The SEC’s new pay-for-performance disclosure can be used by companies and investors to test alignment of pay and performance. Based on our research, there are several important findings regarding the information provided by the pay-versus-performance (PVP) disclosures that shareholders and companies will find useful. This analysis can be used to develop powerful executive incentives that are aligned with strategy and performance and that can be used in proxy disclosures to illustrate alignment of pay and performance.
The Summary Compensation Table Total Compensation figure (SCT compensation) is by far the most frequently used and disclosed pay measure to evaluate CEO pay for performance. SCT compensation is readily available and comparable across companies, making it a useful tool for shareholders to evaluate recent board-level executive pay decisions (e.g., the “target” value of equity awards using grant date fair values). In addition, Institutional Shareholder Services’ quantitative pay-for-performance evaluations use SCT compensation, such as in the relative degree of alignment test, which subtracts a company’s SCT compensation percentile from its total shareholder return (TSR) performance percentile. However, SCT compensation has been repeatedly demonstrated to be inappropriate for pay-for-performance evaluations as it is uncorrelated with TSR; this has brought forth various versions of realizable and realized pay calculations that are typically difficult to collect and calculate and not comparable across companies. The new compensation actually paid (CAP) figure is superior for evaluating pay for performance, as it utilizes the current stock price to “mark-to-market” prior equity grants and applies performance estimates and actuals to determine payout levels for incentive awards.
Case Study
The following is a hypothetical example demonstrating how to use CAP to demonstrate shareholder alignment to TSR over the same period.
Company A reports CAP of $20,000,000 and TSR of +20% for 2023. Against a comparable set of companies, this results in percentile ranking of CAP at 70th and TSR at 75th, a difference of +5, and suggests that while compensation value is high among the group, so is share price performance. Thus, the two are aligned.
Company B reports CAP of $30,000,000 and TSR of -10%. Against a comparable set of companies, this results in percentile ranking of CAP at 80th and TSR at 30th, a difference of -50, which suggests that compensation value exceeds share price performance. Thus, the two are not aligned.
Exec Comp Research
We researched the results of 188 S&P 500 companies and found that:
• The correlation of relative SCT compensation and TSR is essentially zero (.08). However, the correlation between CAP and TSR is a statistically significant .54, demonstrating strong pay for performance alignment both up and down.
• The number of situations where a company’s SCT percentile rank significantly exceeds its TSR percentile rank, and vice versa, drops dramatically when CAP is used rather than SCT compensation.
• A percentile rank analysis against a company’s peer group or industry-specific index provides the most useful evaluation of the relationship between CAP and TSR.
• Significant differentials in relative TSR and CAP rank may help identify competitive deficits/surpluses in total pay opportunities, competitive discrepancies with incentive design features, potential issues with performance metric rigor or alignment with shareholder value.
While these findings were predictable given the large emphasis on stock-based compensation for executives, it should reassure shareholders that their strong support for say on pay over the last 13 years was well-founded. In that sense, the PVP disclosures were successful, and we certainly agree that CAP is much better than SCT compensation when evaluating the alignment of pay and performance.
To demonstrate how to analyze pay and performance using the PVP disclosures, we:
• Compared a company’s percentile ranking of cumulative CAP and cumulative TSR against companies in their two-digit Global Industry Classification Standard Sector.
• Included only companies with revenue between the 25th and 75th percentiles to eliminate the potential effect of exceptionally large or small companies in the analysis.
• Used cumulative figures over a three-year period to minimize the impact of outliers, transitions and other CAP anomalies.
Assessing the relative positioning of CAP and performance using percentile rankings against a relevant peer or industry group demonstrates if a particular company’s pay and performance alignment is commensurate, better or worse than peers.
Figure 1 to the left uses 188 S&P 500 companies and plots each one based on their percentile ranking of three-year cumulative TSR and three-year cumulative SCT compensation. The three shaded areas represent companies where relative TSR performance and SCT compensation percentile rankings are within 25 percentile points (green zone; aligned), TSR percentile ranking exceeds SCT compensation ranking by more than 25 percentile points (yellow zone), and TSR percentile ranking is below SCT compensation ranking by more than 25 percentile points (red zone). These three characterizations are not robust, as SCT compensation does not change based on the performance (stock price) of the company.
• As shown, only 43% of the companies have a TSR rank that is within +/- 25 percentile points of the SCT compensation rank (green zone), which suggests a minority of companies have aligned pay and performance.
• The remaining 57% of the companies fall in the yellow or red zones as described above.
• The correlation between TSR rank and SCT compensation rank is low (0.08). This is a strong indication that using SCT compensation for evaluating pay for performance has limited utility.
When using CAP values rather than SCT compensation for this analysis, the alignment of pay and performance improves dramatically as shown in Figure 2 to the right. This is because the value of equity awards, the largest portion of executive compensation, fluctuates with the performance (stock price) of the company. Thus, strong-performing companies with higher TSRs will not only have higher TSR percent rank, but compensation rank will also increase as a result of equity awards increasing in value, and vice versa.
• The percentage of companies in the green zone increases from 43% to 66%. This model significantly reduces the number of “false negatives” by 43 companies, as SCT compensation is not aligned to stock price changes, but CAP is clearly aligned.
• The correlation between TSR rank and CAP rank is high (0.54).
Considerations
A relative analysis of cumulative CAP and TSR against a company’s peer group or industry sector can provide a more meaningful evaluation of pay and performance than comparing SCT compensation and TSR (or other industry-specific performance measures).
The yellow zone, where TSR rank exceeds CAP rank by more than 25 percentile, may suggest that companies’ compensation programs are not rewarding executives enough based on delivered performance. Some possible factors to evaluate include:
• Are target pay opportunities lower than peers?
• Are goals more difficult than peers, resulting in less compensation value for equivalent performance delivered?
• Are incentive plans less leveraged than peers, resulting in less compensation value for equivalent performance delivered?
• Is there a disconnect between TSR and incentive plan metrics?
The red zone, where CAP exceeds TSR rank by more than 25 percentile points, may suggest that companies’ compensation programs are not sensitive enough to performance. Some possible factors to evaluate include:
• Are target pay opportunities higher than peers? Are there new-hire buyouts, retention, promotion, strategic grants and other special stock grants that are distorting compensation figures?
• Does pay mix place less emphasis on equity incentives relative to peers?
• Are goals less rigorous than peers?
• Are incentive plans more leveraged than peers?
• Is there a disconnect between TSR and incentive plan metrics?
Understanding the results of a relative CAP versus TSR comparison can be a good magnifying glass for both management and the board to evaluate their compensation programs. In addition, they can be used to explain and discuss PVP on a standardized basis. While proxy advisory firms and institutional investors are not currently using this information in their analyses, voting recommendations and actions, there is certainly a use case for using CAP in pay-for-performance evaluations.