To withstand investor scrutiny, directors must understand industry compensation trends and how incentives relate to company strategy.

Directors involved in the creation of executive compensation plans face a double challenge in the 2023 proxy season as they navigate new regulations and growing investor scrutiny on pay. Executive Compensation 2022, a recent report from Insightia, a Diligent brand, sheds new light on how those two phenomena will affect public companies over the coming year.

A New Regulatory Burden

In the 2023 proxy season, much of the workload falling on compensation committees will entail compliance with new rules from the SEC.

Recently, the SEC announced that companies will be required to adopt clawback policies in the event of restatements, even when those restatements don’t affect the bottom line. It’s worth noting that these policies won’t be required this proxy season. Companies should look to their listing exchange for further instructions.

The biggest change came in August and is already effective. New “pay for performance” rules require companies to disclose compensation “actually paid” and a selection of financial metrics, including total shareholder return and net income, along with any other key financial or nonfinancial metrics. 

These disclosures are not a wholly new concept. The SEC first tried to introduce the rules in 2015, and some investors and proxy voting advisors have been recreating them using their own models as part of their analysis. 

Nonetheless, there is considerable excitement in Washington, D.C., and beyond that creating a safe harbor for nonfinancial metrics will encourage the uptake of ESG key performance indicators (KPIs). Diligent data from the report highlights that Europe and Australia are already making great progress in this field, with 50% of companies in our sample expected to have implemented ESG KPIs in 2022. 

In the U.S. context, boards might be forgiven for waiting just a few months to see the outcome of the SEC’s mandatory disclosure proposals on climate emissions and human capital, which will create a dataset that can be easily, cheaply and transparently benchmarked. When they do act, the report highlights that ESG KPIs are more prevalent in short-term than in long-term incentive plans (LTIPs), albeit with a higher weighting in LTIPs.

What Will Pay for Performance Look Like?

Diligent has long collected “realized compensation,” including the carried value of exercised stock options. Looking at 2021 compensation, the report highlights how the data might be distributed. 

Most notably, the report shows that realized pay may dramatically exceed disclosed pay thanks to changes in the carried value of awards. For CEOs of more than 3,000 of the largest U.S. companies, Diligent data suggests that realized pay was 156% of disclosed pay (i.e., that disclosed in proxy statements during the 2022 proxy season) representing undisclosed gains of almost $45 billion.
 
While investors may already realize that a CEO nominally working for a $1 salary has a separate source of incentives, such as large stock grants or founder shares, there will be plenty of cases in which significant stock ownership, even as part of an LTIP, starts to make an executive’s growing wealth look out of alignment with investors in any given year.

Although compensation committees have largely responded to investor concerns about the need to make incentives long-term in nature, the quantum of pay is now increasingly being cited by investors as a problem. Although LTIPs make up almost all realized pay for big and successful companies, these new disclosures may ensure more scrutiny of how much CEOs are making, particularly in relation to the average employee pay ratio that companies already disclose.

However, the report also noted that over 1,700 U.S. CEOs had lower realized pay than disclosed pay in 2021, compared with just over 1,000 CEOs who had higher reported pay. Realized compensation for 2022, given the extent of stock market declines (especially in the mega-cap tech sector), may highlight that the wealth of CEOs is falling. Investors may be keen to engage with directors to understand this unexpected twist to the new rules and whether talent retention is a problem for the company.

No Big Paydays

The report notes that average support for S&P 500 say-on-pay proposals declined to 87.5% in the 2022 proxy season, compared with 89.8% and 88.7% average support throughout the 2020 and 2021 proxy seasons, respectively.

Leading fund managers BlackRock, Vanguard and State Street Global Advisors were openly critical of U.S. compensation plans this year, with BlackRock voting in favor of 92.9% of Russell 3000 “say on pay” plans in the 2022 proxy season — the fund manager’s third consecutive year of declining support, according to Diligent data.

Most notably, investors and proxy advisors were unsympathetic toward claims that issuers needed to incentivize executives with pay hikes following pandemic-related freezes, even when those executives were generally highly regarded. 

Glass Lewis endorsed 86.1% of S&P 500 pay plans in the 2022 season, writing in its U.S. proxy season briefing that excessive one-off grants made “in a bid to attract and retain executives” were often unjustified.

Boards have had little time to prepare for the new disclosures required for the 2022 proxy season, and almost none for changing course. Investors are likely to respect that and treat the new disclosures as a learning moment. But directors will nonetheless have to think carefully about how to calculate and display new data to comply with SEC regulations and leave room for fruitful dialogue with investors. Understanding industry trends, tying incentives to the company’s strategy and being prepared to answer tough questions will be key to successfully navigating a unique proxy season.

Josh Black is editor-in-chief of Insightia, a Diligent brand.