The Advisors' Blog

I blogged last month about the possibility of perfect alignment between executive pay and company performance. In this HLS blog, Stephen O’Byrne of Shareholder Value Advisors points out that director pay programs have drawn from the same conventional structures as executive pay – a portion of compensation in cash at market levels and a portion in equity to align directors’ incentives with shareholders’. But according to the blog, this approach to “skin in the game” may not be having the impact that’s intended – because director pay has fallen prey to a common misperception:

Directors and investors tend to think that 60% of pay in stock provides a similar incentive to 60% of wealth in stock, but, in fact, it provides an incentive that is much more varied and often much weaker.

In and of itself, awarding equity to directors isn’t a bad approach. The issue is in how the award amounts at grant and vesting are calculated. Here’s one contributing factor:

Setting target pay equal to market pay regardless of past performance creates a systematic “performance penalty” that reduces leverage and alignment. High stock returns are penalized with a reduction in grant shares (to avoid exceeding target pay), and poor stock returns are rewarded with an increase in grant shares (to maintain target pay).

To get to better alignment, Steve says that directors and investors should focus on “pay leverage” instead of percent of pay in equity. Pay leverage is the ratio of the percent change in cumulative pay, measured on a “mark to market” basis at each year end, to the percent change in cumulative shareholder wealth. Luckily, Steve also explains how to focus on pay leverage, which may be simpler than how it first appears. One step is setting target pay not just at a market value, but market adjusted for trailing relative performance, in order to correct the shortcoming noted above. Additionally:

[S]tock vesting [should take] out the industry component of the stock return. That is, the vesting multiple is 1/(1 + the industry return from the date of grant). Fourth, any cash paid out prior to the end of the measurement period [should be] treated as a draw against the value of the performance shares. In other words, in our context, all stock is held throughout our five year measurement period and doesn’t vest until the end of the five year period.

Reducing the percent of pay in stock reduces leverage but leaves pay alignment nearly perfect. If all directors had a cash retainer equal to 40% of their initial stock grant value and equity compensation that followed the provisions of the perfect correlation pay plan, director pay leverage and alignment would fall in a very narrow range.

Programming note: In observance of Veterans Day, this blog will not run tomorrow. We’ll return on Thursday. Thank you to all of our service members and service member families for your commitment and sacrifices.

– Liz Dunshee