Pay for Performance (Canada)
Background and Overview
Canadian institutional investors have indicated that pay for performance is a critical factor in determining votes on management say-on-pay (MSOP) resolutions. Two factors resonate in importance when evaluating pay for performance according to ISS’ 2011-2012 policy survey – pay that is higher than peers and pay increases that are disproportionate to performance.
Institutional client feedback has further highlighted a need for change in specific aspects of the current ISS Canadian policy approach, including: reliance on one-year pay change which emphasizes a short-term trend; the absence of an evaluation of pay in both absolute and relative terms; and, the need for a longer term view of performance.
Canadian regulatory disclosure requirements for executive compensation were significantly enhanced effective for all companies with a year-end on or after Dec. 31, 2008. In order to benefit from the results of all three components of the quantitative screen (“RDA”, “MOM”, and “PTA” as described under “Key Changes Under Consideration” below), it is necessary to have compensation data for five complete years. As of 2013 proxy season, Canadian investors will have reasonably consistent and complete pay data for five years with which to evaluate longer term pay for performance. ISS is therefore adopting the new methodology for the Canadian market in 2013.
Key Changes Under Consideration
ISS is proposing to utilize a new methodology to measure potential long-term pay-for-performance alignment based on the following factors:
Step 1: Quantitative
- The Relative Degree of Misalignment (RDA) is the difference between the company's total shareholder return (TSR) rank and the CEO's total pay rank within a peer group1, measured over a 1-year and 3-year period2;
- Multiple of Median (MOM) is the total compensation in the last reported fiscal year relative to the median compensation of the peer group1; and
- The CEO pay-to-TSR Alignment (PTA) over the prior five fiscal years, i.e., the difference between absolute pay changes and absolute TSR changes during the prior five-year period (or shorter period as company disclosure permits);
The new methodology generates a level of concern, which is used to screen companies that exhibit long-term P4P misalignment for further in-depth review. The new screen will replace the current P4P screen (TSR below the GICS group median for both 1- and 3-year periods).
Step 2: Qualitative
As noted above, companies flagged as having potential P4P misalignment will receive a qualitative assessment to determine the ultimate vote recommendation; this assessment shall consider a range of case-by-case factors that may include:
- The ratio of performance- to time-based equity grants and the overall mix ofperformance-based compensation relative to total compensation (considering whether the ratio is more than 50 percent); standard time-vested stock options and restricted shares are not considered to be performance-based for this consideration.
- The quality of disclosure and appropriateness of the performance measure(s) and goal(s) utilized, so that shareholders can assess the rigor of the performance program. The use of non-GAAP financial metrics also makes it challenging for shareholders to ascertain the rigor of the program as shareholders often cannot tell the type of adjustments being made and if the adjustments were made consistently. Complete and transparent disclosure helps shareholders to better understand the company’s pay for performance linkage.
- The trend in other financial metrics, such as growth in revenue, earnings, return measures such as ROE, ROA, ROIC, etc.
- The trend considering prior years' P4P concern.
- Extraordinary situation due to a new CEO in the last reported FY3.
- Any other factors deemed relevant.
The new methodology will inform the ISS CASE-BY-CASE review of executive pay and practices at all S&P/TSX Composite Index companies and for all management say-on-pay resolutions.
ISS will generally recommend AGAINST management say-on-pay proposals, and/or recommend AGAINST/WITHHOLD on compensation committee members (or in rare cases where the full board is deemed responsible, all directors including the CEO), and/or recommend AGAINST an equity based incentive plan if there is significant long-term misalignment between CEO pay and company performance.
Intent and Impact
The updated P4P evaluation addresses concerns expressed during ISS’ extensive market outreach, while continuing to focus on the CEO's annual pay (including earned pay and incentive grants), since the CEO's compensation "sets the pay pace" at most companies and is directly approved by the compensation committee, which is accountable to shareholders. Further, granted pay most directly reflects compensation committee decisions about appropriate executive compensation – i.e., the pay that the committee intended to deliver. While prospective incentive grants generally represent pay opportunities that may not be earned or may decline in value in the wake of poor company performance, ISS recognizes that equity-based pay is also highly sensitive to general market trends and may (or may not) deliver significant value regardless of the company's or executive's performance. Investors expect compensation committees to ensure that compensation (including incentive award metrics and goals) follows a pay-for-performance approach. If granted pay is misaligned with actual performance over time, investors want assurance that it is rigorously linked to specific performance improvement.
ISS' view, particularly supported by client feedback from 2011 roundtable discussions, is that investors ultimately benefit only from the returns on their ownership stake; thus, over time, TSR remains the key performance metric for shareholders. However, ISS' 2012-2013 policy survey results indicate that a majority (52 percent) of investor respondents would "very likely" consider other metrics in addition to TSR in the U.S. market which is also relevant in the Canadian market. The new methodology continues to evaluate performance on the basis of total shareholder return, while trends in other performance metrics (both absolute and relative) may be considered on a case-by-case basis.
Benefits of New Approach
The new methodology accomplishes three key goals:
- Continues to provide a multi-factor approach to pay-for-performance evaluation, putting more significant emphasis on long-term alignment of pay and performance, relative to market peers;
- Allows more consistent and precise evaluation of several factors that have been assessed solely on a qualitative basis under current policy;
- Directly links a key aspect of the P4P evaluation to ranking of the company's performance and pay against the same comparator group, which is designed to reflect its closest market peers while also taking into account revenue/asset size since executive pay is most sensitive to that metric.
The new methodology provides several additional improvements to ISS' overall evaluation process.
First, this methodology evaluates the alignment between pay and performance on a relative and absolute basis, over time, thus it more accurately gauges the strength of the correlation between pay and performance. Testing has shown that, in general, the relative and absolute results are directionally aligned with company performance. The methodology is designed to flag cases, where these results are significantly misaligned with long-term performance, for in-depth review.
Second, the methodology has a greater emphasis on long-term trends because it: i) assigns a somewhat larger weight to the three-year component of RDA, and ii) includes a five year look-back for absolute alignment.
Third, the methodology considers the CEO's total pay relative to the median of peers, to assess whether even high performing companies may be overpaying.
ISS analysts will continue to overlay a qualitative assessment to companies flagged by the new screening process; however, the expectation is that the new methodology will more accurately identify likely P4P misalignments, allowing analysts to focus more specifically on aspects such as the rigor of performance metrics and other concerns that clients have indicated are important (e.g., 81 percent of investor respondents to ISS’ 2010-2011 policy survey said that the way a company's short-term and long-term incentive metrics relate to the company's business strategy is among their most important consideration in evaluating executive pay).
Consideration of the ratio of performance-based to time-based equity will also continue to influence ISS’ case-by-case recommendation. This recognizes that well-designed equity grants constitute pay opportunities that, while expected to be aligned with long-term performance trends, may benefit shareholders by incentivizing specific performance improvement.
Vote results from 2012 proxy season provide support for the new methodology; although no companies received less than majority support4 for their MSOP proposals to date, the companies triggered in the initial testing of the proposed methodology received lower support than the median support for an MSOP proposal in the 2012 proxy season. In Canada, MSOP is not mandatory, and as of Sept. 1, 2012, 106 companies have voluntarily adopted say-on-pay. Due to the voluntary nature of MSOP proposals in Canada, those companies providing shareholders with the ability to weigh in on executive compensation would be market leaders in corporate governance and, therefore, the expectation is that vote results will continue to be reflective of this group's attention to corporate governance expectations and improvements. However, shareholders are becoming more comfortable over time with the advisory vote as another mechanism for holding boards of directors accountable and as longer term evidence of pay for performance misalignment and/or continuing unacceptable pay practices at a limited number of companies becomes available, it is anticipated that there will be some MSOP resolutions in Canada not supported by a majority of the votes cast going forward.
Request for Comment
Please feel free to add any additional information or comments on the proposed policy change. In addition, ISS is specifically seeking feedback on the following:
Peer Group Construction
- Are there alternate or additional criteria that should be used in Canadian peer group construction other than size as determined by revenue/assets; industry group; and market capitalization? If yes, please specify.
Relative Degree of Alignment (RDA)
- Is the 40/60 weighting on the one- and three-year, respectively, for TSR rank, and CEO pay rank (which gives more weight to the longer term three-year component) appropriate in your organization's view? If no, please specify.
- Does your organization consider any additional significant factors, other than those listed in ISS’ qualitative evaluation component of the proposed methodology? If yes, please specify.
To submit a comment, please send via e-mail to email@example.com. Please indicate your name and organization for attribution. While ISS will consider all feedback that it receives, comments will not be published without attribution.
All comments received will be published as received, unless otherwise requested in the body of the e-mail submission.
1. The peer group is generally comprised of 11-24 companies that meet the following criteria:
- Revenue/assets between 0.25X and 4X the subject company's size;
- In the closest GICS industry group (8-digit, 6-digit, 4-digit, or 2-digit) to the subject company's GICS category; and
- Market Cap within limits that vary according to the company's market value, utilizing four market cap "buckets" (micro, small, mid, and large); ISS may expand size boundaries as necessary to achieve a minimum peer group size, while always striving to maintain the target company to within +/-50% of the median size position.
In exceptional cases of very large or very small companies, peer groups will be determined on a customized basis potentially broadening out to "super-GICs" that combine together one or more 2-digit GICs groups and relaxing size constraints further to maintain the target company at the peer median.
2. Weighted as to one-year 40 percent and three-year 60 percent.
3. Note that the longer-term emphasis of the new methodology alleviates concern about impact of CEO turnover. Thus, a "new" CEO will not exempt the company from consideration under the methodology since the compensation committee is also accountable when a company is compelled to significantly "overpay" for new leadership due to prior poor performance.
4. Based on total votes cast including votes cast by controlling shareholders