Home > Compensation, Disclosure, Trends in Corporate Governance > Pay for Performance. (I) Pay definitions

Pay for Performance. (I) Pay definitions

A correct pay definition is relevant when analyzing the connection of Actual Pay to Performance, and its relationship with the universe of peers.

In this post, we will limit to the first concept of the Compensation principle that “Pay” needs to be connected with “Performance”.We will first name and define the main alternative definitions for pay, while taking for given that Performance is well defined, for instance, as represented by Total Shareholder Return, (TSR).

  1. Target or Expected Pay

It includes a total compensation offered to executives in a given year, in an attempt to link his efforts to future performance. Very often, those plans are designed and disclosed around minimum and maximum values, tied to minimum and maximum performance targets.

The problem of “Target Pay” is that it`s more often used on a prospective basis, not in retrospective, which would allow to validate the ties between Pay and Performance.

When Target Pay is used in Proxy filings, it includes Base Pay, Target value of annual cash bonuses and nonequity incentives, target value of any performance-based cash awards, and grant date fair value of long-term equity (options or other) awards.

ISS uses a concept similar to this one. Companies using target pay normally use it to demonstrate the actual ties between Pay and Performance, (perhaps not so easy to explain with other definitions). It shows how the committee intends to link the two variables, but is not useful to show that they were really connected.

  1. Earned Compensation.

 

It is defined as the “total value of compensation that an executive “earns the right to keep” as cash is delivered and vesting restrictions are removed from equity-linked elements. Long-term cash awards are earned at the end of multi-year periods normally, (so, accrual is not considered in the first years of the multi-year period). RSU are included when they vest, at the vesting day price, and stock options are also included at the Black-Scholes (or intrinsic) vesting day value. In general, Earned value includes elements granted in the year, and some other granted in previous years, (stocks vesting in the year, granted before).

 

  1. Realized Pay (also named Actual, or Value Received)

This is more accurate to what an executive receives, and can be disclosed with transparency as to whether pay and performance are connected. It includes actual cash compensation, (base salary and bonuses), actual payouts under performance share or cash awards, and exercised or taxable equity incentives, (vested or sold in the period). In progress equity awards –not yet vested- are excluded. If the executive cashes out in the period, the cash amount will equal realized pay, but it he holds equity or options for longer, realized value for that equity will go up (down) with stock price.

So, in summary:

–         Stock options: gains from exercised options.

–         RSU: the value of those vested in the period, (in other versions, those sold by the executive).

–         Performance Shares: value of those vested in the period, (in other versions, those sold by the executive).

Realized pay has also some disadvantages: firms may differently calculate it, as exposed; it introduces external movements in compensation due to investment decisions by managers, (as they decide when to hold or sell the equity component); also, some options or shares granted before the performance period can be counted, if vested, exercised, or sold in the period, (depending on the exact definition used).

  1. Realizable Pay

It is increasingly being adopted by many firms. It includes compensation earned in the period, based on the amount thar can be realized, (so it is counted when paid, vested or realized), that is: actual base salary and bonus, and the value of equity that executives may recognize, based on actual stock performance as of a specified date, so:

–         Stock options: embedded value of those outstanding, (market value minus strike price). The time value is lost, though.

–         Restricted Shares: value of those granted in the period, vested or not, valued at stock price at the end of period.

–         Performance Shares: value of the target number of performance shares, valued at stock price at the end of period. Using the target number, instead of the actual earned number is a flaw of this method.

This allows stock performance to be reflected in the value of equity components, as equity is overlooked over a multiyear period. It includes intrinsic value of all equity awards outstanding, (realized or not in the case of options or SARs), and paid or vested, (RSU or other equity awards). The greater the % of pay is at risk, (equity linked somehow), the better the case for realizable pay is.

Disadvantages are: different calculations used by companies, the fact that it is not “fully actual pay”, as some events eventually affecting stock value in the future, may dramatically change the actual pay to be received. But it is clearly better than target and realized, (as for investment decisions by executives do not affect).

Until January 2013, ISS dismissed this concept, but from then it decided to combine its own with this one: when its analysys shows some concern, a higher stock (lower) price linked to a higher (lower) realizable than grant date value pay would mean there is a certain adherence to the principle.

The doubt remains as for the best day to take stock price values, (end of period, last quarter, an average value….). Additionally, should exercised options, sold equity, or cashed in tools be counted? Not if granted out of the performance period, but shouldn`t the value change in the reporting period also be counted?

  1. Performance-adjusted Compensation

The focus is on stock options, SARs, RSU, and performance shares, (from now on, Equity Long-term incentives, or LTI). Those may be valued at Grant-date value, (as in Target Pay or USA regulation ordered Summary Compensation Tables, (SCT), (using accounting procedures, such as as Black-Scholes), or as in ISS assessments, (using its own procedures). To cope with the problem of Target Pay, Earned, Realized and Realizable pay were defined, but they, as seen, have their own problems.

Performance Adjusted Compensation, is similar to Realizable Pay, but addresses some of the defects. It can be defined as “annualized total compensation after stock price performance is taken into account”. In brief:

–         Stock options: Black-Scholes value of options granted in the period, vested or not, based on stock price at the end of the period. This includes the time value of options.

–         RSU: value of those granted in the performance period, vested or not, at the stock price at the end of the period.

–         Performance Shares: value of those earned and vested during the period, at the stock price at the end of the period.

Whatever standard definition is used, it should follow below principles:

–          Data should be shown over the long-term (e.g., at least three 3-year rolling cycles).

–          All elements of compensation should be valued after performance has happened, not at grant date.

–          The time horizon of the pay components should match the horizon of the performance measured.

–          The pay definition should put the various LTI vehicles on comparable footing, so that pay and performance comparisons are not distorted.

–          The pay definition should make it easy to compare actual pay across companies.

–         The pay and performance discussion should cover total compensation.

–         The data should be readily available and easily replicated by third parties

In the post we followed “Pay definitions:…” by Farient, (http://www.farient.com/blog/pay-definitions-what-works-best-in-pay-for-performance-analysis/), and What Does It Mean for an Executive To Make $1 Million?, by Rock Center Corporate Governance, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1972627/ ).

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