed, these grants are more symptomatic of a greater problem: the failure to structure pay programs with an appropriate mix of retentive pay and incentive pay. Of course, there are exceptions; when formulas obviously fail and pay low when operating performance is high, there may be a need for a supplemental grant, but those situations are relatively uncommon.
For the purposes of illustrating this argument, we categorize the various elements of compensation in two separate parts: retentive pay and incentive pay. The retentive pay program includes items such as base salary, time-vesting stock, perquisites, and pension adjustments – in other words, items that an executive could depend on receiving, no matter the level of performance of the company. The incentive pay program elements – including bonus, non-equity incentive program payments, and performance stock – are designed to reward executives for their performance-managing and operating the enterprise. (Stock options are conspicuously left out; there are good arguments for putting them in either the retentive or the incentive columns.)
However, today it seems that some companies are convinced that executives are entitled to part of incentive pay, even when performance doesn’t pan out. Some companies have done this by including a minimum payout on below-target performance (doesn’t that make those awards actually just time-based?), while others have resorted to other mechanisms – such as one of the “deadly sin” second-chance awards – to carry out this new philosophy. This practice also relates back to the first venial sin, since these special grants are more often made in relation to failed relative TSR awards.
Ideally, the magnitude of the aggregate of retentive components of pay should be enough to mitigate retention concerns, even in down years. If companies are looking to decide what the right split of performance versus non-performance pay is for their executive team, this should be a guiding principle, instead of presenting retentive pay in the guise of incentive pay.
5. Paying insufficient attention to director or NEO (non-CEO) compensation, particularly when investors may find it noteworthy
Compensation disclosures are often focused on CEO pay, with credit given to many companies who have evolved their named executive officer (NEO) pay disclosures, and a few have addressed director pay, as well. However, these two groups – directors and NEOs – also are often groups where pay disclosures are less than what investors would like to see.
ISS has been reviewing director compensation for some time. But, as announced last year, the ISS benchmark policy will start more systematic voting action based on excessive director compensation in 2020. And while many companies spend 20, 30, or more pages explaining the compensation program for executives, the explanation for director compensation decisions is frequently scant.
Recent editions of Governance Insights have extensively covered director compensation, so there won’t be a dissection of the numbers in this issue. In cases where there are issues that drive unusual director compensation (special committee assignments, strategic situations, new director grants, and more), giving a little insight into those special circumstances, and how they benefit shareholders in the long term, is helpful.
On the NEO side, a variety of issues are sometimes seen. At the extreme, some companies seem reluctant to name five NEOs; we’ve seen S&P 1500 companies that name only the minimal two named executives (CEO and CFO) rather than five. Do these companies, with market caps of more than $1 billion, really only have two individuals that meet the definition of Named Executive Officers? And if so, does that pose an issue for succession and organizational control?
Another issue pertains to pay outcomes for NEOs that separate from service. ISS has noted another wave of companies that disclose their executive is “retiring,” yet severance benefits are paid upon their departure. When there are retirement benefits on top of severance benefits being paid, questions may arise: What triggered the severance payments? How did the payout help the shareholders’ cause?
Paying more attention to director and NEO compensation – particularly in non-standard situations, such as fewer than five NEOs named, or NEO turnover, or special board activity – can impart investors with a lot more confidence in the compensation committee and the company in general.
6. Suffering from “snowflake syndrome”
“But we’re different.” How many times have you read proxy language or heard engagement dialogue that sounds along these lines? Of course, almost every company is different – different capital structure, different competitive dynamics, different geographic footprint, different labor sourcing model, different levels of automation, different points in the business cycle; the sources of difference are endless. But the struggles that almost all companies face when setting executive compensation programs are similar.
It’s hard to gaze into the crystal ball and select metrics that will drive the company forward over the next three years. It’s hard to set compensation goals that will play out over three years. And it’s hard to project where the company might be in three years. These challenges have been faced time and time again by other companies; there aren’t nearly as many snowflake situations as disclosures might attempt to establish. After all, every investment bank and credit rating agency develops projections on a company, and they’re using outside-in data. Companies should be able to do at least as well.
To sophisticated investors, some of these situations often sound like companies aren’t doing enough to think forward about their business. The “snowflake” argument is increasingly falling flat – particularly when companies use the argument to justify opaque or completely discretionary pay programs.
7. Assuming that everyone looks at compensation programs through the same lens
In years past, companies felt relatively safe in that if they addressed issues covered by voting policies at the significant proxy advisory firms, they would also be addressing the concerns of their largest holders. But times have changed; particularly since the advent of say-on-pay, sophisticated shareholders have invested in building significant executive compensation expertise. They’ve hired former compensation consultants and in-house compensation professionals, and they’ve cross-trained stewardship team members to be compensation experts.
Along the way, institutional investors have developed unique ways at looking at compensation, and they are taking bespoke perspectives on pay much more often than in the past. These perspectives may include views on realizable pay, pay leverage, metric turnover, outside-of-plan awards, alternative performance measures, alternative peer groups, longer timeframes, metrics that analyze aggregate NEO pay, and many, many more.
The point is, writing a disclosure in an attempt to satisfy the informational needs of the benchmark voting policies of major proxy advisors may be a great start, but it simply may not be enough. Addressing the company’s shareholder base is what’s most important. That means getting to know your shareholders (largely through engagement) and asking about their viewpoints on compensation. If you get answers from large shareholders that they don’t pay attention to pay, there’s a good chance you’re not talking to the right person.
This post comes to us from Institutional Shareholder Services. It is based on the firm’s memorandum, “Seven Venial Sins of Executive Compensation,” dated May 17, 2019.