If you're not familiar with the new compensation metrics—realized and realizable pay—you should be; more and more companies are using them to provide investors with what they consider a more realistic picture of what their top executives are really earning.
Companies are providing figures on realized and realizable pay along with the executive compensation numbers found in the Summary Compensation Tables mandated by the Securities and Exchange Commission. An analysis by Compensation Advisory Partners shows that in 2013, about 15 percent of Fortune 500 companies disclosed either realized, realizable pay, or both. “This was not something that you generally saw a few years ago,” says Eric Hosken, partner with CAP.
Realized and realizable pay include the full value awards, such as restricted stock and restricted stock units and in the money stock options, rather than the potential value of the awards. Since the measurements use real values, not formulas and estimates, it better reflects the actual pay either delivered (realized) or owed (realizable) to top executives. Investors like the metrics because they can provide a better picture of pay versus performance.
The calculation for realized pay is typically the amount on which an executive pays income tax, says Charles Tharp, chief executive officer with the Center on Executive Compensation. It may include cash as well as the value of any options that were exercised, or stock that vested during the measurement period. It also can include long-term cash incentives vested and paid out.
Realizable pay, on the other hand, attempts to show just what an executive could earn over time, depending on the company's stock price performance. Here, the calculations can vary from one company to another. For instance, the realizable pay number for 2013 may include the intrinsic value of any options granted during the measurement period, based on either the stock's value at the end of the year, or on the value as determined by a Black-Scholes model.
According to analysis by Equilar, slightly more than one-third of the S&P 100 discussed realized pay in compensation disclosures, while another eight provided information on realizable pay, says Aaron Boyd, Equilar's director of governance research. That compares to 2009, when eight companies discussed realized pay and just one offered information on realizable pay. “We expect to see even more in 2014,” Boyd adds.
ISS began using realizable pay in its analysis of S&P 500 CEOs if a company's compensation policies fell into the high or medium concern category.
While the additional disclosures are far from perfect, the information does lend insight to the compensation decisions made, some compensation advisers say. “As long as they're telling the story properly, it's appropriate to show another measure of pay,” says David Eaton, vice president of proxy research with Glass Lewis.”
Indeed, the numbers shown in the supplemental disclosures can differ dramatically from those shown in the summary compensation tables, Eaton says. Especially at companies that aren't doing well, the compensation executives actually receive can be far lower than the tables indicate.
The figures shown in the summary compensation tables “really are an accounting number,” says Tharp. Typically, the numbers in the required tables show future pay—say, a calculated value of performance shares or equity options—although this may or may not be fully earned by the executive, depending on the movements in the company's stock price. Moreover, while the compensation figures show what an executive may earn in the future, they're often compared to the company's historical performance. According to Tharp, “60 to 70 percent of many CEOs' pay is future oriented, but it's compared to performance that occurred in the past.”
“If all practitioners could agree on an approach or an approach was mandated, shareholders would potentially have a better understanding of the pay and performance relationship.”
—Eric Hosken,
Partner,
CAP
To counteract that, some companies have decided to provide compensation numbers that they believe more accurately show just what their executives could or actually are taking home at the moment, “versus doing a hypothetical calculation of what an option might be worth in ten years,” Tharp says.
Such information has become even more critical with the increased focus on executive compensation levels, and especially with say-on-pay votes. “Now that shareholders have a vote on compensation packages, companies are much more aware of the message that shareholders are working off of,” Boyd says.
Added Complexity
While figures for salaries and cash bonuses are typically straightforward, things can quickly get complicated when calculating the value of options and stock awards. Stock options, for example, are reported at their fair value as of the day they were granted. “However, the actual value depends on how the stock appreciates or not over the life of the option, which can be up to ten years,” Hosken points out.
Similarly, awards of restricted stock and performance shares also are shown at their value as of the grant date. Again, however, the stock's performance over time will dictate the executive's actual earnings. If the stock does well, the executive may benefit not only from the increase in the stock price, but, with performance shares, might also be awarded additional shares. Conversely, if the company's shares languish, not only will the price of the shares be lower, but the number of performance shares awarded to the executive may be cut.
Compensation tables also typically include any change in the present value of an executive's pension plan. That number will fluctuate as interest rates go up and down, which is out of the control of any one executive or compensation committee. And this doesn't represent cash the executive takes home. “With the summary compensation table, some items are paid in cash, others are opportunities yet to be earned,” Hosken says.
In light of these shortcomings, some companies are electing to also disclose executives' realized and realizable pay.
As Hosken points out, realized pay can be “lumpy.” That is, it can vary significantly from one year to the next, depending on when the various elements of an executive's compensation package vest, or when he or she exercises options. As a result, disclosures of realized pay typically are used defensively, and as a way of showing that the executive's realized compensation was lower than the numbers shown in the SCT, Hosken says.
The optimal result from the current discussion on compensation would be clearer disclosures on the link between pay and performance, Hosken says. “There's room to come up with a better standard for disclosing realizable pay. If all practitioners could agree on an approach or an approach was mandated, shareholders would potentially have a better understanding of the pay and performance relationship.”
CONCEPTUAL FRAMEWORK
Below is the Conference Board's “Executive Summary of Conceptual Framework” for supplemental pay.
1. Performance Should Be Measured Using Total Shareholder Return and Other Financial Performance Metrics Designed to Drive Business Strategy.
2. Realizable Pay Provides a Relative Comparison to Judge Alignment of Pay With Stock Price for the Company and Relative to its Peers; Realized Pay Provides an Absolute Comparison of Pay to Performance Objectives Established by the Company and Returns to its Shareholders.
3. Disclosure Should Apply Over Multiple Years (e.g., Three Years, Five Years or Longer as Appropriate) to Explain the Pay for Performance and Pay for Alignment Stories.
4. Disclosure Should Be Based on Information Available in the Proxy.
5. Supplemental Pay Disclosures Should Apply to the CEO Only.
6. The Period Over Which Pay is Analyzed Should be the Same as the Performance Period for the Long-Term Incentives to Match Pay With Performance.
7. Disclosure Should Be as Simple as Practicable to Facilitate Investor Understanding.
8. Disclosure Should Be Consistently Applied Year Over Year.
9. Assessment of Pay Versus Total Shareholder Return (Realizable Pay) or Pay Versus Performance Metrics (Realized Pay) Should Be Based Upon Salary, Bonus and/or Annual Incentive and Long-Term Incentives But Not Include Changes in Pension Values or Other Compensation, Which Are Not Directly Tied to the Achievement of Performance Objectives.
10. One-Time Special Awards for New Hires Should Be Disclosed and the Rationale for Such Awards Explained But Not Included in Pay for Performance Comparison.
11. Disclosure Should Employ a Flexible Approach Based on a Standardized Format.
Source: The Conference Board.
Because no one has yet developed a universally accepted definition of realizable pay, companies can define it so that they look their best, Eaton notes.
Value to Companies and Investors?
Despite the shortcomings inherent in the calculations, at least some compensation analysts and investor advisory firms agree that the additional disclosures help investors better understand just what and how executives are being paid.
That doesn't mean all companies would benefit by adding this information to the disclosures they're already making. Executives should address three questions before starting the disclosures, says John Roe, executive director with ISS Corporate Services:
Do I need to demonstrate a pay for performance connection? Will a realizable pay disclosure support compensation discussion and analysis narrative? Will the disclosure be sustainable?
Before proceeding, the answer to all three should be yes, Roe says. For instance, if the bulk of an executive's pay is guaranteed regardless of performance, the additional disclosures probably will just highlight the disconnect between his or her compensation and the company's performance.
Additionally, deciding to show the compensation an executive didn't receive because of a poor year can present challenges when the company's performance improves. At that point, the executive's compensation likely will increase, and disclosing the jump can invite scrutiny. However, changing the calculation or simply omitting it is likely to cause a company to lose credibility with investors, Tharp says.
Although the number of companies making additional compensation disclosures remains small overall, many expect it to rise. The shift is part of a continuing evolution of the compensation discussion and analysis from primarily a legal document, in which companies tried not to give away too much information to their growing interest in engaging shareholders, Boyd says. “More companies will take this as an opportunity to provide their story.”
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