The Advisors' Blog

– Ira Kay and Brian Lane, Pay Governance

With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act a renewed focus has been placed on the alignment of executive pay with company performance. In addition to requiring Say on Pay – where companies will be seeking shareholder approval of compensation programs at least once every three years – the Act also requests that the SEC require filers to disclose information regarding the relationship between actual pay received by executives and company performance. Ensuring that pay is appropriately aligned with performance, a long debated and important shareholder issue regarding executive compensation, will now be brought further to the forefront of annual disclosures.

As Compensation Committees await SEC interpretation on the Act’s executive compensation provisions and begin thinking about how to accurately test and communicate to shareholders their executive pay and performance comparison, an interesting question arises: will companies be able to show that pay is in fact aligned with performance?

Despite the constant criticism of the lack of pay for performance in executive pay, we believe the answer is YES for most companies. Our micro and macro research, with our clients and in the broader market, has shown that executive compensation is indeed well aligned with company performance…when pay is properly calibrated as realizable pay.

In a recent partnership with Equilar, we studied pay and performance at 100 large U.S. companies (median market capitalization of $27B) that filed proxies in early 2010. Making the comparison between 2009 one-year total shareholder return (TSR) performance and 2009 realizable pay (base, annual incentive earned, current in-the-money value of restricted share and stock option awards, and payouts from long-term performance plans), our findings provide further evidence that there is pay for performance – showing that pay is well aligned with company performance (see Table 1). Our analysis for Table 1 finds that CEOs leading higher-performing companies have higher realizable values ($13.8M at median) than their counterparts at lower-performing companies ($8.6M), representing a 60% premium for CEOs of high-performing companies. Other findings include:

– The 2009 shareholder return for high-performing companies (those with above overall median TSR) was 41% and the CEO for these same high-performing companies earned $13.8M in realizable value for 2009.

– Low-performing companies returned -5% for shareholders while their CEOs earned realizable values below the overall median ($8.6M compared to an overall median of $10.6M)

Reviewing the annual change in realizable pay from 2008 to 2009 in relation to performance yields a similar result (see Table 2). There is differentiation in the change in realizable pay from 2008 to 2009 based on company performance. Specifically, high-performing companies delivered 46% to shareholders in 2009 while realizable pay for the CEOs increased by 61% and when shareholders lost (-6% for low-performing companies) CEOs did as well.

While this particular study finds that pay is well aligned with performance over a one-year period – 2009 a particularly important year given the volatile economic environment – we typically make this comparison over multi-year periods, three to five years and in some cases over entire CEO tenure. In fact, we think it is probably best to view the relationship between pay and performance over a longer time period than one year as many compensation programs are meant to span the long term just as many business decisions impact long-term company and shareholder performance. It is important note that the findings for our one-year study are consistent with our past studies of pay and performance over multi-year periods.

Many proxy advisory firms now run pay for performance analyses for their annual withhold votes; comparing TSR or other performance measures to some form of pay opportunity (typically from the summary compensation table). While it is still unclear what the SEC will mandate for this comparison within proxies – whether the required definition of pay will be comprised of summary compensation table values, options exercised and shares vested table values, some combination of the two, or something new entirely – we believe that the Dodd-Frank Act recognizes that pay opportunity is not the best measure of pay for comparison to company performance.

Compensation Committees can now strengthen their message to shareholders for Say on Pay by exploring the alignment between executive pay and performance. Our experience is that most companies already do pay for performance – low realizable pay when performance is weak and higher realizable pay when performance is strong – and that they should get credit for this with shareholders when it is time to vote.