Pay For Performance Or Skin In The Game?

The new SEC “pay for performance” disclosure rules, coming into force for this year’s proxy season, will set new ground rules on corporate disclosure standards for “say on pay” voting. As companies are busy preparing their filings, the new rules provide an opportunity to rethink what metrics would be most useful for investors as they evaluate executive compensation and company performance.

Pay for performance is the usual mantra for CEO pay in public companies, but this assumes that it is possible to measure CEO performance over a long enough timeframe to matter, and that this relationship is motivating to CEOs.

Skin in the game – or alignment between shareholders and CEOs by shared stock ownership – is more common in private companies. Everyone does well or poorly together.

The SEC rules enshrine the pay-for-performance mindset – and use total shareholder return (TSR) as the primary pay metric. This is understandable – it’s what investors want. Investors have, to a large extent, latched on to TSR because it is easy to measure – and it is how investors are measured. But it does not tell the whole story on executive pay and how that pay is linked to company performance.

Historically, changes in executive compensation in the US exceed changes in TSR. Research from Pay Governance, an advisory firm for compensation committees, shows that while median compensation among S&P 500 companies has steadily increased since 2009, changes to TSR have been far more volatile.

Despite the lack of connection between the two numbers, levels of dissent in say-on-pay voting have been consistently low. 75% of pay packages in 2022 were approved with 90% or more of the vote. The SEC’s goal seems to be to address this disconnect.

More importantly, TSR is used in an overly short-term manner by most companies. Before the SEC’s ruling, over half of U.S. companies used TSR as a metric to gauge executive compensation – less than 2% of them used terms of five years or longer. Assessing pay in this way incentivizes executives to focus on short-term stock price rather than long-term value creation. And it does not capture the long-term impact of attracting talent, developing a strong culture, or executing a new strategy, all ways that chief executives create real value over time.

Among other things, the final rules require annual proxy disclosures of the relationship between executive compensation paid by a company and the company’s financial performance. This includes a new table providing total executive compensation amounts and financial performance over the previous five fiscal years (fully phased in), as measured by TSR, TSR of peer group, GAAP net income, and a measure chosen by the company itself. A supplemental table also provides space for companies to choose additional financial or non-financial measures. The latter component is supposed to bring “flexibility that allows companies to describe the performance measures it deems most important when determining what it pays executives,” according to the SEC. While getting the SEC to back away from TSR as the end-all be-all in pay disclosure is a longer proposition, companies should take advantage of the flexibility in the new format to lean into longer-term measures which will better explain executive incentives and expectations of long-term value creation.

In particular, investors should be concerned with the forward structure of pay plans – that executives’ incentives are properly aligned with their companies’ long-term strategy and objectives. There are alternatives to TSR that can better indicate this idea of skin in the game.

Pay duration is forward looking, and simplifies the components of pay – salary, bonus, and long-term incentives (LTI) into a single metric that is comparable across peers. It is simply a weighted average, in years, of the different components of pay. It helps investors understand the time horizon of pay and offers insights into whether the pay package is aligned with the industry’s and firm’s capital allocation cycle. Also consider its ease of use – companies can compute pay duration using existing data in filings.

Most pay metrics don’t consider wealth accumulation of executives over time, particularly through firm ownership, leading to exclusive attention on flow pay. Wealth sensitivity, a ratio of (1) the dollar change in wealth for a 1% change in share price over (2) the grant date value of the total compensation package, offers insight into the impact of previously granted and vested equity ownership.

Do you think Jeff Bezos cares more about his pay this year or how much his wealth changes? This figure provides a more complete story of the behavioral elements that motivate executive decision-making. And, again, consider the ease of use. With the new SEC requirements for companies to report realized pay and mark-to-market unvested equity grants and options, the most difficult part of this calculation is already done.

When exercising their proxy votes, investors should want to understand how pay packages incentivize long-term value creation instead of a short-term snapshot. It is in everyone’s best interest, including the SEC’s, to give it to them in a way that is consistent, comparable, and indicative of the things that matter to companies’ success over the long run. Focusing on skin in the game will help.