The Advisors' Blog

– Liz Dunshee

The test under ISS’ new director pay policy seems pretty straightforward on its face: pay that’s in the top 5% compared to similar companies will be considered an “extreme outlier” – and ISS may recommend against the committee responsible for setting it. Indeed, the top 5% sounds “extreme” – but it’s easier to end up there than one might think.

I blogged a couple months ago about a potential trap in this test for non-executive chairs – their pay gets compared to the median for all directors, not the median for non-executive chairs. This recent Pearl Meyer blog by Terry Newth flags four more factors that could lead to surprising results. Here’s an excerpt:

1. Pay Compression: Within comparable industry and index grouping, director pay data is remarkably compressed. This means that relatively small changes in director compensation can have a dramatic impact on a company’s overall percentile positioning and could put a company at risk of being in the top 5% of ISS’ groupings. For example, the median individual director compensation total for S&P 500 companies in the GICS Materials classification (15) was $262,000 and the 95th percentile was $340,500, a difference of only $78,500 (30%). The difference within the GICS Consumer Staples, Household, and Personal Products classification (3030) is even more compressed at just over $40,000 (14%).

2. Industry Bias: We are encouraged that ISS will look at industry groupings to determine the market for comparison purposes. However, how ISS defines “industry” will be very important to the outcome. Take healthcare for instance. The 95th percentile for the Healthcare two-digit GICS code (35) is $528,000. However there are two distinctly different sectors within this broader industry: Healthcare Equipment and Services; and Pharmaceuticals, Biotechnology, and Life Sciences. The 95th percentile for the four-digit GICS code that houses most biotechnology companies (3520) is $619,000, while Healthcare and Equipment (3510) is $372,000. An analysis of the top 5% of companies in the two-digit healthcare index show 92% are either biotechnology or related companies. This emphasizes that as a board, establishing pay levels based on general industry information (or even broad industry groups) could create future risk.

3. Size Bias: Like industry, index can play an important role in the outcome of ISS’ analysis. Based on previous reports and the ISS guidance to date, we anticipate that ISS will have fairly few “index” groupings, which could create risk for certain company types. Interestingly, it is not as simple as assuming the largest companies are at the most risk because they pay the highest. Our analysis found numerous examples where the 95th percentile director compensation in a particular index was higher than its larger index counterpart, for example in the energy industry (GICS 10) the 95th percentile compensation among S&P 600 firms is $711,182, while among S&P 500 firms, compensation is substantially lower at $448,042. Further, many companies are part of multiple indices, and depending on which index ISS chooses to select can have varying results. For a telecommunications company in the Russell 1000 and S&P 500, the line of demarcation for ISS establishing “excessive” director pay would be $488,000 and $408,000, respectively.

4. Program Features Bias: There are also a number of director compensation plan features that could put a company at risk relative to the ISS evaluation. Generally, these features can be grouped into two categories: (1) features that lead to greater pay variability, and (2) board leadership strategies. Features that could lead to pay variability include but are not limited to: (1) using per-meeting fees coupled with a multi-year period with increased meeting frequency (e.g., large acquisition or turnaround), (2) having a practice of targeting a fixed number of shares or options as opposed to a targeted equity retainer value, and (3) having special committees with significant pay. The board’s leadership structure could also present challenges, particularly if the company has a highly paid non-executive chair of the board or multiple leadership roles such as a non-executive board chair and vice-chair. Although these are minority practices, they could lead to issues for some companies.

Don’t be caught off-guard. Review your director pay and enhance your disclosures.