The Advisors' Blog

The SEC’s pay versus performance rule is one that most companies love to hate – the sentiment that it was created “by economists, for economists” rings true for a lot of us. While the info might be unwieldy and arguably not material to investors, this blog from Stephen O’Byrne of Shareholder Value Advisors points out that companies themselves may have the most to gain from the disclosures.

In short, with the SEC’s standardized format and requirement for both absolute and peer-relative performance comparisons, companies now possess a new dataset: their own long-term compensation and performance history, presented in a way that can be compared with peers. Stephen’s blog walks through how compensation committees could use the data to make pay programs more effective at motivating and retaining executives. A recent paper from Stephen explains what that looks like:

The conventional wisdom in U.S. executive pay is that maintaining a target pay percentile with a high percent of pay at risk achieves the three basic objectives of executive pay. Not letting target pay fall below the median retains key talent, not letting target pay rise above the median limits shareholder cost and a high percent of pay at risk ensures a strong incentive.

The new Pay Versus Performance (PvP) data provides the data – “mark to market” pay – to test the conventional wisdom. Individual company regressions relating relative mark to market pay to relative TSR quantify incentive strength (slope), alignment (correlation) and performance adjusted cost (the intercept). These regressions show that the conventional wisdom only works for about 15% of companies.

To help understand the weaknesses of the conventional wisdom, I show that that there is a simple pay plan with annual grants of performance shares that provides a perfect correlation of relative pay and relative TSR and that this perfect correlation pay plan differs from conventional practice in two ways. First, it says that target pay should be market pay adjusted for trailing relative performance, not market pay regardless of past performance. Second, it says that vesting should take out the industry component of the stock return, not use company performance to leverage industry performance as plans with relative TSR vesting do.

The perfect correlation plan shows that mark to market pay should be equal to the expected future value of cumulative market pay plus a fixed and symmetric share of the excess return. It shows how to improve executive pay by combining fixed sharing – the guiding concept of executive pay before World War II – with competitive pay levels – the guiding concept of executive pay since World War II.

Stephen has a couple other blogs that further explain how to use PvP data. This recent Pay Governance memo also defends the usefulness of “compensation actually paid.”

As Pay Governance noted in its memo – and as we’ve shared on this blog – many comment letters submitted in response to the SEC’s Executive Compensation Roundtable earlier this year suggested ways to improve – or eliminate – mandated PvP disclosures. Getting an edge in performance means a lot these days (probably even more than a favorable “say-on-pay” vote). Companies that want to use PvP data to help incentivize and retain executives may want to make the most of it while it’s still here.

– Liz Dunshee