November 27, 2012
Farient Study – Pay Definitions: What Works Best in Pay for Performance Analysis
Prepared by Farient Advisors LLC
Pay for performance. As the dust settles from year two of Say on Pay proxy voting, and more companies coalesce around accepted pay practices, the top issue for both shareholders and companies is whether pay is aligned with performance. While there is general acceptance that the performance side of that equation should primarily be based on total shareholder return (TSR), there is not yet a commonly accepted definition for pay. The result is that widely divergent compensation numbers currently are being used in pay for performance analysis, leaving shareholders and others unclear on how to evaluate this critical issue.
Given concerns around using the equity grant date values contained in proxy disclosures for pay and performance analyses, a growing number of companies are going beyond what is required in proxy filings and using alternative pay definitions when presenting executive compensation results in order to better make their case on pay for performance. The core issues are whether the right pay definitions are being used, whether the definitions are being used consistently, and whether disclosures allow shareholders and others to replicate these definitions across companies.
While there is agreement among the various definitions on many of the pay components, the debate centers on the valuation of equity long-term incentives (LTIs). Given that equity LTIs account for over 50% of total CEO compensation, pay for performance analysis is dependent on the fair representation of these values.
This report compares and evaluates the three most widely used alternative pay definitions – Realized Compensation, Realizable Compensation, and Performance-Adjusted Compensation™. Each of these alternative definitions produces different compensation results, and some can offer egregiously misleading results caused by:
— Mismatched time periods for pay and performance.
— Different option valuation methodologies, some of which systematically understate the value of options.
— Using target vs. actual number of shares earned in performance share plans, thereby overstating or understating their value.
Several principles are recommended in this report to best define pay and conduct pay and performance analyses. These principles include: all elements of compensation should be valued after performance has happened, pay and performance should be measured on a multi-year basis, the time horizon of pay should match the horizon of the performance measured, pay definitions should not favor one vehicle over another, and pay definitions should allow for comparability across companies. Performance-Adjusted Compensation comes closest to meeting these criteria for purposes of analyzing pay and performance.
Finally, there is a strong case to be made for better disclosure of pay outcomes. While disclosure has improved somewhat in recent years, there are still major gaps and inconsistencies in reporting. Until better disclosure is provided, even consistent pay definitions will lead to different analytical results across companies due to weaknesses in the reporting of executive compensation data. We hope that this report provides a better understanding of the issues and will hasten improved disclosures pertaining to the alignment between pay and performance.