Performance’s Pay Day Has Come

© AdobeStock
For more and more companies, the question is no longer whether to grant long-term performance awards, but rather how to go about it.

Among large public companies, performance-based equity is now a nearly universal component of executives’ compensation packages. Influenced in large part by a push from big investment funds and proxy advisors, 94 percent of the 250 largest U.S. companies in the S&P 500 Index now grant long-term performance awards, according to FW Cook’s 2018 Top 250 Report, an analysis of long-term incentive grant practices for executives. It’s the “how” that companies are grappling with today, as they continue to seek more effective ways of aligning pay delivery with financial and operational performance.

AN ONGOING EVOLUTION

Back in 2011, Say on Pay acted as a firing pistol, setting off a race for companies to conform with best practices on incentive pay plan design or risk the consequences of a negative shareholder vote. Key proxy advisors largely rely on relative total shareholder return (TSR) to gauge whether pay aligns with performance against a group of comparator companies, and relative TSR quickly became a metric of choice for companies. Today, it is the most prevalent long-term performance metric, used by 62 percent of Top 250 companies in 2018 as compared with 39 percent in 2010.

Several factors contribute to that widespread adoption, says Noah T. Kaplan, a managing director in FW Cook’s San Francisco office. “Given broad macroeconomic volatility, long-term goal setting is fundamentally challenging for even the most sophisticated companies,” he says. “It is difficult to set goals that will appear to have been rigorous, challenging and appropriate when viewed in hindsight three years later. Relative TSR takes that off the table.”

The long bull market run also underscored the benefits of performance measures like relative TSR, which require outperformance rather than absolute growth. “Executives are rewarded for at least keeping pace with the market, with above-target payouts only provided for beating a relevant set of comparable companies,” says Kaplan. “There’s a natural alignment with relative TSR and the interest of shareholders.”

MIXING METRICS

At the same time, an increasing number of companies are recognizing that relative TSR has its limitations. By focusing on linking incentive pay with retrospective share price performance, measured on a point-to-point basis, the metric fails to consider whether management is delivering on the key strategic, financial and operating results that position the company for future success and may not be reflected in the stock price. “Relative TSR is valuable but it doesn’t get at certain elements of core performance that companies like to emphasize and that are essential for long-term success,” notes Rachel Gibbons, a consultant in FW Cook’s New York office who works with companies on structuring compensation plans. “So it has become common for companies to use it in conjunction with another performance measure. Seventy-eight percent of companies that use relative TSR complement it with another measure of performance, such as profitability, capital efficiency or revenue.”

Proxy advisors and large investment funds are exploring ways to more accurately measure long-term financial operating performance in a consistent manner. “This is somewhat evidenced in Institutional Shareholder Services’ shift to focus on Economic Value Added (EVA) as a core performance metric,” says Kaplan, who explains that EVA is meant to normalize returns to reflect the risk profile of the company.

EVA attempts to achieve this normalization by comprehensively measuring a company’s sales growth, profitability and capital efficiency, while also accounting for capital costs. While there can be variations by industry, for most companies the measure is defined as net operating profit after taxes (NOPAT) less a full weighted-average cost of capital (WACC) charge on total capital.

“EVA is a bit of a challenge, due to the fundamental complexity of the calculation,” says Kaplan. “Shareholders and companies prefer for incentive plans to use performance metrics that provide a clear understanding of what is being rewarded, so it’s not obvious that ISS’ emphasis on this will lead to broad acceptance on the part of investors or adoption by companies.”

PURPOSE-DRIVEN PAY

The types of long-term incentive grants being doled out have also seen a shift over recent years, with use of restricted stock and performance awards edging upwards and stock option awards declining. (See chart, Executive Long-Term Grant Types and Usage) “We believe the reason for this shift is that long-term incentive programs are broadly designed to achieve two primary goals: retention and value creation,” says Gibbons. “Time-vesting vehicles like restricted stock promote retention, which is becoming increasingly important as companies compete more intensely for top talent in a tightening labor market. And performance-vesting vehicles encourage executives to achieve the longterm goals and strategies that will deliver value for the company.”

The prevalence of stock options and stock appreciation rights among Top 250 companies declined for the third straight year in 2018, dropping from 59 percent to 57 percent. That steady downward trend reflects a confluence of factors, says Kaplan, with the long life of stock options likely the primary one. In contrast to performance stock units, which are typically granted and then earned or forfeited over a three-year period, options can remain outstanding for as long as seven to 10 years. “At a time when an increasing number of institutional investors are paying particular attention to dilution levels, this presents a problem.”

An iffy record during periods of stock market volatility is another barrier preventing options from regaining their former stature as a preferred long-term incentive vehicle. “When we had a broad economic downturn, option grants largely failed to deliver value to employees, while leading to a buildup of dilution levels for an extended period of time,” recounts Kaplan. “On top of that, companies were required to incur a compensation expense for those awards. That’s another reason some companies are reluctant to give them another shot.”

The absence of dividend rights on stock options may also be a contributing factor. “Companies are increasingly delivering value to shareholders through dividend distributions, and stock options don’t include dividend rights. So there’s a bit of a disconnect in the alignment of shareholder returns and returns for option holders.”

OPPORTUNITIES AHEAD

Over the past few years, many of the large investment funds have built out their internal proxy voting departments and developed guidelines that are independent from those used by the large proxy advisors. Kaplan believes that this change “may provide an opportunity for companies to develop customized pay programs to better support their businesses, knowing that such redesigns will be accepted so long as they can show that pay delivery and performance are meaningfully aligned.”


  • Get the Corporate Board Member Newsletter

    Sign up today to get weekly access to exclusive analysis, insights and expert commentary from leading board practitioners.
  • UPCOMING EVENTS

    SEPTEMBER

    16-17

    20th Annual Boardroom Summit

    New York, NY

    NOVEMBER

    13

    Board Committee Peer Exchange

    Chicago, IL

    MORE INSIGHTS