The Advisors' Blog

When it comes to evaluating the alignment of executive pay with company performance for purposes of structuring compensation programs, compensation committees have a number of tools available. This Pay Governance memo discusses the evolution of conducting “pay for performance” assessments – and how to choose the right tool for the job.

The memo recounts that early efforts of comparing pay to performance were based on the “Total Compensation” figure in the Summary Compensation Table – which wasn’t an accurate portrayal of what an executive was earning. Companies, shareholders, and consultants then developed their own models of “Realizable Pay” – which provided useful insight but was not calculated or disclosed in a comparable manner across companies. The memo explains the concept of Realizable Pay as:

RP is a relatively straightforward concept and includes the sum of actual cash compensation earned, the aggregate value of in-the-money stock options, the current value of restricted shares, actual payouts from performance-share or -cash plans, plus the estimated value of outstanding performance-share or -cash plans granted during the performance period being examined (typically 3-5 years). It is also assumed that all shares earned during the performance period are held until the end of the applicable performance period.

When performing a RP analysis, the CEO’s RP is compared to that of the RP of the peer companies’ CEOs to determine the subject company’s percentile rank. The company’s TSR (or any other appropriate financial measure) is also compared to the TSR of its peers to determine the company’s performance percentile rank. The resulting RP and performance percentiles are then compared to determine if there is an alignment of pay and performance. For example, 50 th percentile RP and TSR would indicate a perfect match of pay outcomes and performance. In practice, however, perfect alignment rarely occurs, but pay outcomes within certain ranges (for example, between the 40 th and 60 th percentile) would likely demonstrate sufficient alignment to the Board and shareholders.

Then, along came the PVP rules – with the “revolutionary” concept of “Compensation Actually Paid.” The Pay Governance team walks through the elements of CAP and how those compare to the corresponding elements of Realizable Pay. It’s very helpful for anyone looking for a deeper understanding of these calculations – and for determining which type of calculation is best for your committee to use.

When it comes to the question of the day – “Which is better?” – the answer is every lawyer’s favorite: “It depends.” Based on Pay Governance’s assessments of disclosures & performance, CAP can be a useful data point in assessing pay versus performance, and although it’s not as accurate as Realizable Pay, it’s also not as time-consuming and complex to calculate. Again, understanding the elements of these calculations can help you know just how closely your CAP measure would compare to Realizable Pay – i.e., “whether the juice is worth the squeeze.” The memo concludes:

Both RP and PVP have revolutionized the assessment of executive pay for performance that can be used to demonstrate alignment of pay and performance both internally and externally, rather than relying on a static assessment of pay for performance based on SCT grant values of equity incentives. Indeed, recent academic research suggests that the PVP data is already influencing investors’ voting preferences.

Whether to use RP or the PVP data to construct a shareholder outcome-based pay for performance analysis may depend on the degree of precision a compensation committee may require when assessing pay for performance, the relative importance of certain pay elements such as cash long-term incentive, and the level of effort the company wishes to expend to prepare the analysis, among other considerations. In either case, these methods are far superior to SCT compensation-based pay for performance analyses, which do not consider pay outcomes and can result in both false positive and false negative conclusions regarding pay and performance alignment.

– Liz Dunshee