Since the passage of Dodd-Frank—and along with it, mandatory say-on-pay—institutional shareholder advisory groups have become even more influential in the compensation committee governance process. Institutional shareholders now have a regular opportunity to let companies know how they feel about their pay decisions, which has further bolstered the position of the most influential proxy advisory firm—Institutional Shareholder Services (ISS).
Clearly, not every compensation committee has the same exposure to organizations like ISS—this will vary based on factors relating to the make-up of the company’s institutional shareholder base, current shareholder relations and, yes, recent company performance. However, in today’s governance environment, it’s become a must-have for committees to understand who their top shareholders are, their voting history, and the degree to which those institutions rely on groups like ISS when they cast their votes.
In our experience, we find that directors tend to fall into one of three categories when considering the input of organizations like ISS:
- The Agnostics. These directors aren’t preoccupied with ISS’ views, and their decisions aren’t impacted by them. They manage compensation without any visibility to—or concern about—ISS outcomes. Today, outside of closely-held companies, this population is dwindling.
- The Centrists. Directors in this category want to understand and be prepared for ISS’ views. They will consider modifying their pay programs on noncritical elements or on issues that cannot be defended by market practice, but will hold their ground on issues core to the program, even if they may run afoul of ISS’ guidelines. That said, these directors never want to be surprised by a potential ISS outcome. In our experience, this category makes up the largest proportion of directors today.
- The Believers. Directors here care very much about ISS’ views, and will push for program changes to align with ISS outcomes. They will look to ensure that no box on the ISS scorecard remains unchecked, and may even take steps to modify payouts in order to align with the most influential ISS standard, the “pay for performance” test. We find this population, while still a minority, to be growing.
We have clients in each of the three categories, who often ask us how to interpret how ISS will view—and recommend—on their compensation program. In fact, ISS now offers this service, providing consulting to companies who wish to understand what “the answer” will be. This yields a fascinating question—what could compensation governance look like in a world where ISS calls the shots? If all compensation committee members become Believers, how might programs change?
For 2012, ISS has overhauled its most influential screen, its “pay for performance” test. This analysis has been broadened to include multiple tests that view pay on both an absolute and relative basis, with relativity being both to peers as well as to company performance, represented by total shareholder return (TSR).
If companies began using this new suite of tests exclusively to manage pay, we can foresee several changes to the way companies will need to reconsider their executive pay processes and outcomes. Here are four:
- Limit the breadth of the peer group. Today, most effective compensation programs establish benchmarking peer groups using a variety of factors that are intended to reflect the company’s potential market for executive talent, organizational complexity, and business challenges. For 2012, ISS actually improved their peer group selection process by adding in a revenue screen and reducing the reliance on market capitalization. However, ISS’ continued use of General Industry Classification System (GICS) codes as a broad proxy for the company’s “business” presents an issue for companies that may not compete exclusively for executive talent in their industry alone. Many of our clients—small and large—now use peer groups that also reflect factors like business model, client profiles, and other business similarities that go beyond pure industry classifications. Outcome: for these companies to better align their pay outcomes with ISS’ assessment, they would eliminate any company that did not fit within the industry-specific screen.
- Delay the timing and sizing of equity grants. ISS’ tests view the alignment over time between TSR and CEO pay. In its definition of CEO pay, they focus on the accounting values of equity grants, rather than what those grants are ultimately worth over time. Today, most companies (a) make their equity grants early in their fiscal year, before they know what their year-end TSR will be, and (b) do not vary the size of the equity grants based on annual performance. Companies do this because they are attempting to align the equity grants with the performance review from the prior year. They also do not usually vary equity grants as these are go forward awards usually based on title or grade. Outcome: in order to optimize alignment with ISS’ tests, companies would both delay sizing and making those grants until they had a better sense of their annual TSR performance (and would use that TSR to govern the size of grants).
- Increase the use of TSR in annual incentive plan performance measurement. ISS’ tests use TSR as the baseline for both annual and long-term company performance. While TSR (according to our research) is the prevalent metric in long-term performance-vested share plans, very few companies use TSR as an annual metric—under the belief that management decisions in a given year need to be made for the long-term benefit of shareholders, rather than for short-term stock gains. Outcome: Here, to optimize alignment, companies would need to consider TSR as a primary driver of annual incentive plan payouts.
- Adopt a more conservative target pay positioning and mix of pay. One of ISS’ new tests will look at 1 year pay as a multiple of their peer group median, where—presumably—anything materially above the median will yield a negative outlook. For companies that have a business reason for targeting above median, this will put more pressure to reduce their target market positioning. In order to achieve that new positioning, however, companies are unlikely to look to reduce base salaries, which will put pressure on the other forms of compensation—or the performance-driven—pay elements. Outcome: This will—perhaps paradoxically—shift the overall mix of pay away from performance.
(Be careful, however—in its contextual review of pay programs, which are completed once the hard “tests” are calculated, ISS will look at the proportion of performance-based pay in the entire package, with the more performance weighting, the better.)
Clearly, some of these changes may be more realistic—and appropriate—than others. However, the great paradox of the ISS influence on pay programs—which presumably is to make them more appealing to shareholders—is that it makes it more difficult for compensation committees to have the freedom to align their pay programs with how the company makes money. It prevents the creation of programs that meet the company where it’s at, that reflect the company’s culture and strategy. ISS’ focus is on the output—the TSR—and does not leave much room for any focus on inputs—the drivers of the business.
Many committees are now being forced to choose between optimizing the strategic value of their program and complying with ISS-driven metrics. In our experience, the companies with programs that “work”—irrespective of whether or not they are ISS Agnostics or Believers—can rationalize why they work. The most effective programs we see are focused around inputs as well as outputs, are tailored to the needs of the company’s business, and—importantly—can tell a good story that will make sense to shareholders who are willing to listen.
David Wise is a senior principal and director of Practice Development at Hay Group. Irv Becker is the national practice leader for Executive Compensation at Hay Group.