The dash to embrace pay-for-performance compensation models is gaining momentum.
Ever since the Dodd-Frank Act gave shareholders an advisory vote on executive pay, more companies have adopted mechanisms to tie pay to performance, especially those in danger of failing “say-on-pay” votes. Now, however, even companies that have comfortable levels of shareholder support for executive pay plans are implementing reforms.
When say-on-pay first came onto the scene, companies were in essence in a reactionary mode, Jack Moran, a partner with consulting firm Aon Hewitt, said in a recent Webcast. “Over the course of time, what we’ve seen is an evolution of companies that have moved more into an offensive mode in driving that alignment,” he said.
According to two separate executive compensation reports released last month, companies increasingly are choosing to move away from stock options and toward performance-based awards. “That shows no signs of abating,” says Ted Jarvis, global director of data, research, and publications for human resources consulting firm Mercer.
When Mercer analyzed executive compensation and benefits at 240 companies in the S&P 500, for example, it found that the use of performance shares became a majority practice in 2013, used by 51 percent of companies, up from 41 percent in 2011.
Mercer’s analysis also found that the prevalence of stock options continued to fall in 2013, with just 25 percent of S&P 500 chief executives receiving option grants, down 10 percentage points since 2011.
Similar to Mercer’s study, Aon’s executive compensation survey of 294 corporate directors cited pay-for-performance as one of the top three priorities when determining executive compensation. Other priorities high on the list include pay competitiveness and governance issues concerning say-on-pay.
“As the advisory firms are voicing their opinions, management and committees are constantly fighting the one-size-fits-all mentality.”
Jack Moran, Partner, Aon Hewitt
A significant portion of executive pay continues to come in the form of long-term incentives. According to Mercer’s analysis, for example, pay in the form of long-term incentives climbed to a median $6.4 million in 2013.
Both reports also revealed that most companies offer a balanced portfolio of program offerings. In Aon’s study, few companies in the S&P reported using just one long-term vehicle, with just 9 percent of CEOs receiving options only, 6 percent receiving restricted stock only, and 14 percent receiving performance shares only.
Similarly, in Mercer’s study, just 3 percent of CEOs receive options only, 3 percent receive restricted stock only, and 9 percent receive performance shares or performance cash only. Nearly one-third of CEOs were granted a combination of all three, with an average weighting of 28 percent options, 30 percent restricted stock, and 42 percent performance awards.
‘A Period of Stability’
Shareholders have generally welcomed the diversification of long-term incentive pay structures. The fact that companies are using multiple long-term incentive vehicles in executive pay plans is “quite encouraging,” says Aeisha Mastagni, an investment officer at California pension giant CalSTRS. She cautions that companies should assure that the metrics they’re using are “rigorous enough, that they’re not setting a low bar for executives to meet.”
Despite the increase in the use of performance shares, companies are making fewer changes to their overall executive pay plans. “What we’re seeing is a period of stability,” Peter Lupo, managing director of Pearl Meyer & Partners, says. This lull in activity could have something to do with an absence in progression on Dodd-Frank, or any big changes in the market concerning executive pay, he says.
Another reason, Moran said, may have to do with the fact that many companies began using performance-based options over the last three-to-five years, and have been testing them over that period of time. “We’re at a point where companies like the portfolios they’ve designed in terms of program offerings,” he said.
Shareholder satisfaction on executive pay plans is starting to show in advisory votes on pay. Support for say-on-pay proposals through July 2014 has averaged 92 percent among Russell 3000 companies, Amy Borrus, deputy director at the Council of Institutional Investors, says. Only 54 out of more than 2,300 say-on-pay proposals did not receive majority support, a 2.3 percent failure rate.
Companies have also generally trimmed the fat on lush perks. The number and value of perquisites has dropped off significantly over the past few years. “We’re seeing companies get rid of what I call ‘shareholder irritants,’” Mastagni says. Those are things like personal use of the corporate aircraft, payment of country club dues, tax gross-ups, or any type of guaranteed payments in employment agreements. “All of those are becoming things of the past,” she says.
Some executive compensation consultants caution against going too far when it comes to appeasing investors and proxy advisory firms. The question of whether to design an executive pay program that’s right for the company versus conforming to the demands of proxy advisory firms like ISS and Glass Lewis is a constant battle.
PREVALENCE OF LTI VEHICLES
In the following graph from Aon, respondents were asked to rate which long-term incentives they offered most.
“As the advisory firms are voicing their opinions, management and committees are constantly fighting the one-size-fits-all mentality,” Moran said.
Although companies sometimes design their executive pay programs based on good business strategy, other times motivation is dictated by the preferences of proxy advisory firms, David Cross, a partner with Mercer’s Executive Rewards practice, says. “In our mind, the number one priority should be designing programs to align with shareholder interest,” he says.
“The ‘follow the herd’ mentality, while it may be safe, is not necessarily the best way to construct a compensation program,” Jarvis said. Policies that work well for one company don’t necessarily work well for another, “even other companies in the same industry,” he said.
Another consideration is that the motivations of proxy advisory firms versus shareholders are vastly different, Lupo says. For the most part, shareholders really only care about total shareholder return, and so if a company has aggressive executive pay practices but performs well relative to the company’s benchmarks, shareholders likely won’t have a problem with that, whereas a proxy advisory firm might, he says.
Companies are also reaching out more to their stakeholders. “Say-on-pay has been a major catalyst for engagement between companies and their shareholders,” Borrus says.
“Say-on-pay has made directors themselves more willing to engage in shareholders,” Borrus adds. “This is a big shift from just a few years ago, when directors used to think it was management’s job.”
CalSTRS is observing a similar trend. “Since say-on-pay took effect, we’ve seen shareholder engagement go up five-fold, companies calling us wanting to talk about,” Mastagni says. This engagement comes in two forms: companies that call in the midst of proxy season trying to solicit votes, and companies calling outside of proxy season seeking input, where “it’s more of an exchange of dialogue,” she says.
Moran encourages companies to continuing reaching out to shareholders when it’s not proxy season. “Follow-up calls are always better than first-time calls when battling an issue.”