With the 2012 proxy season just around the corner and the Securities and Exchange Commission expected to issue new pay-for-performance disclosure rules later this year, companies hardly need another reason to revamp their executive compensation programs.
But if those aren't incentive enough, proxy advisory firm Institutional Shareholder Services has given companies one more reason by recently unveiling the new methodology it will use to evaluate executive pay. The change is effective for all companies whose proxy meetings take place on or after Feb. 1.
Because the ISS analysis is a key component for making voting recommendations to its proxy advisory clients, companies and their boards need to understand how ISS evaluates executive pay plans and disclosures if they want to withstand say-on-pay scrutiny in the coming year.
Historically, ISS looked at a company's total shareholder return (TSR) and its chief executive officer's pay relative to a peer group over a one- and three-year period. If the company's TSR fell below the median and CEO pay did not align with performance, ISS would use that as the basis to recommend a negative say-on-pay vote.
ISS explained in a white paper published in December that it decided to revise the methodology following the results of its 2011-2012 policy survey. In that survey, a substantial majority of institutional investor respondents …”confirmed two factors as very relevant to evaluating pay-for-performance alignment: pay relative to peers and pay increases that are inconsistent with the company's performance trend.”
Under the revised methodology, ISS said it will continue to look at TSR and CEO pay relative to peers, but will also use a more quantitative analysis than it has in the past. “In order to do that, we've had to make some changes to aspects of the overall evaluation,” says Carol Bowie, head of compensation research development and products at ISS.
Specifically, the quantitative methodology involves a new two-pronged test: a relative assessment (pay and performance evaluation relative to a peer group), and an absolute assessment (pay evaluation relative to absolute shareholder returns, independent of peer performance). At the core of its quantitative methodology, ISS will use the following three new measures:
Relative Degree of Alignment: Compares the percentile ranks of a company's CEO pay and TSR performance against a newly selected ISS-determined peer group measured over one- and three-year periods.
Multiple of Median: Expresses the prior year's CEO pay as a multiple of the median pay of its comparison group for the same period.
Pay-TSR Alignment: Compares the trends of the CEO's annual pay and the value of an investment in the company over the prior five-year period.
In the past, explains Bowie, ISS evaluated TSR and CEO pay changes over the prior five-year period by plotting them on a graph, superimposing the findings on top of one another. “So the evaluation we were doing I call qualitative, because it was just eyeballing those trends and seeing if they appeared to be aligned or misaligned,” she says.
“My advice to companies would be to look at these ISS tests as early as possible so that they can begin to communicate any issues.”
—Kristine Meyer,
Senior Associate,
ClearBridge Compensation Group
The new quantitative methodology, on the other hand, involves “some fairly sophisticated analytics in order to ensure the results produce a reliable average trend line,” says Bowie. She adds that ISS is “specifically targeting what we consider to be outlier levels of compensation.” (The chart at right shows how ISS will rank companies).
Bowie adds that ISS does not advocate that companies use TSR as the underlying metric in their incentive programs. “We recognize that there are certainly many ways to measure performance,” says Bowie. “Boards should take what they believe is the right approach to compensation for their company and their executives.”
While companies will surely quibble with the one-size-fits-all quantitative method, the upside is that they can easily perform the tests to see where they fall. “My advice to companies would be to look at these ISS tests as early as possible so that they can begin to communicate any issues,” says Kristine Meyer, a senior associate at ClearBridge Compensation Group. “The key here is avoiding any surprises with your board and management team,” she adds.
Qualitative Review
If the results from the quantitative review demonstrate significant misalignment between pay and performance, ISS will perform an additional qualitative review. The purpose of that review is to determine either the likely cause for the misalignment, or factors that mitigate the initial assessment.
For example, if a pay package is later found to be sufficiently performance-based in the qualitative analysis, “then that could potentially mitigate the results of the quantitative analysis in terms of an ultimate recommendation that we would issue,” says Bowie.
ISS provided the following list of other qualitative factors it will consider that may affect pay alignment:
Strength of performance-based compensation: An evaluation of the ratio of performance to time-based equity awards and the overall ratio of performance-based compensation to total compensation. A company that exhibits significant misalignment of pay and performance over time would be expected to strongly emphasize performance-based compensation, as well as fully disclose performance metrics and goals that should be reasonably challenging to achieve.
The company's peer group benchmarking practices: An examination of a company's disclosed benchmarking approach to determine whether it is a contributing factor to pay-for-performance misalignment. For example, a preponderance of self-selected peers that are larger than the subject company may drive up compensation without regard to performance.
Results of financial/operational metrics: If cash pay drives a disconnect, ISS considers the rigor of performance goals (if any) that generated the payouts.
Special circumstances: Exceptional situations, such as recruitment of a new CEO in the prior fiscal year or unusual equity grant practices (e.g., bi- or triennial awards) that may distort a quantitative analysis.
Some executives and compensation experts say the white paper still leaves some questions unanswered. “While we now have better insight on ISS's pay-for-performance metrics and peer group determinations, the devil will be in the details of how these policies are implemented,” says Matthew Lepore, vice president, corporate secretary, and chief counsel of corporate governance at Pfizer.
PAY FOR PERFORMANCE & ISS POLICY
The following information from the ISS paper, ‘Evaluating Pay for Performance Alignment' provides details on pay for performance measures and ISS policy.
These three measures provide the raw material for ISS' initial quantitative evaluation of pay-for-performance alignment under its Executive Compensation Evaluation Policy. ISS has developed a framework to determine whether the measures indicate the presence or absence of a potential pay-for-performance disconnect.
The philosophy of the framework is simple: if a pay-for-performance measure for a company lie within a range of typical values, then it has demonstrated some evidence of pay-for-performance alignment; if the company's measure is an outlier beyond that range, however, it begins to raise some degree of concern that a potential disconnect may exist.
The evaluative approach thus begins by identifying companies that are significant outliers in each measure. The approach is based on empirical observation of the distribution of the measures within the back-testing universe, and on the relative strength of the relationship of each measure to voting outcomes. Additionally, the methodology, where possible, avoids arbitrary threshold effects by using a continuous scoring approach. As a result, scores are additive – concerns raised for multiple measures can accumulate to provide evidence for a potential pay-for-performance disconnect.
Thus the methodology identifies whether: (1) a company's particular measure is a sufficient outlier to demonstrate a likely pay-for-performance disconnect by itself, or (2) it is a sufficient outlier to demonstrate a potential pay-for-performance disconnect in conjunction with one or both of the other measures. The table below shows the levels, for each measure that indicate, based on initial testing analysis, where a company would be considered an outlier (triggering Medium concern) or a significant outlier (which would trigger High concern). High concern for any individual factor will result in an overall High concern level for the quantitative component of the pay-for-performance evaluation, and multiple Medium concern levels may also result in an overall High concern.
Source: ISS.
“Many of the specifics are not included in the white paper,” adds Lepore. “For example, we will need to see how ISS interprets its metrics and whether and how it will use the qualitative components of the metrics.”
Another controversial component of the new methodology focuses on the way in which ISS selects a company's peer group. In general, the peer group will compromise between 14 to 24 companies selected on such criteria as market capitalization, revenue, and industry group. Lepore says Pfizer continues to believe that “ISS should use the peers selected by a company unless it believes these peers are inappropriate.”
Others have raised concerns that the peer group selected by compensation committees to compare its executive pay may not necessarily correlate with the peer group selected by ISS. Essentially, companies are forced to “guesstimate who their peers are, so trying to design a program to get ISS positive quantitative results is not full proof,” says Deborah Lifshey, a managing director at independent compensation consultancy Pearl Meyer & Partners.
“We've tried to be as transparent as possible,” responds Bowie. “Even if a company can't determine all 14 of its peers, it should be able to come close enough to give it a reasonable idea of the peer group of which it's going to be compared.”
“If a company utilizes strong performance-based compensation instruments, than they should not be terribly concerned about whom the peer group is,” she adds.
Once a company has run its tests, the next step is to communicate to the board any potential issues, “so you can make educated decisions about what, if anything, should be done from that point forward,” says Meyer. That may mean making changes to the compensation plan, engaging with shareholders to understand their views on the compensation plan, or enhancing disclosure of the program, “so that the rationale behind the program is clear to ISS and shareholders.”
So while ISS's approach is more quantitative, it's still not completely transparent, says Lepore. “While the white paper and new policies are a step in the right direction,” he says. “We will not know for sure until we get through the process this year.”
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