ISS’ New Pay-for-Performance Evaluation Methodology

Posted by Carol Bowie, Institutional Shareholder Services Inc., on Saturday January 14, 2012 at 10:37 am
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Editor’s Note: Carol Bowie is Executive Director at ISS. An ISS white paper detailing the methodology discussed below is available here.

Escalating CEO pay packages in the last few decades have stirred much debate, culminating in mandated advisory shareholder votes on executive compensation under the Dodd-Frank Act of 2010. The first year of widespread “say-on-pay” votes in the U.S. suggests that investors are taking a conservative approach – about 40 proposals at Russell 3000 index companies received less than majority support from votes cast for and against, and fewer than 200 received support from less than 70 percent. The advent of say on pay in the U.S. has highlighted pay-for-performance as the most significant factor driving investors’ voting decisions on the issue, however.

Doubts about the strength of pay and performance alignment arise from perceptions of “agency problem” conflicts of interest, weak board oversight and aggressive pay benchmarking; from demonstrated abuses such as options backdating; and most recently, from concern that pay practices at some firms likely contributed to the financial meltdown that triggered the latest economic and market malaise.  Further, while executive pay has increased at a fairly rapid pace since the 1980s, investor portfolios have experienced multiple market swings – booms and busts that often appear disconnected from individual executives’ impact — adding to skepticism about long-term pay and performance alignment.

Nevertheless, while it’s clear that shareholders recognize a responsibility to monitor the pay process – as evidenced by overwhelming shareholder support for annual say-on-pay votes – institutional investors do not want to micromanage or interfere with a board’s ability to devise programs that will help create and protect shareholder value.  ISS has regularly polled both clients and other market participants on pay issues and has developed evolving methodologies to detect potential pay-performance disconnects of concern to shareholders.  In the last few years, the approach has utilized a quantitative methodology to identify underperforming companies relative to their GICS peer group, which then received an in-depth qualitative review focused primarily on factors such as the year-over-year change in the CEO’s total pay, the 5-year trend in CEO pay versus company TSR, and the strength of performance-based pay elements.

This year, based on a range of market feedback, we decided to refine our approach to pay-for-performance evaluations and develop a more sophisticated methodology to drive the analysis. The new assessment, like the former one, includes both quantitative and qualitative components. The quantitative phase includes two aspects:

  • 1) A relative analysis — CEO pay and company total shareholder return (TSR) performance relative to a peer group, over one and three years, and
  • 2) An absolute analysis — comparison of the five-year trend in CEO pay versus the trend in TSR.

Both of these have a generally long-term orientation. Companies identified has having significant misalignment between pay and performance as a result of the quantitative analysis will continue to receive an in-depth qualitative review to determine either the likely cause (e.g., problematic pay benchmarking practices) or any mitigating factors (such as rigorous performance-based award opportunities designed to drive improvement, or the impact of a new CEO). In keeping with ISS’ commitment to transparency, our recent white paper provides detailed discussion of the new quantitative methodology as well as the qualitative factors incorporated in this evaluation.

Inevitably, publication of the ISS white paper was quickly followed by a raft reports from law firms and consultants about its contents. While these communications typically do a good job summarizing the “how and what” aspects of ISS guidelines, however, they rarely include the “why’s” embedded in ISS’ policy and evaluations, which reflect the perspective of institutional investors and their long-term economic interests.

Given that many interested parties rely on these third-party summaries to explain ISS policy, it’s perhaps no wonder that there is often a lot of misunderstanding about its rationale, which is explained in the white paper but merits review here. One question that often arises, for example, is why ISS believes that companies should link executives’ rewards solely to TSR — a measure that they have no direct control over and that is influenced by many factors external to company performance. In fact, ISS does not advocate that issuers necessarily use TSR as a performance metric, and certainly not as the sole metric. On the contrary, investors surely benefit most from incentive plans that are designed to motivate executive behavior and decision-making linked to the company’s business strategy, which we presume is intended to create long-term value for shareholders. From an investor’s perspective, however, TSR (whether absolute or relative to peers) is the only meaningful measure of performance over time, as well as being both objective and transparent.  If, over the long-term, the market fails to recognize the value of a company whose internal operational and financial goals are consistently being met (and generating financial rewards for executives), investors clearly have reason for concern.

Another frequent question is why ISS considers granted pay, rather than realized pay, in the compensation evaluation. The lion’s share of top executives’ compensation flows from equity-based grants, where the ultimate amount received is based on the value of those grants when they become vested or are exercised; thus, some observers argue, this “realizable” amount more accurately reflects the linkage with performance since it depends on the trend in the company’s stock price after the grant date.  It is inarguable that executives at companies with better performing stock will realize more value from their equity grants than executives at similarly situated companies with poorer performing stock, all else being equal — it would certainly be surprising if otherwise.  But as noted, the realized value from equity-based grants may be influenced by many factors aside from company performance.  Also, from an investor’s perspective, what is most important are the pay and pay opportunities (i.e., equity-based grants) reported in each year’s proxy, which provide the most accurate picture of the amounts the compensation committee and board determined that each named executive officer ought to receive. It is those decisions that investors generally wish to monitor and evaluate, since their aim is to ensure that executives will be paid fairly, but not overpaid, for the performance they ultimately deliver and sustain. This is especially important since the pay opportunities make their way into databases that most companies use for peer group benchmarking – i.e., to help determine the pay and equity awards their executives should receive in the future.

On the issue of benchmarking, another common question about ISS’ compensation evaluation is why we don’t use company’s self-selected peer groups for our relative comparisons of pay and performance.  After all, issuers typically spend a great deal of effort constructing peer groups to ensure they are providing appropriate pay packages to attract and retain executive talent.  However, even many companies describe this process as more of an art than a science. There are no definitive standards for determining benchmarking peer groups, although several studies have demonstrated a tendency by some companies to select an abundance of peers that are larger or better performing, which may generate benchmarks that result in higher pay without regard to the benchmarking company’s performance. The primary reason ISS produces its own peer groups for our pay-for-performance analysis is because its purpose is not to benchmark pay, or to serve as a list of “competitors” against which a company might compare itself or even that an investor might compare in picking individual stocks. The ISS comparison groups are intended specifically to help evaluate the alignment of top executive pay and company performance that results from a board of director’s pay decisions over time. ISS’ comparison groups are constructed to help determine whether a CEO’s pay and pay opportunities – relative to investment opportunities at similarly sized companies where top executives would be expected to have comparable management/leadership talent and general industry expertise – are commensurate with the performance that the company has achieved over a similar long-term period.

Designing executive pay packages is a complex undertaking where multiple factors – competition, motivation, and performance chief among them – must be delicately balanced with regard to each decision.  Monitoring pay‒performance alignment is also challenging but ultimately critical to ensuring that compensation programs are effective and efficient over the long term. ISS’ evaluation is designed to assist our clients, institutional investors, in identifying outlier companies that have demonstrated a substantial disconnect between pay and performance over time, given that Congress and the SEC have clearly put that responsibility in their hands.

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