“The Top Compensation Consultants Speak,” Featuring Blair Jones

Blair Jones was a featured speaker during the webcast, “The Top Compensation Consultants Speak,” hosted by CompensationStandards.com on Feb. 14, 2018. With the groundwork for implementation of pay ratio happening now, this annual webcast focused on what compensation committees should be learning about—and considering—today. Jones joined other experts to talk about:

The transcript of the webcast follows:

Broc Romanek, Editor, CompensationStandards.com: Hi, it’s Broc Romanek, Editor of CompensationStandards.com. Welcome to today’s program, “The Top Compensation Consultants Speak.”

For today’s program, initially I geared it mostly towards pay ratio, but as we round out the agenda, pay ratio is being addressed. We’re covering much more than that. The panel is always a tremendous one, and this one will be as useful as any of the ones that they’ve done over a decade of doing this program.

Mike Kesner is Principal-in-Charge of Human Capital Advisory Services for Deloitte Consulting; Blair Jones is a Managing Principal of Semler Brossy; and Ira Kay is a Managing Partner of Pay Governance.

Mike is going to start us off on last minute items you might need to take care of for a pay ratio. Mike?

Pay Ratio

Mike Kesner, Principal, Deloitte Consulting: Thank you, Broc. Good afternoon or good morning, depending on where you’re located.

I think at this point, most companies are deep into their disclosure. They have got the data and put together the initial estimates. The few things I wanted to comment on are as follows:

One, Equilar just came out with a study. They had a webcast on February 1st and have some information I thought was useful insight in looking at data that we have assembled for our clients.

One, the median pay ratio was 140 to1 and the median pay was about $60,000, although the data really changes with smaller or larger companies. For example, companies that have over 43,000 employees had a ratio of 318 to1 and the median employee’s compensation was $46,000. Smaller companies with revenues less than $1 billion, the median was $73,000, and the ratio was 47 to 1. It really does vary, but I thought it was good to have a sense of how your ratio compares.

They also break it down by industry. Some of this was in the Wall Street Journal the next day, and I do recommend you look at it. Again, it may influence your communication strategy or your disclosure.

The second thing is if you don’t like your pay ratio or your median, there are a couple of things you can do that might help. I have had clients that thought the median employee pay was too high, and they were trying to figure out how to lower it. That has been the problem for most of my clients.

One way is to consider annualizing new hires. I found with a couple of companies where they had hired a number of people as they were growing rapidly by annualizing compensation for those new hires. It had a very positive effect on the median employee’s compensation.

The other is healthcare, by adding healthcare into the total annual compensation (medical, dental, vision, disability). Things that aren’t ordinarily included in the summary compensation table can add a significant amount.

Again, just to give you an example, I had a client that added about $12,000 to $13,000 to both the median employee and the CEO. It had a big impact on that median employee’s total compensation. It also lowered the ratio, but the bigger part was it had a nice boost to the median employee’s compensation.

Now, if you do include the healthcare, you’re going to need to reconcile your shareholders and the proxy. The summary comp table adds up to $12,000 less than what is in the CEO pay ratio number, because you included healthcare. You need to make sure you cover that off.

Finally, when you’re going through your disclosure, make sure you have itemized all the required assumptions, exclusions, etc., to double-check. It’s easy to forget some of these assumptions that have to be included in the disclosure.

Then there’s one last point, take care of your median employee, because they’ll be around for the 2019 and 2020 disclosures. Make sure you have a good median employee, one that thinks stable. Take good care of them; give them a good parking spot close to the building or something like a new computer.

That’s all I have on the last-minute CEO pay ratio consideration. Ira or Blair, do you have some other thoughts on this?

Ira Kay, Managing Partner, Pay Governance: I’ll make two quick comments. One is there’s a trade-off on the size of your ratio and any issues with generating a higher median employee pay level, obviously the higher their median employee, the lower the ratio.

Also, the higher the median means more of your employees possibly could think they are below the median, and they are underpaid somehow. As a general matter, I think the going-in proposition probably should be “less is more,” less disclosure is better, because it’s possible turning those dials could create problems.

The second quick point I wanted to make is that if you have a situation that violates “my less is more,” but where the CEO has a lot of either performance shares or stock options that are under water, their realizable pay would be much lower than their summary compensation table. You might want to look at and certainly the committee should see what the ratio of realizable pay would be to the median employee in that sense.

I’m sure many of you would have been disappointed if I didn’t mention realizable pay in one of these webcasts. That’s what I wanted to say.

Blair, do you have anything to add?

Blair Jones, Managing Principal, Semler Brossy: The one thing I would add as I’ve been watching Mark Borges’ blog, and he has been highlighting the new disclosures around pay ratio. One of the things that I thought was interesting in one of his latest disclosures is a disclaimer paragraph that talks about these ratios aren’t comparable across companies, because of the different assumptions and demographics that might exist, and different business models.

While that’s a well-understood point by all of us, I suspect that will become boilerplate language most companies will want to consider including.

Romanek: Yes, Mark put a blog up last night called, “The Longest CEO Pay Ratio Disclosure (To Date).” Here is Mark’s blog.

Tax Reform Bill

Kay: I’ll talk a little bit about the tax reform bill eliminating the 162(m) exemption and what impact that might have. I’ve heard that President Bill Clinton said the $1 million exemption was the worst piece of legislation that he was involved with. What he meant by that, there was a giant loophole for executives to get a lot more pay and money. We could debate that, and that’s another conference.

It certainly seems to have increased the amount of stock options, performance-based pay, and stock held by executives. Certainly, from the corporate perspective it had a lot of benefits that ended up with higher CEO pay. That’s whole other matter.

That exemption has been closed; and any amount over $1 million for any NEO in a given year, will be a forfeited tax deduction.

I’ve actually asked some people about what are examples of things where you don’t have a corporate tax deduction, and where it has an accounting cost but no tax deduction. I guess business meals also came under some pressure in the tax reform. I think there are very few things where you’re not allowed to take a tax deduction. In any event, that is the case here.

Many companies, and I’ve seen both sides of this issue, are eliminating their umbrella plans and that’s a big impact. I’ll come back to that. There are examples of companies raising salaries and getting rid of bonuses. There might be some upward movement in salaries, because you’re not going to lose a tax deduction, or any additional tax deduction.

As a general matter there’s a great deal of pay for performance and it’s working so well from the corporate side. And the shareholders though the say-on-pay votes agree that the pay for performance model is working very well. I don’t think that tax reform will damage that model. That would be very sad if it did.

The last point I wanted to make is that some are keeping their umbrella plans and it’s a little unclear why companies have different reasons. One of the things we were thinking about was if you’re going to use upward discretion on a bonus it helps to have an umbrella plan. We are seeing more companies have part of their annual incentive payout impacted by individual performance factors and so on. What’s the disclosure on that? What’s the governance? What’s the discussion?

I think if you’re going to use upward discretion in a good way and you have a reason for that, it could be fine. For example, if the company had some overarching strategic success or the stock price went up or various things, having an umbrella you would be useful, just not for the 162(m) exemptions. Having an umbrella plan might be something worth keeping so that it gives you economic validation of where you’re setting your ultimate bonus decision. Those are a couple of my thoughts.

Jones: The things I would add for the immediate term are things that companies need to do to preserve the grandfathering under 162(m). If you use any discretion with agreement that were made prior to November 2, 2017, that could potentially taint 162(m), and that includes making discretionary decisions under an umbrella plan for some of your 2017 payouts both for the annual incentive or things that might be discretionary affecting PSU cycles that have yet to pay out.

A word of caution for companies to think about is what’s formulaically required under your plans versus where you’re using discretion. You need to check with outside counsel so you don’t inadvertently taint the 162(m) deduction that you might otherwise get. That would be one thing.

The other thing that’s been of interest to me that companies haven’t yet tackled, that we’ll see in the future, that once a covered employee always a covered employee. Deductions will be lost on compensation as long as it continues in retirement or a post termination, we’ll see some companies rethinking how those payouts happen, and trying to keep some of those payouts as close to the million-dollar annual limit as they can to maximize their ability to maintain their deduction.

Kesner: Yes, I think to Ira’s earlier point about the umbrella plan, companies will be inclined to add an individual or strategic plan modifier so there are parameters around, “Here’s what we’re going to measure, and we can increase our decrease the payout by 0.75 to 1.25 so that there’s the ability to have upward discretion in addition to downward discretion.”

A number of companies already have that, but I could see that becoming more popular now that we don’t have to follow these rigid 162(m) rules outside guardrails.

I agree also with Ira that comp structures are unlikely to change. Netflix announced they are getting rid of their annual bonus and putting it in a base salary. I don’t see a whole groundswell of companies make similar announcements. I’m guessing there won’t be too many companies that decide to go that route.

I don’t see much in the way pay is designed necessarily. I mean, there are some administrative things you’re getting rid of the outer goal in the umbrella plan. Certainly, it’s going to go away.

Also, there will be some companies that get rid of individual share limits on the equity plan. There are some plans where we usually set the limits high. There’s some benefit of having limits so you can’t turn around and grant all the shares to the top five executives.

The ability to remove some of those plan limits that were in there specifically because of 162(m), we may or may not see it, but that’s still on the fence. I’m going to still advocate leaving them in.

I do think too that a lot of the plans have been designed so far post 162(m) and had very specific rules about what adjustments would or would not be made in calculating earnings use for incentive plan purposes. There will be more companies that consider having more flexibility around this, and they won’t be as rigid.

There’ll be a list of potential adjustments and committed discretions to make them or not. I do see some loosening that we need in the 162(m) guardrails. How we administer it and how these plans were written.

Kay: Do you even think options will get another chance to be emphasized even more? The proxy advisors do not distinguish between restricted stock and stock options. There used to be good reasons to grant options. They were deductible for the top five and highly aligned with shareholders. Do you think we’ll see a slide away from options even more than we have already and a more restricted stock as a result of the exemption going away?

Jones: I haven’t seen any activity in that regard. If anything, the interest in stock options has picked up over the last couple of years, so I wouldn’t anticipate that change.

Kay: I agree with that. Stock options, despite what ISS treat them in both their quantitative and qualitative calculations & analysis, can be motivational. Stock options are substantially more shareholder-friendly than time-vested shares. We’re at a pretty low level now, 20% or 25% of a typical top executive.

Let me say I hope from an alignment, governance, and a corporate image kind of perspective, the share of stock options doesn’t get much smaller.

Calculating Existing Performance Awards Under Tax Reform

Kesner: Okay, next subject, calculation of existing performance awards with the impacts of tax reform. Let me tee this up for a moment.

Many of you are dealing with this already, but a lot of companies took major charges to earnings in 2017 or will do so in 2018, because of the repatriation of non-U.S. earnings. They had provided U.S. tax for those items; or they’ve got what we refer to as deferred tax assets, where they have tax benefit on certain items. Assuming your 35% rate would be deducted in the future, and now those deductions will only generate 21% tax benefit. Those assets have to be written down to their 21% value, not their 35% value.

A number of companies have been struggling with this. They’re using after tax measures. They’re using EBITDAs, probably not more addressed. Whether it’s the 2017 annual incentive plan or it could be the performance shares ending 2015 to 2017, 2016 to 2018, 2017 to 2019, all those plans were based on assumptions that had the tax rate that no longer applies and didn’t anticipate this big potential charge to earnings with some companies.

For a lot of my clients, they already had automatic adjustments for the effects of a tax law change, the change in accounting method like the revenue recognition rule change, and other events like goodwill impairments and restructured charges. There won’t be a whole lot of discussion. Those will get adjusted out. The big hit in 2017 will get added back in determining earnings.

Then the benefit in the say 2016 to 2018 cycle, because the 2018 taxes are going to be less than what they had assumed, they are going to lose the benefit or reduce the earnings as a result of lowered taxes because their company will presumably make more. They are going to reverse that out.

There are a number of companies though where adjustments are not hard-coated, and they are discretionary, and this goes back to the point Blair made. If you’re making discretionary adjustments, you could blow the grandfather under 162(m) out. On the other hand, you have a tough issue here, it’s like we could have wiped out the 2017 profit and there’d be no bonuses if you don’t make the adjustment.

If you make the adjustment, you’re going to provide a fair rate of compensation that reflects the operating performance of the management team, but you’ll lose your tax deductions. I think most boards I work with would air in favor of treating the executives fairly for their performance, even if it did mean losing the deduction.

Again, this is an issue that companies are going to have to deal with and it’s going to be something that won’t go away until 2019 presumably you have a three-year performance cycle because they’ll end up 2017 to 2019 performance share plan. The 2018 and 2019 are going to show higher profits than what have been budgeted because of the lower tax rate.

The only other thing I wanted to mention is if you do use discretion and make some adjustments, and the plan for the PSUs now, the performance shares, and the plan didn’t provide for that as an automatic adjustment. You probably have a new measurement date for accounting purposes which could require a big catch-up charge to earnings. If there is additional value because of the modification, it also has to be reported in the proxy as additional compensation.

Be very careful. Blair said earlier, talk to your tax people. Talk to your accounting people as well if you’re making these kinds of adjustments.

Kay: The only thing I would add is, in general, for the annual incentive plans and performance shares also, I have an example and I’m sure there are many of these, where the 2017 impact was positive. I have most of the ones for our clients, they went down because of the deferred tax assets that I talked about.

I’m sure you have a client with a deferred tax liability from an acquisition. So, it was a positive and they were agonizing over whether to reverse it out. It seems to me that you need to be consistent on this, maybe not perfectly consistent, because if you don’t back that out, how are you going to make a weaker case for adjustments in the future. You need to be reasonably consistent.

The other issue that came up was a committee chair asked if they did let them keep it in their 2017 results, which took them from a low payout to a target payout. Does that higher EPS number for 2017 become the denominator for the growth rates that would happen thereafter for 2018? That was a quick no. No, they didn’t want that because it really is a one-time event.

Therefore, people need to be very strategic about this and take the long-term perspective. They need to make sure that we’re really balancing the puts and takes on this and making it symmetrical in terms of how we’re treating it, in terms of whether it was a plus or a minus.

I did ask the management team if the tax reform had hurt them, if it had gone up from 35% to 39%. Would they want to back that out? They honestly answered yes. So again, there’s need for consistency on this.

Director Pay

Jones: Yes, I fully agree with that. Our next topic is director pay. We have seen director pay getting additional attention from both proxy advisors and the plaintiff’s bar. I thought it might be helpful to talk about what the new attention on director pay might mean for how it should be structured and administered going forward.

ISS has now come out within its policy guidelines and said it would consider recommending against directors and on the committee that determines director pay, if director compensation is viewed as excessive for two or more consecutive years. That’s if there’s no rationale or mitigating factor.

ISS is going to look at excessive pay by both looking at some of the benefits that most companies no longer provide, and perks, if those were provided; but also by looking at the magnitude of director pay relative to the ISS peer group.

Then on the plaintiff’s bars, we’ve been seeing and talking for a couple of years the wisdom of adding separate individual limits on equity plans for director equity grants. Some companies have been turning that even further and added these types of limits for cash compensation, as well.

More recently, a lot of attention has been given to the December 13, 2017 Investors Bancorp decision given out by Delaware Supreme Court, and some of its potential implications. For those of you who are unfamiliar with the decision, Investors Bancorp was a mutual company that transitioned to a stock company in 2014.

The board proposed the discretionary equity incentive plan that provided additional incentives. They put the equity plan to a vote and 96% of the shareholders approved it. The plan did include the limits for non-employee directors like we’ve been seeing as best practice and I was just talking about.

Shortly after they approved the plan, they then issued shares to the directors that were within the plan limits, but they averaged about $2 million for each of the directors in contrast to a peer median level around the $176,000. The plaintiffs alleged that the board had breached its fiduciary responsibility by granting excessive compensation.

What was interesting in this case is that the Supreme Court issued an opinion that stockholder challenges to certain director compensation awards will now be governed by the entire Fairness Standard rather than the Business Judgment Rule, and that includes plans that have these limits in them that we’ve been implementing.

More specifically what that means is if there is a stockholder challenge that review under the Business Judgment Rule won’t be available, unless the stockholders have approved the specific director award, or the plan is formulaic. Of course, that’s not something that happens right now for most companies.

They go further to say where discretion is exercised, the boards must demonstrate that the compensation awarded was entirely fair to the company and consistent with the board’s fiduciary to this.

As you think about the ISS attention, the limits that we’ve all been looking at for individual director awards and this new Investors Bancorp decision what does it all mean? The short answer is probably more conservatism around director pay changes. We may see smaller increases overall, except where it’s warranted by competitive need or rationale for larger increases.

If they didn’t already, coming out of some of the other plaintiff’s bar decisions, boards will benefit from doing regular reviews of director compensation competitiveness, making sure that compensation is staying within competitive norms on pay levels, unless there are extenuating circumstances and supporting rationale.

It will be important to pay attention to director pay that does differ from median, and that includes pay for non-executive chairs. Boards want to consider carefully any special payments to directors. Of course, if you’re outside the norms, giving more information, for instance, on non-executive chairs about what the duties are and why that might warrant additional pay would be recommended.

If we were to take the Investors Bancorp decision, literally, that would mean that most companies would start having their director pay approved by shareholders or putting it in formulas. We have not seen any plans moving in that direction. I’m curious whether Mike or Ira have seen any movement there.

To close out on this point, one other thing worth considering relative to director pay is looking at disclosure. In the past, most companies have talked about just the facts around their director pay program and that’s been the norm across the board. Now, it makes more sense to talk more about the philosophy behind director pay, the peers you’re using, and your positioning philosophy, as well.

Kesner: Deloitte and the National Association of Stock Plan Professionals did a survey in 2017, and we asked what percentage of companies had limits. Whether it was the number of shares that could be issued or the total compensation that could be paid to the directors, and only 33% have limits.

That tells me that given this environment, those companies are really at risk. I think Investors Bancorp says as long as they’re meaningful and specific limits, they are okay right? I take that means within the competitive range.

Jones: Yes.

Kesner: The fact that only a third of the companies have limits and not all have total comp limits, it suggests you have a limit on the equity. That’s a red flag and companies really need to make sure that they are adding these limits to their plans next time they get a shareholder approved, or even if they don’t need to get a shareholder approved, it might be a reason to go back and get it approved.

I don’t see us moving to say-on-director pay, although, the U.K. or Australia and some other countries have say-on-pay director’s pay approved as part of their process. In Australia, it’s a binding vote on the director’s pay, they all vote yes, you can pay it. I think in the U.K. it’s just the policy that they are voting on. There are two votes, the policy and then they actual pay.

I don’t see us going to say-on-director pay vote, but we may wind up there if there’s enough litigation.

Jones: I don’t see us going to say-on-director pay vote either. I do think there will be a higher bar for companies to talk about how they have chosen to pay their directors, particularly if they go outside the bounds of the median ranges.

Kesner: Yes, I think the way the SEC rules were originally written is barebones. You know, the CD&A got everything in the kitchen sink for the executive pay, and then they let the director pay slide.

A lot of companies say, “We use the median. We use the same peer group we use for the executives.” They give some context straight, but they probably need to provide more, especially as you said when they’re outside the normal boundaries why they would pay more. Like extreme number of meetings or whatever could perhaps help justify these pay numbers of $2 million or $1.5 million. I have a hard time saying how you would justify that for a board member.

Jones: In the Investors Bancorp decision there are circumstances that aren’t typical for most companies. However, the implications of the actual decision do apply to all.

Ira, have you seen any people implementing formulaic plans or getting their plans approved as a result of that?

Kay: I haven’t seen anything like that. It’s a very interesting development. I hope there’s no more say-on-pay for the directors. It’s enough.

Kesner: Ira, do you see most of your clients at the large companies have limits both in equity and total comp?

Kay: Typically, they do. They all pay, and I don’t know if you’ve noticed the data that the difference between median and 75th percentile is $20,000, or 5% or 10%.

Kesner: Right.

Kay: So, there’s been a tremendous compression, basically indicating that companies are really paying towards trying to focus median. That’s practically the time difference. We’re seeing similar compressions at CEO pay become sum pay, but nothing like what we have seen in director pay.

Kesner: Yes, that’s a good point. There’s not much difference between the quartiles.

Clawbacks

Kay: Let’s move on to clawbacks?

Kesner: Yes, where do I start? First of all, I think everybody understands this, but clawback is not the same thing as a forfeiture of unvested awards. There was a lot of confusion not long ago where big bank’s CEO and the president at one of their business units had to forfeit a lot of unearned compensation and that was being referred to as clawback. That’s not what a clawback is.

Clawback is you get the money and I’m taking it back. I just want to make that clear.

I don’t think the SEC is going to get around to finalizing its clawback rules. As a result, most companies have gone ahead and adopted clawbacks. They’re very narrowly construed so that they only apply where the executive officer engaged in this conduct that led to financial restatement, and then their clawback is limited to the difference between the bonuses that would have been paid with the upper earnings versus what was paid.

I really think this is a missed opportunity, and a lot of companies should look to the financial institutions for probably a better view on clawbacks.

Now, banks went that way because they were nudged by the regulators. Clawbacks, due to reputational harm to the company, failure to comply with the company’s code of conduct, violation on non-compete or restrictive covenants, should be things that are discussed as possible clawback events.

I think limiting it to executive officers doesn’t make sense. This should probably apply to all incentive eligible employees. I could tell you that when we first did clawbacks, even the most restrictive ones that I described earlier, there was huge pushback from the executives, and they are not liking the conversation around expanding the clawback for some good valid reasons.

One, they like having a bright-line test and some of these things like not complying with company’s code of conduct, or a reputational harm in the company. They’re highly judgmental and worried that there could be retaliation against them, and that’s how they were terminated. The company is trying to punish them by trying to clawback money which probably, in their view, wouldn’t be warranted. They don’t like that broad authority potentially being abused.

I’ve seen situations now where somebody has left the company and had the right to exercise options. They exercised the options, they were vested, and violated their non-compete. The company couldn’t claw that money back. The board is sitting around the table, looking at each other and asking themselves, “Well, how did this happen? How could they violate the covenant and still get to keep all that option profit that they had exercised before they went to work for the competitor?” That’s the answer which nobody liked.

I do see clawbacks starting to evolve and, again, broaden out in terms of participation, the types of events that might trigger clawback. I think it’s going to be awhile and I certainly won’t count on any SEC rule to be the catalyst for the change.

There’s big reputational harm for data breaches. There are some other examples where I wouldn’t want to be the one that tells the board that they can’t do anything about the executive’s pay, even though the market cap of the company went down by 50%.

Kay: I agree with what Mike is saying. Let me give my own perspective on a couple of things.

I think the reputational risk is being added. We’re seeing that being added as concepts. In other words, it doesn’t require a restatement or even malfeasance, but could in fact be something that would damage the reputation.

As a general matter that can be alarming for the executives. There hasn’t been the denominator on some prominent cases, but the denominator on that is thousands and thousands of executives at thousands of companies. That means that the number of companies with reputational damage by executives is a very small % of total companies and executives.

It’s a tiny little fraction where this is coming up. Overall, the U.S. corporations are extremely well run. They are highly ethical organizations and there’s very limited amount on this.

Mike really came up with a trigger point on this about how do you deal with a non-compete, and is there a clawback already vested or exercised? It really depends upon the overall risk assessment that the company faces.

If you have somebody who could damage the market cap by 50%, that’s probably something where you want a non-compete that has more than pure economics, but also has the possibility for litigation, an injunction or whatever.

We are seeing a trend towards, at least, exploring a broader group. It’s sort of staying with the officers, but there’s certainly reason to think about a broader group who could, in fact, do damage.

The last point I wanted to make is that the public will not be satisfied with the types of clawbacks we are discussing. This is very annoying and disappointing, as the current emphasis on clawbacks come out of Dodd-Frank. The real impetus for clawbacks was the public was outraged by Sarbanes-Oxley and Enron also. The public was outraged that Wall Street executives made mistakes, damage was done and there couldn’t be money taken back.

The public’s concept of that was there should be clawbacks. You should forfeit, historically received and taxed stock, stock or exercised options or bonuses that should be clawed back if you make a mistake. I certainly hope that will never happen, and I predict it will never happen.

Therefore, I think the company should put in reputational risk relatively carefully defined out of the ethics policy and so on. It’s not going to satisfy the public or the media, but that shouldn’t be the standard.

Jones: I fully agree with that. I think some of what is underlining your comments, Ira, speaks to companies doing a more intensive job around their risk reviews, particularly as it relates to what might happen to compensation. They make sure that whatever policy they put in place does cover those risks. The risks they would want, and the board to have some consideration about whether they wanted to clawback dollars.

Pay-for-Performance Best Practices

Jones: I think we can transition now to talking pay and performance, and how companies can best kick the tires around their own pay and performance assessments.

Pay and performance, that’s why we design incentive plans and it’s important to confirm what you’re getting. You’re spending a lot of money on these plans to take investment and you want to make sure that you’re getting the right alignment of pay and performance.

I think what complicates matters today is there are a lot of outside bodies weighing in about what is the right pay and performance. We’ve had quantitative tests from ISS and Glass Lewis for quite a while that have become pretty well understood by most companies. Now, we have some new things coming into the mix.

ISS has now introduced this financial performance assessment, where it’s looking at ROIC, ROE and ROA, as well as, EBITDA growth or cash flow relative to the peer group. It will be used to modify or potentially modify low and medium concern ratings for companies on the historical quantitative test, but not at this point the high concern ratings.

With the very recent announcement that ISS has acquired EVA Dimensions which is Bennett Stewart’s company, we can expect that this assessment will continue to evolve and that ISS will continue to try to drive more deeply into the performance equation. The introduction of the EVA Dimensions actually puts the EVA platform into the whole equation, as well.

In addition to the financial performance assessment, ISS has also indicated that its policy survey came back with a fair amount of interest from investors looking at outcomes based on measures of pay, like realizable pay. In addition to the likelihood that their performance model may evolve with the new acquisition, we also will likely see some evolution of how they think about pay to include outcomes-based measures.

Investors of course, have their own models. Then we have the SEC pay-versus- performance disclosure requirement on hold, and that has an entirely new definition of pay, as well.

We’ve got all these bodies weighing in, and it’s the Holy Grail. If we could come up with the perfect equation around pay and performance, but in the absence of that, we have to believe that there probably isn’t one model that can prove pay and performance alignment.

As a company, you really need to be your own best skeptic. You need to get ahead of all of these different ways that the outside bodies are looking at pay and performance, and kick the tires on your own around all of these different equations. That means you want to look at all of these models, look at them over different timeframes, one, three, five years, maybe the 10th year of your CEO.

You also want a scenario test. You might be performing very well right now but look at what would happen under these models if your performance declined, if you were performing more closely, for instance, to the 25th percentile company. How would your pay programs respond and how would they look under these? You probably want to aggregate and disaggregate your pay, so look at the different components of pay and how they perform under a variety of different scenarios.

The truth of the matter is all of this data is getting easier and easier for investors and others to get at and play with. You want to make sure that you’ve done all these analyses before your investors and other bodies that are weighing in, so you can come up with a coherent story. If you look at these analyses and don’t have a coherent story, then that’s an opportunity to improve the design of your pay programs and strengthen the program.

Kay: Blair made a lot of great points and I agree with all of them.

A couple of observations: one is that there is a major flaw with ISS’s and Glass Lewis’s models, plus most academic articles, on executive pay and performance. They all use the summary compensation table which covers the CEO. They are looking at the value of the stock grants which are 60% or 70% of the total value of the CEO’s pay package. Also, they’re looking to see if that is aligned with performance. These studies find that CEO pay for performance is not aligned, and that is a flawed conclusion.

This debate has been going on a very long time. I think that is not the complete answer and it’s less than half the answer. There have been some studies that show misalignment and are the wrong conclusion.

It’s obvious given the say-on-pay votes and looking at realizable pay over large samples of companies in industries, that there is good alignment. The stock-based incentives that yield up a value that goes up and down with the stock price and earnings and other operating metrics, that there is very strong alignment between those two, and that the shareholders understand that.

There are academics and others who think that’s tautological, it’s so obvious that stock-based incentive should be aligned with the stock price. That is exactly the point. It’s not exactly or completely tautological, but it’s highly mechanical. You want it so that if the executives do well their shareholders do well, or if the shareholders do poorly the executives do poorly. The vast majority of companies have an aligned pay and performance analysis if you look at realizable pay.

Another aspect, Blair mentioned is the ISS financial metrics. As I understand it they are going to use GAAP. There’s no adjusted metrics. There’s also an academic literature that says non-GAAP metrics are better for explaining shareholder performance than GAAP metrics.

If you make adjustments, you’re going to see a return on assets or EBITDA growth that is very different than what you’re looking at internally. You know your shareholders are probably saluting and respecting what you’re doing with those adjustments. You have to be careful with that. We’ll come back to that later if there’s time.

As a general matter, looking at GAAP is a very incomplete picture, as incomplete as looking at the summary compensation table.

The final thing I would say in terms of evaluating pay and performance is that the objective should be to match the time period as close as possible between the pay period and the performance period. By doing that, you make comprises.

In my opinion, all other methods, e.g., realized pay which is very valuable, but if it’s an older stock option that’s coming in today, then you’re going to have a misalignment of the time period. So, as much as possible, try to match the pay period and the performance period. That is all I wanted to add.

Kesner: I just want to embellish this idea, both ISS and Glass Lewis use GAAP results. I had a client that had a $300 million tax refund awarded to them by the IRS, and their ROE went up from 6% to 26%. They are going to look great on these financial scores, but it is nonsense. If they excluded that, they’d be right back where they were.

Next year what happens is ISS says, “It looks like you’re lowering your goals over what you achieved last year. You’re paying target pay for last results and we’re going to dig to see if you lack both on the performance assessment,” and then how they evaluate whether your goals are strenuous enough.

I just want to make a couple of common sense points when thinking about pay and performance. One thing you have to do is take a long-term view, as Blair pointed out, whether it’s three, five and 10-years as a CEO, tenure or whatever. I think you must look at it over the long term.

One, you have to look at whether or not things like whether annual bonus is consistently being paid above target and if you are outperforming your peers to justify that number.

Two, are your shareholders getting a good return? The fact that you’re outperforming your peers is a positive reinforcement that you probably have earned above target bonus. If it’s not showing up in the stock price over long periods of time, something has to be wrong. I think that would be one point.

I also think looking at how earnings have grown over time and correlating that with payouts under performance plans, along with stock price is something that should also be looked at. This is like a rearview look at how pay and performance have stood out over time, and to the extent that there’s any misalignment that it could be that you got the wrong measures, or you’re setting the goals too low or too high.

I’ve seen other clients too aggressive with their goals. They haven’t paid the target bonus in seven years, yet they are consistently high performers and their stocks have done well. So, this goes both ways.

Again, just common sense will tell something has got to be wrong in that situation where you’re never making your bonus goals, yet the company is star in its industry and their stock has done very well.

Should we move to goal setting?

Goal-Setting & Performance Adjustments

Kay: The next topic is goal setting and performance adjustments, just to be brief about it. From what I can tell 90% of companies make adjustments to their earnings releases and incentive plans, and the other 10% are liars. I read that one of the world’s most famous investors says that he really doesn’t like adjustments and only makes the adjustments that he absolutely has to.

This is something that you’re trying to create alignment of your incentive plans and stock price hopefully with that you think are your core earnings. So adjustments are very, very common. They’re not inherently bad and they’re not inherently good. Virtually, every company makes them and it’s very important for there to be a justification.

A couple of points on that are, one is to have as much precision as possible in both the goal setting and the evaluation of the adjustment. I think it’s important to make sure you have alignment between the adjustments that you make for your earnings release and the adjustments that you make for incentive plans.

Typically, not always, but the incentive plans have more adjustments than the earnings release. I guess there are some places where some companies make an FX or currency adjustment in their incentive plan, but they mention it in their earnings release. They don’t mention currency in their earnings release, but they don’t make the adjustment.

I think from a goal setting perspective and probably external from the analyst’s expectations and what guidance you’re giving, you want to be very consistent about that to make sure that you know, the analysts are looking at you. They may disagree but make similar adjustments.

There is, as I mentioned earlier, academic literature that shows that adjusted earnings are as good – or better – than GAAP in explaining stock price movement.

Theoretically, you can compare GAAP. I think whatever chance you have to compare operating earnings to another company, it probably needs to be adjusted for currency and acquisitions. You can’t compare revenue growth of an organic company versus a company that makes acquisitions.

We think it’s very important to be as precise as possible and to look at it relative to your earnings release, and to be thoughtful and have a clear rationale for adjustments you make.

Kesner: I agree with all that. I think many of my clients also like to look at what their peers are guiding to in terms of earnings growth or returns. They are evaluating whether or not they are performing at the peer level or higher or lower.

They do tend to look if they have good industry peers. They look at some of the broader economic indicators, as well. Peer guidance is something that they try to pay close attention to in setting goals.

I also think when you’re doing the goal setting, as Blair mentioned, is doing some stress testing of various outcomes. When you set goals for the bonus pay, you’re setting three in most cases. You are setting the target which is driven many times by the budget process that gets embedded. There’s also a threshold and a maximum target that has to be set.

I have seen a lot of screw-ups happen around the performance curve setting, so how far below target you can get before you get zeroed out, or how high you have to go before you hit max. There is more art and less science in the shape of the performance curve, so the entry point at threshold than the max at the top-end of the curve.

One example, I have a client that set their goals for the coming 2018 at 98% of target. Last year, they came in at 94% of target. I said, “What makes you think you are going to get that much closer?” because they are going to be zeroed out. There’s almost no doubt, if they stick with this 98% threshold, they are going to get zeroed out likely. It could be a small miss, or one of their contracts doesn’t close on time, it could make them miss their goal.

Again, I think part of the goal setting is not just the target, but it’s also spending the same amount of time looking at the threshold and the max. Some of the stress testing helps you understand how volatile some of your results maybe within that performance curve.

The only other I’d say is that I don’t see these curves get too steep. So, a small little increase like on the downside, a small downside has a huge impact on payouts; same on the upside a small improvement could have a huge impact on payout side.

I would try to smooth those out if I can, recognizing that sometimes the targets are set pretty aggressively so the over performance of target to get to a max payout might be less. You might have 90% on the threshold and a 105% on the maximum because the targets are already aggressive. So, beating that by 10% would be hard, and beating it by 5% would still be hard but you will have a pretty sizeable payout.

Romanek: I believe that’s it. Thank you very much, Mike, Ira and Blair. It was great as always.

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