The 2021 proxy season was dominated by COVID-19. Close to half of Standard & Poor (S&P) 500 companies took some type of COVID-19-related action in 2020, including base salary reductions, modifications to incentive plan targets, and the grant of special awards.

Despite the significant upheaval in compensation, financial results, and stock price performance during 2020, shareholders supported 97.3% of Say on Pay votes among Russell 3000 companies through December 31, 2021, with strong average support of 92.2%. Sixty-four companies — or 2.8% — failed Say on Pay, including some large, “name-brand” companies. The reasons for these high-profile failures can be primarily attributed to several factors including the use of positive discretion in determining annual incentive payouts, modifications to in-flight long-term incentive (LTI) awards, grants of “out-sized” stock awards without a compelling rationale, and a disconnect between pay and performance.

Part of the strong showing in shareholder support can be attributed to Institutional Shareholder Services (ISS) recommending a vote for Say on Pay at 88.3% of Russell 3000 companies, which was only down 0.7% compared to the 2020 proxy season. While ISS approved most companies’ Say on Pay proposals, those companies that received an against recommendation from ISS were more likely to fail Say on Pay (24.1%) compared to prior years (for example, 18.4% in 2020, 18.8% in 2019, and 17.1% in 2018). Thus, ISS influence increased in 2021 and an against recommendation was more likely to result in a failed Say on Pay vote compared to prior years.

The 2021 compensation year has also been filled with continued uncertainty due to COVID-19, supply chain issues, workforce shortages, and — most recently — inflation fears and the Russia-Ukraine conflict, so what should we expect to see (or not see) during the 2022 proxy year compared to 2021?

The 2022 Proxy Season

Given strong shareholder support in the 2021 proxy season, it is unlikely companies will have significantly revamped their 2021 compensation programs. In some cases, compensation practices that were adopted in 2020 to address COVID-19-related uncertainty will have carried over to the 2021 compensation year, including:

Wider performance curves. Many companies widened their performance curves to minimize the chance of a zero or maximum payout given the uncertainty in setting performance targets. This uncertainty persisted at the beginning of 2021, and a widening of the performance curve allowed companies to retain the basic structure of existing plans but with far less pay/performance leverage.

Semi-annual short-term incentive performance periods. Companies in industries facing the greatest level of uncertainty continued or adopted a “1st half/2nd half” short-term incentive plan whereby 6-month goals are set at the beginning and the middle of the performance year to allow for a “resetting” of targets at mid-year
based on a more current financial outlook.

Inclusion of qualitative metrics . After unprecedented levels of discretionary adjustments were applied in 2020, some companies added or increased the weighting of qualitative metrics to allow the Compensation Committee to exercise discretion within predefined guardrails (e.g., +/- 20%).

Above target annual incentive plan payouts. Given the limited visibility at the beginning of 2021 amid the continued impact of COVID-19 (e.g., supply chain pressures, “The Great Resignation,” etc.) and 2020 annual incentive plan payouts, the majority of which were below target or zero, many companies may have established relatively conservative financial targets for their 2021 annual incentive plans. Early indications are that above target (or maximum) annual incentive payouts are being reported by companies that were more resilient than forecasted and capitalized on better-than-expected market opportunities in 2021.

As of the writing of this Viewpoint, actual annual incentive payouts for 2021 at Russell 3000 companies are tracking between target and maximum (average of nearly 150% of target). Eighty percent of the companies in the sample are paying annual incentives above target (average of 160% of target), while the remaining 20% of companies have average payouts of 67% of target. Based on year-over-year comparisons for a subset of companies paying 2021 annual incentives above target, 2020 annual incentives were paid out at an average of about 90% of target.

Inclusion of relative total shareholder return (TSR) as a metric in performance share (PSU) plans. Many companies struggled to set annual financial targets, let alone multi-year goals for PSUs. To address this uncertainty, more companies may have added relative TSR to their PSU scorecards, thereby eliminating the need to establish absolute goals at the beginning of the performance cycle.

Replace multi-year goals with multiple annual goals in PSU plans. Another approach companies carried over or adopted is the use of annual goals within PSU programs, with performance measured each year and earned shares distributed on, for a 3-year plan, the third anniversary of the grant. This approach allows companies to maintain a performance-oriented plan while minimizing the risk with 20-20 hindsight of setting overly aggressive or conservative performance targets.

We do not expect to see, in the 2021 compensation year, some of the compensation practices that were originally adopted during the pandemic. These include:

Base salary reductions. All but the most severely-harmed companies by COVID-19 restored 2020 base salary reductions prior to the end of 2020. Thus, only a handful of companies have maintained reduced base salaries in the 2021 compensation year.

Exercise of upward discretion. Given the more conservative approach in setting performance goals as noted above and the most recent trend in 2021 annual incentive payouts, there will be far less need for compensation committees to exercise discretion to increase annual incentive payouts. It is possible some compensation committees will exercise negative discretion if the formulaic result does not fit with the overall health/performance of the company.

Modifications to in-flight LTI awards. Given the 2021 proxy season investor and proxy advisor backlash delivered to companies that modified to in-flight LTI awards in the 2021 proxy season, it is unlikely companies made similar changes during the 2021 compensation year.

The payout outcomes of LTI award cycles ending in 2021 are likely to be across the full spectrum — zero to maximum. Among companies that set multi-year goals pre-pandemic, payouts are likely to be at or below target in certain industries. Performance plans tied to relative TSR or based on 1-year performance metrics are more likely to be above target or at maximum.

Stock Price Performance

Stock price performance will continue to play a role in compensation decisions, with higher performing companies having significantly more flexibility when making compensation decisions than lower performing companies. After the “COVID dip” in stock prices in March of 2020, which impacted all major market indices and sectors, the rebound was almost as swift. However, the rate of recovery has varied by sector, which led to a broad spectrum of compensation actions. In summary, while the playbook for managing incentive plan actions due to the COVID dip was relatively consistent, the playbook for managing the recovery was more nuanced during 2021 depending on the strength of the company’s performance — a trend that we expect to continue during 2022.

The chart below shows the performance of a hypothetical $100 investment from December 31, 2019 through March 15, 2022 for the S&P 500, S&P 400, and S&P 600 as well as the highest and lowest performance sectors (during this measurement period) within each of these indices:

‍Looking Ahead to 2022 Proxy Season Outcomes

Two areas of potential concern could arise if shareholders and the proxy advisory firms consider the 2021 annual incentive goals lacked rigor or if companies significantly increased 2021 equity awards (either delivered through annual awards or through special, one-time arrangements) without a detailed explanation. Companies are likely to have addressed these concerns by providing fulsome disclosure of the degree of goal rigor, rationale for increased LTI awards, and the linkage to shareholder value creation in their 2022 proxies.

Given the compensation changes made in 2021 to adapt to an uncertain economic environment and likely avoidance of the “foot-faults” that occurred in the 2020 compensation year, it is highly likely shareholder support for Say on Pay in 2022 will be as good as, if not better than, 2021. While this could make for a far less exciting proxy season, it should be a welcome relief and allow companies more time to focus on what could be a challenging business environment.

‍

‍For more information on this article, please contact Mike Kesner (mike.kesner@paygovernance.com), Ira Kay (ira.kay@paygovernance.com), Linda Pappas (linda.pappas@paygovernance.com) or Joshua Bright (joshua.bright@paygovernance.com).

Introduction

In 2010, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). One of the important provisions of the Dodd-Frank legislation was the requirement that companies registered with the Securities and Exchange Commission (SEC) disclose how the executive compensation actually paid (CAP) by the registrant company relates to the company’s financial performance in both tabular and narrative disclosures. This disclosure mandate is referred to in Dodd-Frank and by the SEC as “Pay versus Performance,” although we prefer to describe it as pay-for-performance (P4P), as it more accurately describes one of the primary objectives of companies’ compensation programs.

In 2015, the SEC released its initial proposal for meeting the Dodd-Frank P4P disclosure requirement. However, 6 years passed without resolution regarding the initial SEC proposal. On January 27, 2022, the SEC released a supplemental proposal adding additional financial disclosures to the P4P proposal. At that time, the SEC announced that it was reopening the initial release of 2015 for public comment as well as inviting comment to the 2022 supplemental release. The SEC extended a 30-day comment period for written comments to be submitted to both the 2015 and 2022 proposed disclosure rules.

The original 2015 P4P proposal remains unchanged from its original submission by the SEC. This initial proposal is quite extensive and includes proposed reporting of CAP to the company’s Named Executive Officers (NEOs), the company’s Total Shareholder Return (TSR) as a financial metric, use of a designated peer group for comparative disclosures, and other requirements. The 2022 supplemental proposal stipulates two additional financial metrics considered important by the SEC and an option for companies to include a Company Selected Metric (CSM).

Pay Governance LLC, in its role as a consultant advisor to corporate boards on executive compensation, submitted its views on the SEC’s P4P disclosure requirements with written responses in both 2015 and 2022. The purpose of this Viewpoint is to share with you the highlights of our response to the SEC and how we believe the SEC’s proposal could be enhanced by our experience in advising companies on P4P issues and reporting.

Pay Governance Commentary on, and Suggestions for, Enhancing the SEC P4P Proposal to Facilitate Useful Analysis

The SEC’s proposed “Pay Versus Performance” disclosures — if designed properly — could be very valuable in shaping shareholders’ and other parties’ views of companies’ compensation policies, corporate governance practices, and board of directors’ effectiveness. This topic has been challenging for all companies, but the SEC’s selected approach is highly controversial and of limited utility given the wide-ranging views on what constitutes compensation, performance, and the time frames for measuring this relationship.

Pay Governance strongly endorses using the proxy tables and Compensation Discussion and Analysis (CD&A) as tools to demonstrate to shareholders the alignment of executive compensation with shareholder value creation. This alignment is very important to shareholders, especially given another Dodd-Frank mandate requiring non-binding say on pay votes, as P4P alignment can signal that the board of directors and management team are managing the company effectively. This is especially true if TSR and compensation are strongly aligned over multiple years and business cycles. In order to be useful for shareholders and other parties to properly evaluate pay and performance alignment , the measurement periods for evaluating both performance and actual pay should be the same or as similar as possible.

However, the SEC’s proposed definition of CAP and performance period methodology does not achieve this objective. This is primarily, but not solely, due to companies’ prevalent and significant usage of performance stock units (PSUs) to deliver long-term incentive award opportunity. PSU grants typically vest 3 years from the date of grant, thus there is no performance period included in the SEC’s proposal that properly compares performance for the completed PSU performance cycles from grant to vest/payout. There is a similar issue for time-vested shares (RSUs) and stock options. Further, every year t he beginning of TSR measurement period will change for each year’s P4P disclosures but the CAP stays the same for each fiscal year. This means that the shareholder alignment for CAP can change dramatically year on year from “strongly-aligned to misaligned”—and yet compensation did not change at all. This is a major flaw in the process.

Additional Perspective, Commentary, and Suggestions

1. ADVANCES IN P4P ASSESSMENTS
The SEC’s 2022 release notes that “executive compensation practices related to company performance have continued to develop and evolve.” [i] Pay Governance has also observed a significant increase in the sophistication of institutional shareholders in assessing P4P when determining their say on pay votes and other governance-related decisions since the SEC’s 2015 proposed rules were issued. We find that these shareholders use their own proprietary P4P models, companies’ disclosures of P4P, and detailed P4P analyses prepared by the two major proxy advisory firms in their decision-making. The SEC’s proposal, in contrast, appears to be out of step with these more sophisticated approaches of relating pay and performance.

2. THE DEFINITION OF CAP DOES NOT ALIGN WITH THE PERFORMANCE PERIOD
We see several major shortcomings with the SEC’s proposed methodology using CAP to test the alignment of P4P. CAP solely reflects amounts vesting or paid out (salary/bonus) in a given year. Our primary issue is the timing for reporting the CAP amounts is mostly not aligned with the performance period in which it was earned, thus distorting the true economic underpinnings of the payout and the reliability of the test of P4P alignment. This is particularly acute for PSUs where typical vesting occurs in the year following the completion of the performance period.

To illustrate: assuming a 3-year PSU plan, a PSU is granted on February 15, 2022 and earned based on relative TSR from January 1, 2022, to December 31, 2024. The earned shares (if any) vest on February 15, 2025. The SEC proposal requires the PSUs vesting in 2025 be compared to performance ending in 2025. Irrespective of whether it is 1 year’s data or rolling 5-year data, the mismatch in the performance periods and payouts could yield a significant amount of allegedly “misaligned” payouts.

Our second issue is how the SEC has defined CAP. While we understand the SEC is bound by the statutory language in Dodd-Frank to use CAP, we note that the vesting of stock options represents potential compensation and is only CAP to the executive upon exercise of vested stock options. Moreover, the use of the Black-Scholes value of vested stock options, which considers future stock price performance rather than the “in-the-money” value of stock options (i.e., FMV minus exercise price), further departs from the true amount of CAP and creates the potential for additional P4P alignment issues.

3. EXPANDING THE P4P TABLE TO INCLUDE FINANCIAL METRICS

Inclusion of Pre-Tax Net Income and Net Income: Mandating the use of pre-tax net income and net income because they are familiar to investors and are easily found in the Generally Accepted Accounting Principles (GAAP) financial statements is not enough to overcome the major shortcomings of both metrics.

• Neither of these metrics is among the most commonly used to determine incentive pay ; thus, any correlation of CAP with these measures would be low or random.

• Second, when pre-tax net income and net income are used to determine incentive pay, they are almost always adjusted for unusual items that distort the company’s operating performance. For example, if a company makes a large acquisition, it is likely pre-tax net income, and net income will increase. Incentive payouts often exclude the impact of acquisitions and divestitures on the reported GAAP results.

• Third, the use of absolute measures in dollar values provides little to no context to evaluate performance let alone P4P . The original and current proposals require companies to report their cumulative TSR and the TSR of their peers (i.e., growth metrics), which allows for a relative comparison of performance. The SEC’s proposal does not include a requirement to report the peers’ pre-tax net income and after-tax income, therefore omitting important perspective investors need when evaluating performance.

• Fourth, pre-tax net income and net income are essentially the same metric with the only major difference being the companies’ effective tax rates . Thus, it is unlikely these overlapping measures will provide investors with a more complete picture of company performance that the SEC intends with the new rule.

• Fifth, not including the peer groups’ compensation also omits an important investor perspective, namely, how does compensation earned compare to the company’s peers? To illustrate, if a company’s pay is increasing but is still well below its peers, investors may be far more willing to support increases in pay to ensure the management team is not vulnerable to recruitment by competitors. Conversely, if compensation is well above peers but performance is far below peers, investors may have reason to question the P4P alignment.

Addition of a CSM: We believe allowing companies to include a CSM is a welcome addition to the P4P disclosure; however, we still have significant reservations about its usefulness given the current format of the P4P table, namely:

1) the mismatch of time frames and the SEC’s definition of CAP;

2) both the dollar denomination of these metrics and the lack of relative financial performance and pay levels described in the previous sections; and

3) companies must use the same CSM for all 5 years included in the table, yet the financial metrics used to support a company’s objectives are often subject to change during the prescribed timeframe for the P4P disclosure. Thus, the current year’s CSM may have only been in place for a portion of the 5-year performance period displayed in the table.

We suggest that the SEC allow companies to select the metric that was used to determine pay for a given period, rather than use the same metric for all five years if it was not applicable or relevant during a portion of the 5 years represented in the table.

4. THE NEW “TOP FIVE” METRIC TABLE
The SEC has proposed including an additional table in the P4P section of the proxy that lists the companies’ top five metrics used to drive compensation outcomes. The SEC release explains the need for this supplemental table as follows:

There is no existing rule that specifically mandates disclosure of the performance measures that actually determined the level of recent NEO compensation actually paid. Tabular disclosure of a list of the five most important performance measures that drove compensation actually paid may be useful to investors in addition to the more detailed disclosure relate to the consideration of the registrant’s corporate performance and individual performance in the design of NEO compensation required in the CD&A. [ii]

It would appear the rationale described above is partially valid as it relates to the discussion of long-term incentive payouts, but it is inconsistent with both our understanding of the proxy rules and first-hand observations of hundreds if not thousands of proxies where the overwhelming practice is full disclosure of performance metrics and the resulting payouts of the annual incentive plan. We believe that instead of adding a simple table that lists the top five metrics, the SEC should instead provide additional guidance on the disclosure of the payout calculations for the annual and long-term incentive plan to improve the transparency of performance outcomes and the corresponding payouts.

Alternative Potential Definitions of Dodd-Frank’s “CAP”:

Through our client work and research, we have demonstrated that alternative measures of “performance-adjusted pay” (described below) are superior pay values for testing this alignment and addresses this timing issue. Our experience with clients is that the boards of directors greatly appreciate the P4P analysis using performance-adjusted pay in addition to the amounts reported in the Summary Compensation Table (SCT).

In addition, as pointed out in the release, this is further complicated by the current important movement by companies toward linking ESG metrics and stakeholder values to executive compensation. Stakeholder value changes may take time to show up in TSR and, in the short-term, could adversely impact a company’s financial results as it invests in new technologies, training, and research and development.

There are several possible alternative definitions of performance-adjusted pay the SEC could select to determine P4P — including realized pay, incentive payout alignment, and realizable pay. While Pay Governance endorses relative comparisons of pay and TSR to peers, we believe that CAP is not an ideal compensation value for that purpose. Based upon our firm’s research, we believe that some of the alternative definitions of performance-adjusted pay would be a better pay definition for this type of comparison than CAP. These alternative definitions of performance-adjusted pay also have their limitations and do not precisely reflect “compensation actually paid.” As previously noted, the SEC’s definition of CAP includes the Black-Scholes value of vested but unexercised stock options, which does not literally reflect “compensation actually paid.” We believe several other definitions that meet the Dodd-Frank definition are arguably the optimal value for these P4P purposes.

Pay Governance and many of its clients have used various performance-adjusted pay definitions over the last 12 years to demonstrate the degree of alignment of companies’ pay and performance to compensation committees, management teams, investors, and the public/media. We believe many of the other definitions of performance adjusted pay could meet the Dodd-Frank standard better than CAP but with better a priori theoretical alignment with performance. In addition, several of these definitions facilitate peer comparisons as an important context for investors, which is absent in the SEC’s proposal. Similar methodologies — both realized and realizable pay — have been incorporated into shareholder voting analyses by ISS, Glass Lewis, and large institutional shareholders. While not perfect, we believe that several of these pay definitions are superior to CAP when evaluating P4P alignment.

We urged the SEC to utilize a different form of CAP. However, the new rules will allow companies to include their own P4P analysis as long as the disclosure is not misleading or more prominent than the SEC’s mandated table.

General questions about this Viewpoint can be directed to John Ellerman at john.ellerman@paygovernance.com, Mike Kesner at mike.kesner@paygovernance.com.

[i] U.S. Securities and Exchange Commission. “Reopening of Comment Period for Pay Versus Performance.” February 2, 2022. https://www.federalregister.gov/documents/2022/02/02/2022-02024/reopening-of-comment-period-for-pay-versus-performance.

[ii] U.S. Securities and Exchange Commission. “Proposed Rule: Reopening of Comment Period for Pay Versus Performance.” January 27, 2022. https://www.sec.gov/rules/proposed/2022/34-94074.pdf .

‍