Executive remuneration systems can be complex: Multiple layers of STI and LTI plans, the latter usually overlapping over several periods. Specifically, LTI plans covering multiple years can have different targets for the same metric in the same year. Beyond that, the number of metrics and the breadths areas they cover (think ESG) has also massively increased...
- Bigger and more complex companies
- An aspiration to capture (and reward) the key drivers of value creation
- Changes in laws and regulations, mainly driven by criticism of lavish remuneration
- Pressure from investors and proxy advisors to base payouts on measures accepted by a multitude of stakeholders
- Demands for the inclusion of non-financial incentive metrics centered on ESG goals
Challengers of executive compensation have introduced several initiatives aimed at addressing perceived complexity issues with executive pay.
=> Why haven’t these initiatives reduced complexity? ?
=> And even more important: should they...?
Critics say that the initiatives have overlooked the supply and demand dynamics in the executive talent market. In fact, enhanced disclosure equates to greater pay transparency for executive talent – obliging boards to offer competitive pay to attract, inspire, and retain the necessary talent to steer large, intricate, global companies. Ultimately, the multitude of regulations and legislation surrounding executive compensation has only heightened the complexity, both in terms of plan design and disclosure.
Sources of Increased Complexity
- As mentioned above, annual and long-term incentives comprising the typical mix of executive compensation are increasingly complex
- They span different time periods, use a mix of internal and external performance metrics and may vary among named executive officers (e.g., mix of corporate-wide and single division metrics)
- Most firms grant long-term incentives based on a forward-looking approach. In other words, the final value of the incentive depends on the achievement of future financial targets and stock price growth, and the company’s evaluation of the pay-performance relationship is carried out at the end of the performance period when the results are known and the awards have been earned and vested
- On the other hand, investors and proxy advisors usually evaluate the pay-performance relationship by comparing the total pay reported in the Summary Compensation Table, which largely represents the current estimated cost of long-term incentives that may or may not be earned in the future, with the total shareholder return over the previous 3- to 5-year period. This discrepancy in the time frames for evaluating performance and the use of the Summary Compensation Table (measure of pay at the date of grant, rather than the pay realized at the end of the performance period) contributes to the complexity of evaluating pay for performance
Supplemental pay disclosures:
- To mitigate the limitations of traditional disclosure methods like the Summary Compensation Table, companies have introduced supplemental measures such as realizable and realized pay
- The SEC mandates additional disclosure requirements, adding to the complexity of compensation reporting
- Proxies have become longer and more convoluted over time, leading to decreased investor engagement - the average investor only reading 32% of it
- Variation in the names of similar incentives across different companies further complicates proxy analysis and comparison
However, complexity is not necessarily always bad:
Complexity can be intentional and each of the line-items (metrics) may be essential. The progression of executive remuneration design and disclosure is an attempt by compensation committees to reconcile the anticipations of external stakeholders and regulators with the objectives of the company. The amalgamation of these factors has led to a certain level of intentional complexity in the structuring of executive pay programs.
Long-term incentive programs aim to:
- Foster a strategic, long-term perspective for executives by rewarding performance in all key driver drivers of the business
- Deter short-term decision-making that may undermine the company's sustained value creation
- Alleviate the agency problem by aligning executive interests with those of shareholders
- Secure favorable accounting treatment for compensation expenses (e.g. basing them on grant date rather than awards)
- Ensure ongoing alignment with shareholders through mechanisms like share retention requirements
B. Forms of bonus allocations:
A variety of equity types aims to reward multiple aspects of performance
- Stock options?align with the interests of shareholders as the executive only profits if the shareholders also benefit from an increase in share price. Stock options usually have a ten-year term and require vesting over multiple years, emphasizing long-term performance
- Performance-based awards?in the form of shares, units, or cash, encourage the achievement of medium-term performance, typically over three years, based on strategic and operational goals associated with sustained value creation and relative returns to shareholders compared to peers
- Time-vested restricted stock?immediately aligns with shareholders through share ownership and serves as a potent instrument to uphold the company’s talent strategy and retain key individuals crucial to the company’s long-term success
Metrics are anticipated to bolster both the degree of performance, e.g. revenue growth, and the quality of performance, e.g. return on investment. To incentivize competitively exceptional performance, some metrics might be gauged relative to peers or an industry index, while other metrics might be evaluated based on an absolute target to underscore the attainment of budget or strategic objectives. Metrics could be
- entirely financial in character
- non-financial yet strategically significant (this could also encompass ESG objectives)
- relative or absolute returns to shareholders
D. Investor expectations:
Companies must navigate varying investor and proxy advisor preferences regarding performance metric selection. This list includes those of the two key proxy advisors:
- ISS focuses primarily on relative TSR to an ISS-defined peer group
- Glass-Lewis uses both TSR and four standard financial metrics: change in operating cash flow, earnings per share growth, total shareholder return, return on equity and return on assets
- Investors on the other side may prioritize financial vs. non-financial metrics, absolute vs. relative returns, or specific industry benchmarks
Critics argue for a drastic overhaul of existing incentive structures to reduce complexity:
- ‘Levels of CEO pay do not correlate with company performance and increasingly complex remuneration takes up considerable time and focus in the relationship between companies and investors’
- Proposal: Current long-term incentives should be eliminated. A substantial portion of annual pay should be delivered in restricted stock that vests over the long-term. This is simple and provides an ongoing alignment of management interests with those of shareholders. Side effect: this might limit the size of CEO pay
Council of Institutional Investors:
- ‘Performance plans are a major source of today’s complexity and confusion and are susceptible to manipulation’
- Proposal: Compensation Committees should consider whether performance shares should simply be replaced with long-vesting restricted shares over a period of at least 5 years and preferably as long as ten years, or even into retirement
UK Department of Business, Energy and Industrial Strategy:
- ‘The complexity of executive pay has contributed to poor alignment between executives, shareholders and the company, sometimes leading to levels of remuneration which are very difficult to justify’
- Proposal: Eliminate LTI programs and merely grant restricted shares that vest over a minimum of 5 years
- The company eliminated long-term incentives for its top 500 managers and instead implemented a co-investment model to drive an “owner’s mindset.” Under the revised approach to incentives, executives were encouraged to invest up to 100% of their annual incentive payouts in Unilever shares. The company matched the participants’ investment based on the performance of the company (from 0% to 200% of the participants’ investment) and vested over a 4-year period
Critics’ proposed solutions :
- Eliminate LTI awards and provide only salary and annual incentives, but require a significant portion of the annual incentive to be deferred into restricted stock to negate the potential for short-termism and align with long-term shareholder interests
- Eliminate LTI and provide only salary and restricted stock, with shares vesting over a multi-year period
- Grant only one form of performance-based long-term incentive to reduce complexity
- Grant only stock options that provide a clear pay for performance relationship with shareholder returns
- Simplify the number of performance measures used in both annual and LTI awards
Based on an article by Charles G. Tharp, HR Policy Association
