The Advisors' Blog

– Daniel Cheng, ISS Corporate Services

The following are excerpts from a recent ISS white paper, “Executive Pay Through a Peer Benchmarking Lens,” which summarizes key findings from ISS Corporate Services’ study of almost 15,000 DEF 14A filings over the past four years. Drawing on ISS’ executive compensation database, this report analyzes both pay levels as well as the processes by which companies benchmark their pay relative to peers:

The enhanced executive compensation disclosures mandated by the U.S. Securities and Exchange Commission in 2006 have provided a significant new data set for investors and companies to analyze and benchmark pay practices across a broad set of U.S. corporate issuers. Moreover, precisely how companies choose to benchmark their pay practices has received much attention following the outcry over Wall Street payouts and the recent promulgation of legislation requiring most U.S. issuers to put their pay to a non-binding shareholder vote.

The median value of total CEO compensation for S&P 500 companies decreased 4.8 percent in fiscal 2009 but jumped 20 percent to $10.6 million in fiscal 2010. A similar trend was observed among small-cap companies (defined here as members of the Russell 3000 index excluding the S&P 1500). The decline in median CEO pay for those issuers was 10 percent from 2008 to 2009, followed by a 26 percent surge in fiscal 2010. Although the gains are evidenced across all industries in fiscal 2010, those with the biggest increases were financial and information technology companies with jumps in median pay of 47 percent, followed by energy companies at 30 percent. In fiscal 2009, utility companies were on top, paying their CEOs 13 percent more than the previous period, followed by consumer discretionary companies’ 11 percent jump, when most other industries cut CEO pay.

In fiscal 2009, the global economic slowdown, coupled with increasing pressure from investors to rein in executive pay, resulted in a sharp decline in the use of equity-based compensation. Our study shows that the median option value granted by S&P 500 companies in 2009 declined almost 17 percent, while nearly half of small-cap firms suspended option awards. Instead, discretionary and non-discretionary bonuses became popular alternatives. S&P 500 companies increased their payouts of cash bonuses to CEOs by 13 percent from levels in 2008, for example, while cash bonuses climbed 28 percent at small-cap firms in 2009.

In fiscal 2010, this trend saw dramatic growth. Companies across all indices not only resumed the grant of equity-based compensation but also increased discretionary and non-discretionary bonus awards. S&P 500 companies raised equity-based compensation by 28 percent, while small-cap firms increased such pay by 46 percent. Much of the increase can be attributed to the growing popularity of stock awards. For instance, 53 percent of equity-based compensation was composed of stock in 2010 among S&P 500 companies–up from 46 percent in the previous period. Continuing the trend from 2009, large-cap companies gave 40 percent more in bonus awards to their CEOs, while small-cap companies rewarded their chief executives 54 percent more, as reported in 2011.

Better Disclosure of Benchmarking Peers

More than 97 percent of S&P 1500 companies disclosed their benchmarking practices in fiscal 2010, compared with 84 percent in 2007. Among companies reporting in 2011, we see nearly 60 percent having selected 10 to 20 peers to benchmark their CEO’s pay level, with a median number of peers selected of 15. In addition, we found that peer group size typically increases at larger companies. More than 30 percent of S&P 500 companies selected over 20 peers to benchmark pay, with only 23 percent of companies beyond the S&P 1500 doing so.

When determining peer groups, a key observation is that a majority of companies tend to select benchmarking peers whose sizes are between 0.5 and two times their own. Another observation is that the most popular standards to measure company size are corporate revenue, market capitalization, and assets, in descending order of prevalence.

We studied over 40,000 pairs of company-peer data disclosed for fiscal years 2010 and 2007. Our analysis shows that about 60 percent of peers’sizes are between 0.5 and two times that of the choosing company’s revenue. The trend is consistent between fiscal 2007 and 2010 and applies across all indices. If the focus is turned to the percentage of total peers composed of larger-cap companies, defined as companies with revenues of more than two times their own, we find the percentage is about 19 percent for S&P 500 companies, and increases to 33 percent for small-cap firms.

Payout Targets Can Be Vague or Moving

Despite the SEC’s guidance to encourage companies to increase transparency and disclose targeted levels of compensation, our study found more than 66 percent of the studied sample did not specify targets or provided ambiguous disclosure. The poor quality of disclosure is more prevalent among small-cap companies, with 72 percent of Russell 3000 companies (excluding S&P 1500 constituents) failing to disclose what percentile levels of pay they plan to target, as reported in 2011. For companies revealing the targeted percentile, we find over half set the target at peers’medians while another 40 percent target the top quartile or above median.

The report’s other key findings include:

– Peer selection remains a key concern with roughly 1,400 companies including peers that significantly increased their CEO pay while, concurrently, shareholders saw weak returns.

– Highly paid CEOs are the most prevalent peers for benchmarking. For the highest paid group in our study, the average number of times that a company is benchmarked is 27, which is 34 percent higher than that of the lowest paid group at 20.2 times.

– For a sizeable portion of study companies, our analysis found a significant misalignment between our measure of relative pay rank and relative performance rank.