Orgs May Soon Take Stock in Pay vs. Performance Data

The new pay vs. performance (PVP) disclosure requirement from the U.S. Securities and Exchange Commission (SEC) has not made a big splash yet, but it still has the potential to reshape the executive pay landscape as time goes on. Investors and proxy advisors are still in “wait and see” mode around whether the disclosure is useful. The missing link to make sense of the requirement is time. The disclosure is, for the most part, meaningless until investors can look at the trajectory of pay over a CEO’s entire tenure. As time passes and more data is disclosed, that will be possible.

The key innovation of the PVP disclosures is the new “compensation actually paid” (CAP) metric, which has been overlooked due to its complexity (more on that to come) and its misnomer, as it includes unvested equity that hasn’t been actually paid yet. However, with more data, the metric becomes less complex and starts to tell a clearer story. When you aggregate CAP over a CEO’s tenure and compare it to summary compensation table (SCT) values over that same period, it provides an alternative picture of performance alignment to traditional approach. But to use it, you need full tenure data.

Currently, only a few organizations have CEOs with CAP figures reflecting their full tenure because the requirement is so new. As more data is available, using PVP disclosures can become a credible and potentially even a preferable approach for evaluating compensation and performance alignment among investors, proxy advisors and boards of directors.

So, let’s look a little deeper.

CAP Limitations and the Value of ‘Full Tenure’ CAP

In its simplest form, the CAP calculation includes:

Cash paid,
Equity delivered at the value at vest,
Equity granted at the grant date fair value, and
Change in value of unvested equity.

Any single year of CAP data is a narrow snapshot, heavily influenced by stock price fluctuations, which can sometimes render CAP as negative. The term “actually paid” is somewhat misleading since only a portion of the calculation has been “actually paid” in any given year. The biggest challenge is the data item listed in the fourth bullet point, the change in the value of unvested equity, which can cause the numbers to swing dramatically each year and can even drive the numbers to be negative.

When they are negative, compensation is never actually recouped; this can add to confusion over CAP calculation. However, the year-over-year fluctuations balance out over a CEO’s entire tenure, and the picture becomes more apparent.

One way to think about full-tenure CAP is that it is the best possible running estimate of what compensation has been and could be delivered. The annual fluctuations in unvested equity values net themselves out over time and end up showing the tallied value of compensation the moment someone could have taken their pay off the table. Even the method for calculating stock options gives credit to the long lifespan of this vehicle. By using a Black Scholes calculation at the time of vest, CAP gives credit to the long life of a stock option, even if it is “underwater” when it vests (but still has economic value). It shows a credible estimate of what could be delivered to the executive the moment it was theirs to take.

The problem is that each individual year of disclosure is meaningless in isolation. Most years are overly influenced by the change in value of outstanding equity, not the full tallied value. When there is a big negative CAP value, it’s hard to make sense of it unless you know how much the outstanding equity was initially worth. There isn’t a clear story to tell unless you can compare the full tallied value of SCT and CAP numbers.

Future Insights from Expanded Data

Once full-tenure CAP is available, CAP/SCT ratios become powerful because they are apples-to-apples comparisons of everything that was awarded and what it turned into (i.e., the actual compensation outcomes that were delivered) in a manner that allows for comparison across organizations. In the first two years of PVP reporting, only 84 companies in the Russell 3000 had new CEOs join in the window that would provide enough information to look at full-tenure CAP.

By 2025, organizations will be required to report five full years of data. As CEO transitions occur over time, the data set of full-tenure CAP/SCT ratios will get richer and allow for benchmarking. There will also be the opportunity to assess and develop clearer market standards for a reasonable relationship between full-tenure CAP and SCT.

Assessing Performance Alignment

The ratio between full-tenure CAP and SCT moves very predictably with stock price. Early analysis of the 84 organizations in 2022 with CEOs with a short enough tenure show how full-tenure CAP/SCT data validates this hypothesis. Instances of misalignment are worth a review of:

Pay mix and leverage. Is the mix of cash/equity and equity vehicles appropriate?
Pay design. Are the metrics the ones investors care about, and are they aligned to strategy?
Goal setting. Has performance justified payouts?
Special actions. Have one-off actions undermined PVP?
Lumpiness in performance over time. Were performance outcomes varied over time, creating a compensation story that isn’t linear or straightforward?

Across the sample, when full-tenure CAP/SCT and total shareholder return (TSR) didn’t correlate, the factors mentioned above were present. Two instructive outliers are highlighted below:

Agricultural retail company. The CEO’s full-tenure CAP/SCT was higher than relative performance due to a strong leverage profile in its long-term incentive (LTI) structure (25% options and 50% performance stock units [PSUs]) and a 200% payout on PSUs in recent years. This outcome begs the question: Has performance justified the payouts?
Pharmaceutical company. The organization had low full-tenure CAP/SCT and flat performance due to a 100% stock option design. The CAP values decreased as options neared vesting without price improvement, and the Black Scholes calculations remained low. This scenario raises the question: Is the design working, or are there any retention risks to address?

As more PVP data becomes available, full-tenure CAP/SCT ratios will become a better tool for assessing performance alignment. Sufficient data will allow for identifying outliers and give practitioners, boards, proxy advisors and investors more credible benchmarks to evaluate pay and performance. Full-tenure CAP/SCT might even play a bigger role in annual CEO pay evaluations, compensation discussion and analysis (CD&A) disclosure narratives, and shareholder engagement. Despite the complexity of the PVP calculations, more data should bring clarity. PVP has the potential to become a credible — and maybe even preferred — resource for evaluating pay and performance.

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