The Advisors' Blog

It’s hard to believe we are rolling into Year 3 of pay versus performance disclosures. Glass Lewis already incorporates this data as a supplemental quantitative factor in its executive compensation analysis (pg. 53), but ISS and many investors are still in “wait & see” mode. This Semler Brossy memo predicts that the “Compensation Actually Paid” metric will become a more valuable data point over time. Here’s why we aren’t there yet:

One way to think about full-tenure CAP is that it is the best possible running estimate of what compensation has been and could be delivered. The annual fluctuations in unvested equity values net themselves out over time and end up showing the tallied value of compensation the moment someone could have taken their pay off the table. Even the method for calculating stock options gives credit to the long lifespan of this vehicle. By using a Black Scholes calculation at the time of vest, CAP gives credit to the long life of a stock option, even if it is “underwater” when it vests (but still has economic value). It shows a credible estimate of what could be delivered to the executive the moment it was theirs to take.

The problem is that each individual year of disclosure is meaningless in isolation. Most years are overly influenced by the change in value of outstanding equity, not the full tallied value. When there is a big negative CAP value, it’s hard to make sense of it unless you know how much the outstanding equity was initially worth. There isn’t a clear story to tell unless you can compare the full tallied value of SCT and CAP numbers.

But:

Once full-tenure CAP is available, CAP/SCT ratios become powerful because they are apples-to-apples comparisons of everything that was awarded and what it turned into (i.e., the actual compensation outcomes that were delivered) in a manner that allows for comparison across organizations. In the first two years of PVP reporting, only 84 companies in the Russell 3000 had new CEOs join in the window that would provide enough information to look at full-tenure CAP.

By 2025, organizations will be required to report five full years of data. As CEO transitions occur over time, the data set of full-tenure CAP/SCT ratios will get richer and allow for benchmarking. There will also be the opportunity to assess and develop clearer market standards for a reasonable relationship between full-tenure CAP and SCT.

Taking a closer look at the 84 companies that report “full-tenure CAP,” the memo shows how the data can raise questions (or tell a story):

– Agricultural retail company. The CEO’s full-tenure CAP/SCT was higher than relative performance due to a strong leverage profile in its long-term incentive (LTI) structure (25% options and 50% performance stock units [PSUs]) and a 200% payout on PSUs in recent years. This outcome begs the question: Has performance justified the payouts?

– Pharmaceutical company. The organization had low full-tenure CAP/SCT and flat performance due to a 100% stock option design. The CAP values decreased as options neared vesting without price improvement, and the Black Scholes calculations remained low. This scenario raises the question: Is the design working, or are there any retention risks to address?

I’m willing to bet that there are diligent compensation committee members (and advisors) who would intuitively know that something is amiss in these types of scenarios. At some point, full-tenure CAP could give them another data point to help articulate concerns. . . hopefully before an investor brings it to their attention.

– Liz Dunshee