The Advisors' Blog

– Scott Oberstaedt and Sharon Podstupka, Towers Watson

As we recently blogged: It’s the most wonderful time of year for business writers, especially those looking for a compelling story line that’s sure to generate discussion: “How much did that CEO make this year?”

Yes, it’s the proxy season and, as has become an annual tradition, executive pay is back in the headlines. The inevitable eye-popping ones capture readers’ attention, to be sure, but the narratives often provide few insights into what really was paid — or worse, they mislead the reader into thinking that compensation committees took actions that are not in shareholders’ best interests.

Clearly, there are situations in which media criticism of a company’s executive compensation program is totally warranted. However, if you find yourself staring at an unflattering headline about your company’s executive pay that seems less than fair (or are worried about what future press coverage may bring), you might want to be ready to explain the real story. A little advance planning for negative publicity can help go a long way in helping you prepare an explanation for your key stakeholders. Here are some suggestions for laying the groundwork to respond to six hypothetical headlines (based on real-world examples) that some companies may encounter in the upcoming proxy season.

1. “CEO Pay Rises Dramatically in 2011”

– What the reporter may have done: The reporter may have looked up the Summary Compensation Table’s (SCT) rightmost column, which shows Total Compensation for the past three fiscal years, and then subtracted the 2010 total from the 2011 total to uncover a large increase.

– What you can say in response: “The total shown on the SCT is not what we paid our CEO in 2011. It includes the accounting cost of equity grants we made that don’t vest for years or, in the case of stock options, have no value unless the stock price rises. It even includes things like 401(k) contributions and pension value changes. Our CEO’s W-2 compensation for the year was only a fraction of the amount listed.”

– What you can do: Include a table in your CD&A that highlights realized or realizable compensation. These amounts can be parallel, and in many instances, better indicators of annual executive compensation.

2. “CEO Pockets Huge 2011 Bonus”

– What the reporter may have done: Here, it’s likely that the reporter compared the 2011 annual cash incentive number listed in the SCT to the 2010 annual cash incentive number.

– What you can say in response: “Our target bonus amount did not change, but our business performance improved substantially. Our executives’ bonuses paid below target in 2010, but above target in 2011 due to improved performance. We have not changed our approach to bonus payments or targets.”

– What you can do: Include a pay-for-performance chart in your CD&A that plots variable compensation against key financial metrics, such as income growth or TSR. This can be historical performance or relative to a peer group. Explain how pay and performance are aligned, and if not, what the compensation committee has done to ensure better alignment in the future.

3. “Executive Stock Grants Skyrocket in 2011”

– What the reporter may have done: This journalist probably looked at the value of the equity-based awards grants in 2011, also from the SCT, and compared that line to 2010.

– What you can say in response: “If you look at the detail in the Grants of Plan-Based Awards on the following page, you’d see that we granted the same number of options/shares in 2011 that we did in 2010. The accounting cost changed on each share/option, but we haven’t changed our approach to annual share grants.”

– What you can do: Provide a clear explanation of how the company determines equity grant practices. For example, does the committee follow a fixed-value or fixed-share approach in making equity grants? (Note that illustrating realized or realizable compensation and pay-for-performance alignment will also help.)

4. “Departing CEO Gets Huge Parachute”

– What the reporter may have done: This reporter may have compared the pay of an outgoing CEO (which often includes accelerated accounting charges on multi-year vesting of stock and pension benefits) to last year’s pay levels.

– What you can say in response: “The total 2011 compensation cost we reported in the proxy statement is for both current year and future payments that were part of the former CEO’s contract. This included deferred compensation and a pension that was earned over many years of service with the company.”

– What you can do: Explain in the CD&A which payments were made upon termination versus which are payable in future years. Also, it may be helpful to list the values of any awards or other compensation that were forfeited upon termination, such as unpaid bonus or unvested stock options and performance shares. Most termination payment disclosures are one-time events that will cause a temporary disclosure headache, and there may be potential for the company to be accused of “paying for failure,” so stay vigilant about how you explain this one-time payment and how it might compare to future payments for outgoing executives.

5. “CEO Takes Massive Pay Cut”

– What the reporter may have done: This is the inverse of our first headline, involving a comparison of 2011 total pay to 2010 total pay in the SCT, and reporting a large year-over-year decrease.

– What you can say in response: “Our approach to compensation has not changed in the past year. We provide market-competitive target compensation levels that are earned over time based on the company’s performance. We take a long-term approach to compensation, just as we take a long-term approach to building company value. Financial statement users should not read too deeply into one-year changes in reported numbers.”

– What you can do: Provide details on each executive officer’s target compensation value as well as actual compensation paid in the last year. While a decrease in CEO pay may seem like a good thing to some outsiders (and to shareholders especially if the company had a particularly bad year), it will be helpful to highlight the consistency in target pay levels year over year, especially when performance (and pay) bounce back.

6. “Overpaid CEO Cashes in on Millions of Dollars in Options”

– What the reporter may have done: This reporter may have looked at an 8-K filing or the Options Exercised table of the proxy and concluded that the CEO got a massive payment in a year when shareholder returns were flat.

– What you can say in response: “Options are granted to provide our CEO incentives to increase shareholder value over a period of time. By their nature, options give the CEO discretion over the timing of any gains, and this exercise is in line with sound financial planning decisions. It reflects the increased value the CEO has delivered to all shareholders over the past several years.”

– What you can do: Provide a table within your CD&A or in a press release that would illustrate the value delivered to shareholders over the period in which the CEO’s options increased in value. Here again, a pay-for-performance depiction based on realizable pay would best help illustrate the close alignment between CEO pay and shareholder returns.

Ultimately, a company’s ability to affect the numbers reported in the SCT itself is limited by SEC rules. Many companies will decide that a public debate with any reporter or media outlet on executive pay has a limited upside and substantial potential downside. However, the inclusion of realized or realizable compensation tables and/or pay-for-performance charts in the CD&A is becoming increasingly common as more companies view the SCT as providing only an incomplete picture. And, of course, if there is a misalignment between pay and performance, an explanation of why it occurred and how the company’s programs are designed to ensure that pay will be aligned in future years is a critical consideration for investors.

Companies should look to use the CD&A as an opportunity to continue a dialogue on executive rewards between the company and its investors. And, while it may not garner a Pulitzer or be turned into a Hollywood screenplay, a clear and dynamically written CD&A that fully explains a company’s executive compensation philosophy — and how it reinforces the company’s long-term business strategy — is the best defense against media or other outside scrutiny of executive pay practices