CEO pay continues to be discussed extensively in the media, in the boardroom, and among investors and proxy advisors. CEO median total direct compensation (TDC; base salary + actual bonus paid + grant value of long-term incentives [LTI]) increased at a moderate pace in the first part of the last decade — in the 2% to 6% range for 2011-2016. CEO pay accelerated with an 11% increase in 2017, likely reflecting sustained robust financial and total shareholder return (TSR) performance, before returning to 3% in 2018 and 1% in 2019, more in line with historical rates. Our CEO pay analysis is focused on historical, actual TDC, which reflects actual bonuses based on actual performance; this is different from target TDC or target pay opportunity, which uses target bonus and is typically set at the beginning of the year.
As proxies are filed in early 2021, we expect that 2020 overall CEO actual TDC will decrease, potentially by 3-4%, due to the COVID-19 pandemic and lower bonus payouts – there will be some variation with companies in strong performing industries likely seeing increases in compensation; 2020 actual pay will be balanced by steady base salaries and LTI grants, as most companies had strong financial performance at the time awards were granted (typically Q1). The last time CEO compensation decreased was during the 2008 to 2009 “Great Recession,” where the financial crisis triggered a meaningful contraction in the economy resulting in poor company performance and lower CEO pay. With regard to 2021 CEO target pay, however, we are expecting increases to be in the low single digits primarily due to some companies making “supplemental LTI grants” to partially offset for lost value for performance share plans that were damaged and mostly worthless due to the financial impact of the pandemic. Executives in industries with favorable economic conditions and higher growth (e.g., technology and biotechnology) will likely see more significant pay increases, while those in hard-hit industries may see flat or continued pay declines.
CEO pay rebounded 31% in 2010 after -9% and -13% decreases during the financial crisis of 2008 and 2009, respectively. Since then, year-over-year pay increases have been moderate — in the 2% to 6% range — except for the 11% increase in 2017 (Figure 1).
Over the last 10 years, LTI vehicle use has shifted away from stock options, mostly in favor of performance-based plans. From 2009 to 2019, performance plan and restricted stock prevalence increased, and stock option prevalence decreased (Figure 2). The rise in performance-based plans can largely be attributed to the introduction of Say on Pay and the preferences of proxy advisors and some shareholders toward LTI systems that they consider to be “performance-based” (note: the proxy advisors do not consider stock options to be performance-based). This being said, we would not be surprised to see stability in the use of stock options — or even an uptick in usage in the future given the COVID-19 pandemic. Many companies made stock option grants during the depth of the Great Recession in early 2009: this is likely due to the difficulty in setting multi-year goals at the time and the fact that stock options provided a direct linkage to share price improvements and an opportunity for significant upside leverage.
In recent years, CEO pay increases have been supported by strong TSR. In fact, pay increases over the last 9 years have trailed TSR performance by ~9% when examining the compound annual growth rates (CAGR) of compensation and shareholder return: TSR CAGR was 16% while CEO pay grew at 7%. The year 2019 is notable in that during a period of excellent TSR performance (31%), CEO pay increased by only 1% (Figure 1).
There is a positive correlation between share price performance and CEO pay. In a positive stock price environment, Compensation Committees are often more supportive of CEO pay increases, typically delivered via larger LTI grants, while CEO base salaries increase modestly or periodically (i.e., less frequently than an annual basis) and comprise a small portion of the executive pay package. Annual actual bonuses, though not as significant as the LTI portion of total compensation, can have a meaningful impact on whether compensation grows year over year. When a company is having a good year and is exceeding budget goals as well as investor and analyst expectations, the CEO bonus often pays above target and increases year over year (often, the share price also increases as company performance is strong). That said, there will be some years where a CEO’s bonus pays above target when the company exceeded its budgeted goals, while the share price declines due to stock market volatility or correction and sector rotation. The opposite can also happen: goals are not met, resulting in lower bonuses, while the stock market goes up — this is what happened to many companies in 2020 in part due to the COVID-19 pandemic.
1) We expect 2020 overall CEO actual TDC to decline in the low single digits due the COVID-19 pandemic and weaker financial results that impacted bonus payout decisions; there will be some variation with strong performing industries likely seeing increases in compensation .
a) The Aggregate S&P 500 Index year-over-year revenue and operating income for 2020 are currently forecasted to decrease by 5% and 18%, respectively (S&P Capital IQ).
b) We expect median CEO target pay increases in early 2021 will be in the low single digits as a result of LTI compensation increases primarily due to some companies making “supplemental LTI grants” to partially offset for lost value for performance share plans.
2) In certain high-growth industries (e.g., technology and biotechnology) and high-performing companies, executives may experience increases in total compensation, while executives in slow-growth industries or heavily impacted companies might see no increases or declines.
3) Going into Q1 2021, companies will want to be careful and strike a balance of having competitive executive pay with the public, investor, and proxy advisor expectation that companies exercise restraint in light of the pandemic’s continued disruption.
The above projections assume successful global rollout and broad usage of the COVID-19 vaccine; they do not account for additional major market shocks (e.g., geopolitical uncertainty, dramatic changes in the economic or political environment, significant and unanticipated modifications to the Federal Reserve’s interest low rate policies, or significant drops in the overall stock market).
The CEO pay analysis consists of S&P 500 companies led by CEOs with a ≥3-year tenure. Pay data includes base salaries and bonuses paid for each year as well as the reported grant date fair value of LTI awards. Our analysis of consistent incumbent CEOs was designed to highlight true changes in CEO compensation (as opposed to changes driven by new hires or internal promotions, which typically involve ramped-up pay over a period of 1 to 3 years).
Our methodology used year-over-year CEO actual pay and was based on the accounting value of LTI as reported in proxy summary compensation tables. These amounts are more akin to pay opportunity than realizable pay, which includes in-the-money value of stock options, ending period value of restricted stock, and estimated value of performance shares. Our past research has strongly correlated realizable pay and TSR performance. While we have shown there is a positive correlation between CEO annual pay increases and TSR performance, we are confident the correlation is not as significant as that between realizable pay and TSR increases.
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On June 23, 2021, Chairman Gary Gensler of the SEC gave a formal speech in which he discussed three key areas of the reform agenda at the SEC. [i] In this speech, Chairman Gensler offered his views of the areas in which the SEC will focus over the upcoming 12 months as well as longer term issues the SEC will likely address. Chairman Gensler is newly appointed by the Biden administration and has shown that his agenda is ambitious. The purpose of this Viewpoint will be solely informative and a recast of Chairman Gensler’s comments.
General questions about this Viewpoint can be directed to John Ellerman at john.ellerman@paygovernance.com.
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During a recent compensation committee meeting, the CEO expressed some level of frustration with the public discourse on including EESG (Employee, Environment, Social, and Governance) goals — specifically, DEI (Diversity, Equity, and Inclusion) — into executive incentive plans. “Our culture is all about equity, diversity, and inclusion,” she exclaimed. “Why should we be bonusing our culture?”
The impetus for the CEO’s cultural pushback was a compensation committee member’s suggestion that next year’s annual incentive plan include a 10-15% weighted factor with threshold, target, and maximum goals tied to the number of underrepresented employees in management and executive groupings by year end. The compensation committee member had heard that “everyone” was adding an EESG or DEI bonus factor to their incentive plans, so their company needed to do so, too.
Now, it wasn’t that the company hadn’t tracked diversity progress: it had for the past five years. It wasn’t that the succession planning process hadn’t been geared towards providing women and employees of color opportunities for mentorship and new development assignments: it had been doing so for a decade and was proud of their track record in developing and promoting diverse talent at all levels of the organization. And it wasn’t for wont of public recognition about the company being an employer of choice: a number of “Top 50…” and “100 Best…” lists named the company. All of this was accomplished, the CEO reminded the compensation committee, without taking away any of the focus on delivering financial results in the annual incentive plan because EESG and DEI was, and is, so much a part of the company’s culture.
There’s no question one of the today’s biggest compensation committee discussion topics is if and how to incorporate EESG and DEI goals into annual or long-term incentive plans. Companies that have no such considerations in their FY2021 incentive plans are deciding if and how to best weave these metrics in with financial and other strategy goals for FY2022. Companies that consider EESG and DEI in their individual performance assessments are questioning whether such goals should move in FY2022 to a scorecard that can be presented to shareholders in their Compensation Disclosure and Analysis (CD&A) report. And companies with scorecards are considering whether internal systems can sufficiently support the goal setting and evaluation processes for EESG and DEI goals with the same rigor and robustness as how revenue, earnings, and free cash flow goals are established and evaluated.
A veritable cottage industry of consulting advice has sprung up to help companies and compensation committees consider if and how EESG and DEI are best incorporated into incentive plans. There are multiple studies that count percentages of companies in industry groups, indices, or geographies that already include these non-financial measures. Many authors weigh the pros and cons of adding EESG and DEI into annual (currently most common) or long-term (far less common) incentive plans. And others describe the pitfalls of treating EESG and DEI as the “flavor of the month” by rushing to add these measures without adequate consideration of organizational readiness and communications necessary to support any incentive plan metric. All of these perspectives should be considered regardless of the stage in which a company is considering EESG and DEI in reward systems. As a recap of the questions to be asked…
However, there appears to be no specific consulting guidance on supporting EESG and DEI when (a) they both were already culturally important to a company and when (b) traditional “threshold,” “target,” and “maximum” incentive plan goal setting are viewed as counter-cultural and potentially detrimental to the consistent progress the company is expected to achieve. Is it possible to include EESG and DEI measures in an incentive plan without “bonusing our culture?”
For this company, the answer was yes. Their solution was to borrow a concept from one of its manufacturing unit’s incentive plans that reinforced quality as “Job One.” At this unit, product quality is a cultural expectation every day. As such, different quality achievements are consolidated against expectations in a point score. Meeting or exceeding expectations are communicated proudly but carry no individual financial gain. Only when an aggregate quality score misses expectations are communications delivered about lessons learned and process improvements to be made, backed up with a haircut to quarterly production bonuses and a commensurate reduction in bonuses for the unit’s management team. It is a culturally congruent incentive plan for that business unit. There’s no bonus for supporting the quality culture but there is an incentive plan message sent when the culture has a quality miss.
Based on this concept, an EESG/DEI Modifier was built around an expectation that 50 points would be delivered through multiple DEI initiatives and achievements. Some factors have a higher weight than others in the scoring. However, a score of less than 50 points would result in a 5 percentage point reduction and a score of less than 40 points would result in a 10 percentage point reduction in all annual incentive plan participants’ earned awards for that year. Implementation of the EESG/DEI Modifier is slated for the annual incentive plan in FY2022. An illustration of the scorecard looks like this:
As in most things in life, there is not just “one best way” to consider including EESG and DEI in incentive plans. Some companies may find it most effective to consider EESG and DEI progress in individual performance assessments, and others may choose to add a leveraged upside and downside weight on EESG and DEI metrics as with financial metrics. A small but growing number of companies incorporate an EESG and DEI component in a performance share unit (PSU) plan.
For this company, and perhaps for others, the concept of allowing for upside leverage on EESG and DEI cultural imperatives is inconsistent with core values. Further, such companies may believe that continued progress on EESG and DEI results supports culture better than would a traditional “plus-and-minus” pay-performance scale. Because the culture is being supported, meeting or exceeding EESG and DEI objectives should be celebrated — not bonused. Missing a cultural expectation should produce introspection about how to improve and a message through a bonus reduction that all need to do better next year.
For companies intrigued by advancing their cultural journey through the inclusion of EESG and DEI components in incentive plans, careful thought about key objectives, weightings, scoring, and outcomes, plus support from executive management and the compensation committee, can result in a plan design that builds progress toward culturally significant objectives.
General questions about this Viewpoint can be directed to John England at john.england@paygovernance.com.
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