Equilar Executive Compensation Summit 2017 Conference Roundup
Equity Methods was part of the Equilar Executive Compensation Summit in Chicago from June 12 to 14. We helped lead three of the sessions, and heard from a host of distinguished executive compensation professionals throughout the conference. Here’s a summary of our experience.
CEO Pay Ratio Disclosure Case Studies: What to Expect
With next year’s proxy season on the horizon, it’s time to get serious about pay ratio. David Outlaw joined Wells Miller, Marshall Scott, and Emily Del Toro (Intuit) to discuss the strategic issues that companies can expect as they prepare their pay ratio disclosures.
First up was the question on everyone’s mind: Will this rule be around by the next proxy season? The answer, for better or worse, is that it’s very likely. As the Q4 calculation window draws near, pay ratio should be considered a reality to plan for.
But there’s no single template for planning. Each circumstance has its own set of issues. For example, a company expecting a high ratio will want to put it in context for different stakeholders, including investors, employees, and the media. Likewise, companies with unique worker arrangements or workforce structures should anticipate possibilities like inconsistent employee definitions or different results from competitors. Companies with highly seasonal workforces should minimize their effect through thoughtful use of the rule’s flexibility. And decentralized conglomerates should expect a little bit of every issue, giving themselves a long runway to manage it all.
The key is preparation. Use the months before go-live to work out the process and, more importantly, get a preliminary result. That leaves time to think strategically about supplemental analysis and narrative, employee communications, and the proxy disclosure.
Incentive Design Strategy in a Post-TSR World
Relative TSR designs are not the panacea many hoped they would be. Acknowledging this, Takis Makridis, Melissa Burek, Shane Meredith (Northern Trust), and Sven Skillrud (Mondelez International) discussed emerging designs that may strike a better balance between external and internal pressures.
Internal pressures stem from executive recipients, who need line of sight for their awards to influence behavior. External pressures come from shareholders and proxy advisors, both of whom need to see a robust pay-for-performance story. To address these pressures, the compensation committee needs to strike a balance in which executives value their awards and low (high) performance is matched with low (high) pay. One solution involves “hybrid awards,” which combine a TSR metric (either relative or absolute) with one or more financial or operational metrics.
Other observations that emerged from the session:
- It’s easy to forget about stock options given the spotlight on rTSR. Still, many would argue that options provide the cleanest pay-for-performance alignment. Many companies have rolled out performance options in order to successfully label them as “performance-based” in ISS’ eyes.
- Shareholders don’t necessarily demand rTSR programs, but they do expect pay to be highly sensitive to performance. A natural appeal of rTSR is that it auto-indexes pay to performance similar to how proxy advisors think about performance.
- There are countless ways to design hybrid awards. The two main approaches involve an independent and modifier relationship between TSR and the non-TSR metric(s).
The panel closed with some practical considerations for designing hybrid awards, such as the potential for accounting surprises. They also discussed goal-setting difficulties on multi-year performance metrics, as well as bleeding-edge designs to look out for.
Incentive Goal-Setting in Difficult Times
Mark Emanuel (Semler Brossy), Christina Hall (LinkedIn), Steve Keyes (Abercrombie & Fitch), and Gary Prescott (Exelon) led this session. It was about the issues companies face when they have to set goals for their incentive plans while in the middle of a volatile operating environment.
A company in the midst of being acquired, for example, would have to educate employees about new award metrics while merging different cultures and processes.
A company undergoing a strategic turnaround confronts the possibility that if earnings underperform but other key business metrics don’t, executive recipients would not receive enough value from their awards. Finally, a company responding to a failed Say on Pay vote might need to take on an extensive shareholder outreach campaign even as it works to enhance its CD&A disclosure.
Companies in these and other unique situations should look to the following during the goal-setting process:
- Identify key decision makers early and engage them often.
- For future reference, keep a good record of key decisions and their underlying intent.
- Be flexible in the overall process and, for turnarounds, avoid overly strict adherence to best practices.
- Be explicit and transparent about how the program aligns with, and supports, the strategy.
- Prepare to “pull out all the stops” to demonstrate responsiveness to shareholder concerns.
Through the Looking Glass: What Does the Future Hold for Executive Compensation?
One major topic was regulation and disclosure. The CD&A has become bloated and too focused on “what” at the expense of “why.” But materially shorter proxies seem unlikely given the level of risk aversion and scrutiny on executive compensation. In fact, they predicted that we’ll only continue to see more executive compensation regulation in the near future.
Meanwhile, metric selection and goal-setting are becoming more important. There are pros and cons to matching annual and long-term incentive plan goals with the budget and the strategic plan. Forecasts and targets have different contexts and different constituencies they need to address. Also important is the alignment of pay with strategy. Incentive plans need to match both the conversations that happen with investors and those that happen every day in the hallways.
The panel concluded with their best predictions for the coming year:
- Pay ratio will indeed be required for next proxy season.
- Succession planning will come into more focus.
- Gender pay equity will move to the forefront.
- Goal setting will get the same level of scrutiny as other executive compensation areas.
Point Counterpoint: Debating Compensation Practices
One point of agreement? At most companies, executive compensation is well aligned with company performance, as evidenced by high Say on Pay outcomes. More controversially, they discussed the merits of making Say on Pay votes binding, considering that has worked in other jurisdictions and binding votes already exist with other compensation issues like share plans. They ultimately agreed, though, that a binding vote may not be necessary if shareholders aren’t demanding it.
Panelists had varying takes on how to align pay with performance. Some liked performance awards such as those common today. Others preferred long-term ownership, pointing out that three-year vesting periods aren’t truly long term. That said, declining emphasis on annual incentives is at least a step in the right direction.
The final topic was relative total shareholder return (rTSR). There was general acknowledgement that one size can’t possibly fit all and TSR offers poor line of sight to recipients. But rTSR does play an important role in the overall executive compensation package. After all, shareholders want to see a link between value creation and pay, and a well-constructed TSR metric directly draws that connection.
Peer Groups: Helping or Hurting Your Comp Program
Ben Chereskin (Cinemark Holdings), Martin Leclerc (ProMetic Life Sciences), and Aalap Shah kicked off this session with a discussion on how companies can find the right peers for a compensation program. To begin with, the narrower the group, the harder it is to find good peers. Even though ISS and Glass Lewis focus on companies traded on the same exchange, a company like Quebec-based ProMetic is simply forced to look outside of Canada and make compromises in order to find the right set of peers.
Which is better, a large peer group or a smaller one? A smaller group—say, 20 to 25 companies—is presumably more tightly defined. Then again, large indices are more consistent year over year. It all comes down to what the peer group is for. If it’s for pay-for-performance disclosure, then a large group can be tricky. It needs not only the right size and the right set of comparable companies, but the right metrics as well. In economic downturns, companies often use larger peer groups to dampen the outcome.
As for performance metrics, TSR is a common one. It’s not necessarily the best, but choosing a different metric takes a lot of effort. It requires determining what the right metric(s) should be, then normalizing them across the peers.
One important consideration is that the target company may move in a different direction from the companies in the peer group, such as due to niche business cycle shifts. If that’s the case, avoid limiting the group to a specific industry and size, which in the long run can impose rigidity and potential mis-selection of peers.
Even though companies often prune and add peers, it’s very hard to get the perfect peer group every single year. If a company has a small group of 15 comparable companies and 5 need to be changed, the board won’t like the amount of churn. Changes in the peer group also require explaining which portion of the compensation increase is truly due to improved performance versus underperforming peers. As a company continues to grow, it’s important to keep adding aspirational companies along with the “safe” counterparts.
The panel concluded with a discussion about compliance versus fair pay. Boards often insist on peer groups that are carbon copies of the company (an impossible task in itself). Next, some boards tend to be very compliance- and disclosure-driven. If the information in the proxy is correct and sufficient, then the compliance issue resolves itself. But focusing too much on compliance as opposed to fair pay can hurt a company in the long run.
Effective Incentive Plan Disclosure in a Skeptical World
Jim Kroll (Towers Watson), W. Robert Main (Vanguard), David Martin (CamberView Partners), and Scott Matarese (Allergan) launched this session by pointing out that more companies are issuing performance-based awards. Although ISS & Glass Lewis are not prescriptive—they have a more formulaic approach—companies have to explain why they chose their metrics. And there needs to be a connection between pay and performance. If the company has totally missed its targets, there’s no way it could have had a year of stellar performance.
Whatever industry peers are doing, a “check the box” approach won’t do. Sometimes, companies might even have pipeline goals that are commercially sensitive and cannot be disclosed in a proxy. At the end of the day, the mix of equity grants and the metrics chosen have to be right for your company.
In addition to determining the right incentive metrics, compensation committees must use some sort of discretion in determining pay that cannot or should not be positive every time. More often than not, committees decrease final payouts. But what investors and the public really look for is consistent decision making. Sometimes, idiosyncratic circumstances need to be taken into consideration (like certain metrics or successes that are not quantifiable). In these cases, companies should explain them in the proxy instead of leaving a void for someone else to fill.
When evaluating compensation plans, keep in mind at least three fundamental things will need to be disclosed:
- Link between pay and performance.
- Compensation level relative to the peers.
- Relative performance measure (such as TSR).
Keynote Session with Tom Quaadman
In his keynote address, Tom Quaadman mentioned that the SEC has three missions: capital formation, competition, and investor protection. Right now all eyes are on the first two. Fewer companies are going public nowadays. At the same time, public companies are finding it harder to communicate efficiently to their investors and the public, which is why going private has become increasingly common. But public companies are important, Quaadman argued. During the 1980s and 1990s, 2,000 IPOs created 2.2 million jobs, resulting in a 4% economic growth rate. Today, that same growth rate is 1 to 2%.
According to Quaadman, former SEC chair Mary Jo White emphasized enforcement. During her tenure, White implemented a “broken windows” policy, the intent of which was to change behaviors by going after a large amount of small cases. However, recent leadership changes at the SEC indicate a policy shift toward pursuing bigger cases.
In terms of legislative changes, Quaadman stated that the Choice Act was intended to repeal the Dodd-Frank legislation. But it seems that the Senate will fall short of the votes it needs to repeal the CEO pay ratio rule. At the same time, rules that are proposed but not finalized—such as pay vs. performance disclosure, clawbacks, and employee and director hedging—have stalled. For now, expect to see the biggest changes take place in banking deregulation.
The Art of Gaining Shareholder Approval of Equity Compensation Plans
Interestingly, fewer than 1% of equity proposals fail. Why? Because the costs of failure are so unpalatable that companies over-prepare.
In fact, 63% of companies say they begin preparing for their next equity plan proposal 6 to 12 months before their proxy submission date. About 6% say they constantly monitor and calibrate when they will need to go out for more shares. It’s important to be proactive given how stock price fluctuations and underwater options can quickly undermine what was an effective grant.
Companies can encounter numerous flavors of surprises. A sudden stock price decline is one, since this requires granting more shares to deliver the same value. Fungible share pools (which are very common) can also give rise to awkward optics, if the share request shows a number much larger than what the company intends to grant (e.g., Coca-Cola requested 500 million shares, but if they issued all restricted stock, they’d only be able to grant 100 million). Another surprise is calibrating against ISS, only to find that Glass Lewis or an institution not following ISS votes against your plan. Among those attending the workshop, 22% said they had encountered a surprise along these lines.
As surprising as it seems, proxy advisors’ voting recommendation reports may have errors in them. Therefore, it’s important to tie out every number once these reports are released. Another best practice is to never underestimate the internal socialization needed to carry out changes in the plan design. Even something as simple as adding a minimum vesting requirement (to gain points on the ISS scorecard) can trigger considerable internal backlash. Early and frequent communication is essential to getting internal stakeholders on board.
Equity plan proposals are hardly new (the SEC has required them across the board since 2003). Even so, each year more energy goes into planning and preparing.
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