CEO-to-worker pay comparisons are generating a lot of buzz surrounding executive compensation this proxy season, but the new pay ratio disclosures only reflect one requirement under the 2010 Dodd-Frank Act. Another is the say-on-pay rule, which gives the shareholders of publicly traded companies a chance to voice their approval or disapproval of executive compensation plans in nonbinding votes.
In the years since say-on-pay first took effect, proxy adviser firms have ratcheted up the attention they give to executive compensation. For example, Institutional Shareholder Services has updated its approach for determining vote recommendations with added emphasis on the connection between executive compensation and company performance.
The say-on-pay rule requires corporations to submit compensation plans for “Named Executive Officers” to a shareholder vote at least once every three years, but many companies hold say-on-pay votes annually, Senior Vice President Ani Huang of the Center On Executive Compensation in Washington, told Bloomberg Law.
She was responding to emailed questions about say-on-pay and new “pay for performance” evaluation methods used by ISS to determine how well executive pay has been aligned with shareholder returns and company performance.
The interview has been edited for clarity and brevity.
Bloomberg Law: Why is the link between executive compensation and performance such a hot topic?
Ani Huang: As companies continue to engage with their shareholders on issues relating to executive compensation and governance, ensuring that executive pay is aligned with performance (and thus with shareholder interests) is of paramount importance. The emphasis on performance has evolved to focus on metrics companies use to determine incentive pay and whether those metrics are aligned to strategy.
Bloomberg Law: What approach is ISS using in its latest executive compensation guidelines?
Huang: ISS’s updated approach—which drives its vote recommendations regarding say-on-pay—is to evaluate a number of factors including pay relative to peers and performance, corporate governance including board decision-making, and a focus on long-term alignment with shareholders. The firm’s evaluation of executive pay starts with a quantitative assessment of how well pay aligns with performance. Historically, ISS has defined “performance” as “Total Shareholder Return,” or TSR. However, investors, corporations, and other stakeholders have been increasingly skeptical of the sole use of TSR as a performance metric since it’s influenced by so many external factors.
For 2018, ISS is including a new quantitative test called the Financial Performance Assessment (FPA), which provides a comparison of CEO pay and company performance relative to a group of industry peers that are similar in size. This measure shows how the CEO’s pay and the company’s financial performance stack up versus the peer group over the long term across selected financial metrics, which can include:
Bloomberg Law: How does the addition of this new assessment affect ISS’s evaluations of executive compensation?
Huang: The ISS guidelines state that the Financial Performance Assessment will be applied as a secondary measure following its traditional quantitative screening of the alignment between pay and performance. We don’t yet have a full sense of how this new test will affect company evaluations, but ISS has said the new test will only impact the overall score when the traditional screening results in a “medium” or “low bordering on medium” concern level regarding the alignment between executive pay and company performance. In other words, the new FPA won’t impact the overall score with respect to companies that have a low concern level (that is not bordering on medium) or a high concern level after ISS has completed its traditional pay-for-performance screening.
Bloomberg Law: What steps should companies take in response to the increasing emphasis on the alignment between executive pay and company performance?
Huang: Companies should keep in mind that any identification of a misalignment between pay and performance will result in greater scrutiny by ISS, including a qualitative review, which will encompass factors such as the rigor of performance goals, general financial or operational performance, and peer group benchmarking practices. And as a proactive step, companies can conduct their own assessments utilizing the financial performance metrics that ISS is including in its quantitative pay-for-performance screening. They can even go as far as disclosing the results in their proxy statements.
If they have the opportunity, companies should check draft reports prepared by ISS, reviewing them carefully for errors and mischaracterizations. Lastly, it’s always important for companies to prioritize direct engagement with shareholders on the issues that matter to them.
For additional reading on related topics, see these articles: CEO-to-Worker Pay Reports Show Wildly Divergent Ratios; Big Question Under CEO Pay Ratio Rule: Who Is Your Median Employee?; and `Tis the Season for 2018 Proxy Disclosure Preparation.
Gain a deeper understanding of the legal complexities of employee benefits and executive compensation with a free trial to Bloomberg Law: Benefits and Executive Compensation .
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