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Matteo Tonello is Managing Director at The Conference Board, Inc. This post relates to CEO and Executive Compensation Practices: 2019 Edition, an annual benchmarking report authored by Dr. Tonello with Paul Hodgson of ESGauge and James Reda of Gallagher. Related research from the Program on Corporate Governance includes the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, by Lucian Bebchuk and Jesse Fried, Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here); and The CEO Pay Slice by Lucian Bebchuk, Martijn Cremers and Urs Peyer (discussed on the Forum here).
The Conference Board recently released CEO and Executive Compensation Practices: 2019 Edition, which documents trends and developments on senior management compensation at companies issuing equity securities registered with the US Securities and Exchange Commission (SEC) and, as of May 2019, included in the Russell 3000 Index.
The report has been designed to reflect the changing landscape of executive compensation and its disclosure. In addition to benchmarks on individual elements of compensation packages, the report provides details on shareholder advisory votes on executive compensation (say-on-pay) and outlines the major practices on board oversight of compensation design. Moreover, the study reviews the evolving features of short-term and long-term incentive plans (STIs and LTIs) and performance metrics in a sub-sample of mid-market companies included in the Russell 3000 index. This year, a new section of the study reviews data from the first year of pay ratio disclosure, which became mandatory for many U.S. public companies in 2019.
Compensation data is examined and segmented by business industry and company size (measured in terms of annual revenue). For the purpose of the industry analysis, the report aggregates companies within 11 industry groups, using the applicable Global Industry Classification Standard (GICS) codes. In addition, to further highlight differences between small and large companies, findings in the Russell 3000 index are compared with those from the S&P 500 Index. Figures and illustrations used throughout the report refer to the Russell 3000 analysis unless otherwise specified.
The following are some of the insight from the study.
Just as the demand for “pay-for-performance” has led to an increase in the percentage of CEO compensation delivered via stock awards, so investors may encourage companies to extend the vesting and performance-measurement periods of such awards. In the S&P 500, the portion of CEO pay represented by stock awards (including restricted stock and performance-based shares) exceeded 50 percent for the first time in 2018, while stock options, perks and change in pension value have been on a clear declining path. For CEOs in the Russell 3000, stock awards now represent almost two-fifths of total pay. This trend may be contained in the future by softening stock market results, but it will continue to be supported by investors’ demand for pay-for-performance alignment and the scrutiny over excessive pay. The documented shift to stock-based awards that vest over time is meant, among other things, to promote long-termism. In the coming years, in particular, compensation committees may be asked to consider extending the vesting period (and associated performance assessment period for performance-based shares) beyond the traditional 3-year period. Institutional investors, on their part, have started to signal their interest to longer performance evaluations (earlier in 2019, for example, CalPERS announced its intention to use a new 5-year measurement period to assess CEO realizable pay vis-à-vis stock performance across a company’s peer group).
While compensation committees enjoy greater discretion in designing and implementing performance-based compensation, they could find themselves on a collision course with investors if they choose metrics that investors do not view as appropriate or if they use their discretion in a manner that is viewed as de-linking pay from performance. U.S. public companies are relying on performance-based stock awards more than ever, despite the removal of the performance-based deduction exemption under IRC Code 162(m). This is, in part, because performance-based equity awards are viewed as critical in optimizing pay and performance alignment. In 2017, performance-based stock awards surpassed 50 percent of the total long-term incentive (LTI) award value for the first time ever among the Russell 3000, increasing to 51 percent from 48 percent in 2016. In 2018, performance-based awards jumped even more significantly, to 57 percent. Indeed, since 2017, performance-based stock awards have represented more than 50 percent of the total value of long-term incentive plans among mid-market companies, a practice that was previously observed only among the largest organizations.
While the reliance on performance-based stock awards has increased, companies now have greater flexibility in the design and implementation of those arrangements because they no longer need to meet the technical requirements of Section 162(m). Specifically, the tax deductibility of performance-based compensation components was subject to a number of conditions, including the approval of the incentive plan by shareholders and the restricted use of discretion. Now that companies can no longer claim deductibility for this compensation, compensation committees can consider using a wider variety of metrics and can exercise more discretion (including through modifiers or year-end adjustments) in determining the ultimate number of performance-based shares paid to executives.
Nevertheless, compensation committees should be careful in choosing metrics that investors will accept as valid indicators of corporate performance and should be aware that taking advantage of that higher degree of discretion in making year-end adjustments to financial metrics could put the company at odds with institutional investors, especially if economic and market conditions deteriorate. Institutional investors, in particular, continue to argue against the amount of discretion companies retain in adjusting the non-GAAP performance metrics included in incentive plans, complaining about the adequacy of disclosures included in the Compensation Discussion and Analysis sections (CD&As). [1]
Some companies are embedding non-financial metrics relating to environmental, social, and governance (ESG) factors in their executive incentive plans. Given the increasing attention paid to companies’ ESG practices, more compensation committees may wish to do so—especially for ESG factors that are relevant to business strategy, quantifiable, and verifiably measurable. [2] ESG-related performance goals currently remain far from common in senior executives’ compensation packages. But their adoption by some boards should not be ignored: In 2018, they were found in 71 Russell 3000 companies’ compensation disclosures. They almost always apply to short-term incentive plans and seem to be limited to three main categories: Environmental compliance, (workforce or product) safety, and diversity and inclusion. Notable examples include: Chevron (which has adopted a short-term incentive plan linking 15 percent of its short-term incentives to the greenhouse gas emission targets); LyondellBasell Industries (which links as much as 20 percent of its CEO’s short-term incentives to the Company’s performance with respect to personal and process safety standards, and also considers environmental incidents as an overall plan adjustment factor); and Verizon (which recently announced a plan conditioning the award of annual bonuses to the target of having at least 58.9 percent of its workforce composed of women and minorities).
Compensation committees could consider exploring the use of ESG and other extra-financial performance metrics—whether in the individual performance portion of an incentive plan or, for those goals that cannot easily be attributed to key individuals, as modifiers to the overall plan funding. The main challenge posed by these indicators of performance is ensuring the objectivity of their measurement and avoiding the perception that they may be arbitrarily awarded. However, the practice, which could be tested for a very modest portion of the incentive program and gradually extended over time, could signal to the investment community and other stakeholders that the company appreciates how long-term shareholder wealth is also a function of extra-financial, ESG-related business performance.
Scrutiny of generous executive pay could intensify, prompting the need for greater transparency on the pay-for-performance alignment and the far-reaching strategic benefits that incentive plans are meant to generate. So far, pay ratio disclosure, which became mandatory for most SEC-registered public companies in January 2018, has not led to the extensive negative press coverage that some had anticipated. As shown in this report, broad data variations even within the same business sector and company size group suggest that pay ratio figures should be interpreted with caution in a peer comparative analysis. But public scrutiny could intensify amid deteriorating economic conditions and during a presidential campaign that will likely debate the implications of the widening income gaps observed across the country. In fact, the report found that, in 2018, the value of the median S&P 500 CEO total compensation package was 167 times the pay of the median company employee.
The issue of inequality in the United States has been inextricably tied to executive compensation since the financial crisis of 2008. It has influenced the legislative agenda and has become a growing concern for institutional investors, some of which have a specific fiduciary duty to safeguard the economic interest of large groups of employees and retirees. [3] In the last two decades, in particular, wages at the top of the income distribution have outpaced the growth of the median worker’s salary, magnifying income gaps and thrusting inequality to the forefront of public policy discussions. In 2018, median total compensation for the Russell 3000 CEO increased by 12.5 percent, up from the 9.9 percent of 2017 and for a total 69.9 percent growth since 2010. Continued increases are observed across all market segments and almost all industries; other named executive officers (NEOs) earned less than CEOs but their total pay growth rate over the 9-year period was similar, or 63.3 percent. In comparison, for the median U.S. employee, in 2018 The Conference Board reported an actual total salary increase of 3 percent, the same of each of the last seven years. [4]
Tasked with the delicate role of balancing the need to compete for top talent with the expectation to reward performance and avoid overpaying, today more than ever the compensation committee cannot ignore how its decisions will be perceived by employees and the public. They may find it helpful to include in proxy statements a description of the compensation policy that elaborates on the rationale for the weights assigned to individual compensation components and the choice of performance metrics. It should be thorough and clearly articulate how the boards of directors intends to align pay and performance milestones.
Compensation committees should be aware that the challenges described above may only be exacerbated by an economic or stock market downturn. They would therefore benefit from continuing to develop the skills needed to successfully engage with large institutional investors and gain their voting support. A recent survey by The Conference Board confirms that, following the introduction of say-on-pay vote by the Dodd-Frank Act of 2010, compensation committees and management have been proactively pursuing forms of engagement with shareholders, especially the large institutions that can make or break the advisory vote. [5] This engagement seems to be having an impact, as shown by the limited number of repeat failed say-on-pay votes. There were 52 failed votes in the Russell 3000 in the first half of 2019, and and only six of them made the list of failed votes in 2018.
This engagement may have also contributed to the in the volume of shareholder resolutions on compensation. Compensation policies and design issues—especially those related to plan design and pay-for-performance—are now often discussed with investors in the “off season” rather than in the weeks immediately prior to the company’s annual shareholder meeting (AGM).
Nonetheless, some investors are continuing to submit shareholder proposals on compensation-related topics, such as equity retention, limits to golden parachutes, clawback policies and gender pay gap disclosure, Moreover, given the continued scrutiny of executive compensation, and the view among many investors that executive compensation (especially CEO compensation) is a topic best discussed by the chair of the compensation committee or another board member, not management, [6] it is important for one or more compensation committee members to be prepared to engage with investors on the company’s executive compensation programs, including on topics relating to the mix of compensation, incentive plan design (including the choice metrics), and any discretion the committee may have exercised.
The complete report is available here.
1 In a petition filed on April 29, 2019, the Council of Institutional Investors (CII) asked the U.S. Securities and Exchange Commission to require companies, in the CD&A section of their proxy statements, to explain why they are using any non-GAAP metrics in setting executive compensation and provide a quantitative reconciliation of such metrics to their GAAP financials. CII is an association of asset owners, asset managers, and other financial service providers representing approximately $40 trillion worth of assets under management. See https://bit.ly/2x9ocab (go back)
2 For a meta-analytical review of studies on the business value of ESG, see Matteo Tonello and Thomas Singer, “The Business Case for Corporate Investment in ESG Practices,” The Conference Board, Director Notes, Vol. 7, No. 4, July 2015.(go back)
3 At the request of board members, which expressed concern about the risk to investment from income inequality and political unrest, CalPERS has recently announced that it is seeking the collaboration of “industry peers and partners to fully develop and increase adoption of frameworks and standards for reporting on Human Capital topics, including workforce compensation.” See Beth Richtman, Sustainable Investments Update, CalPERS Investment Office, March 18, 2019, available at https://www.calpers.ca.gov/docs/board-agendas/201903/invest/item09a-01_a.pdf(go back)
4 Judit Torok, U.S. Salary Increase Budgets for 2019, Research Report No. 1666, The Conference Board, July 2018.(go back)
5 See Matteo Tonello and Matteo Gatti, “Board-Shareholder Engagement Practices: Findings from a 2018 Survey of SEC-Registered Companies,” Director Notes, Vol. 10, No. 3, The Conference Board, July 2019. The study summarizes findings from a survey of 145 SEC-registered corporations that The Conference Board conducted in the fall of 2018.(go back)
6 The survey discussed in Tonello-Gatti, “Board-Shareholder Engagement Practices,” Id., revealed that executive compensation (and, more specifically, the choice of equity-based awards for senior executives’ incentive plans) is the most frequent engagement topic for boards and investors (p. 5).(go back)
