The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Nice analysis from Steve Seelig and Andrew Goldstein of Towers Watson in this article:

Today, many institutional shareholders consider recommendations from proxy advisors who rely on proprietary pay-for-performance models as their first level of review in making their say-on-pay voting decisions. Over the years, these models have been subject to criticism for imposing quantitative testing regimes that focus on pay opportunity relative to total shareholder returns (TSR). In response, proxy advisors have honed their models to be more granular and more qualitative, although some critics have suggested these analyses don’t focus quite enough on the particular results the programs seek to elicit.

This may be changing. In working with clients in the 2013 proxy season, we’ve reviewed a number of proxy advisor reports regarding qualitative matters and their focus on how incentive programs are structured and precisely what those programs reward. The companies examined in these reports may have failed a quantitative test on pay for performance that necessitated closer scrutiny from the proxy advisor. Understanding these reports is important because, as has become clear in the say-on-pay era, every company is just one bad performance year away from coming in for increased proxy advisor scrutiny. Fortunately this does not mean that all companies end up getting a negative vote recommendation. For example, when we examined S&P 500 companies that triggered a qualitative review by Institutional Shareholder Services (ISS) in 2012 based on their quantitative test results, we found that three-quarters of those companies ultimately received a favorable vote recommendation.

Nonetheless, from our consulting experience we have begun to see a pattern of analysis from proxy advisors on pay structures they find objectionable. Here’s a look at some of the issues they’ve been focusing on:

Degree of difficulty for annual incentives: This gets to the essence of whether compensation committees are setting goals that are challenging enough for executives to warrant a target bonus. While the proxy advisers are not yet making subjective determinations on this issue for all companies, we’ve seen the issue raised for companies where above-target bonus payouts were made in previous years for good performance, but where current-year payouts remained at the same levels even though year-over-year performance declined on key financial metrics such as revenues, earnings or cash flow. Influencing the advisor’s concerns could be payouts above target even though some performance metrics under the annual plan fell below target or where the target itself did not signal improved corporate financial results. While the proxy advisors could be right in their assessment, in most cases they are making such determinations without the benefit of knowing critical factors relevant to the goal-setting process. If the proxy advisors push further on this issue (which we believe is a logical path), then it will be incumbent on companies to provide a descriptive rationale for the incentive plan goals in the CD&A, particularly in cases where performance goals are not higher than the prior year’s results.

Justification and performance conditions for retention awards: It’s established that proxy advisors tend to be skeptical of large retention awards, particularly in circumstances where options are under water or annual bonuses are not earned, but companies will accede to retention grants that include performance hurdles. We’ve seen circumstances in which advisors have questioned whether retention awards should ever be used as they may indicate a company that is not committed to pay for performance. Companies that do not offer a clear explanation of the need for retention awards and for awards granted without meaningful performance conditions are inviting scrutiny.

Duplicate performance measures for both annual and long-term incentives: Proxy advisors tend to favor multiple vehicles for long-term incentive programs and reward companies that focus on performance goals for these plans. But this favorable view can evaporate in cases where a company’s long-term performance share plan uses the same metrics (e.g., net income, total cash flow) as its annual plan, creating a duplication of payouts albeit in different forms: cash and equity. This concern may be exacerbated where the performance period under the long-term plan is shorter than three years or where the plan’s weighting is not pro-rata over the performance period, resulting in more concentration on the same metrics to determine payouts.

Increases in maximum payout potential: Increases in payout maximums from 150% to 200% of target or higher are not common, but there are companies that had lowered their maximums during the recent recession as a mechanism to limit payouts (and avoid windfalls) where goal-setting was challenging. There are also companies that will raise the maximum payout to be more consistent with market practice or to incent even higher levels of stretch performance. We’ve seen cases where proxy advisors have criticized such changes in the annual or long-term plan in years when shareholder returns are down under the assumption that executives are earning more for less, even when that is not really the case.

Absolute metrics for long-term incentives: Finally, we’ve seen proxy advisors find an emphasis on absolute metrics under long-term incentive plans to be inappropriate because performance may reflect economic factors or industry-wide trends beyond the control of executives, rather than the executives’ own performance. Instead, they have insisted that companies should incorporate relative measures to determine awards granted under a long-term incentive plan, regardless of the known pitfalls associated with relative performance goals.

Severance for departed CEOs: Proxy advisors are taking a close look at severance packages for terminated CEOs, particularly when the separation is the result of an extended period of poor company performance. We’ve seen cases in which companies have been taken to task even where their severance payments are absolutely consistent with prior contractual obligations, with no enhancements granted by the board. We interpret this as another attempt to reign in “pay for failure,” but the new twist is that companies will not be able to rationalize such payments simply by saying they were made according to the terms of a previously executed employment contract or severance agreement, or by structuring the terms to be generally in line with market practice.