Evaluation of Executive Pay (Management Say-on-Pay) (US*)

*Note that the newly proposed pay-for-performance methodology is also being considered for Canada.

Background and Overview

The advent of near universal say on pay has underscored the importance of a balanced evaluation of executive pay practices.  For institutional investors, pay-for-performance is a cornerstone of this evaluation: 94 percent of institutional respondents to ISS' 2009 policy survey indicated that pay-for-performance is a critical or important consideration in their vote determinations. As part of ISS' 2011-12 policy survey, we inquired as to the relevance of two factors in evaluating pay-for-performance alignment: pay relative to peers and pay increases that are disproportionate to the company's performance trend.  Approximately 62 percent and 32 percent of investor respondents considered the former to be very relevant and somewhat relevant, respectively, while 88 percent and 11 percent considered the latter to be very relevant and somewhat relevant, respectively. Among issuers, 86 percent responded that pay versus peers is an appropriate factor, while 97 percent said pay increases in light of company performance should be a consideration. In addition, both investors and issuers have indicated in roundtables and other feedback that pay-performance alignment should be viewed in a long-term context rather than the most recent year.

In light of this guidance, ISS is proposing to revise our approach to identifying pay-for-performance alignment in order to better address market needs. The new approach will identify strong as well as weak pay-for-performance alignment over a sustained period, thus giving clients a more robust view of the relationship between executive pay and performance at portfolio companies.  In cases where alignment appears to be weak, further in-depth analysis will determine causal or mitigating factors.

Key Changes Under Consideration

ISS currently identifies pay-for-performance disconnects by scrutinizing underperforming companies (i.e., those with 1- and 3-year total shareholder returns (TSRs) below the median of their 4-digit GICS industry group), and then applying a qualitative examination of other factors, including the year-over-year change in the CEO's total pay and a view of the five-year trends in company TSR and CEO pay, to determine whether pay and performance are misaligned. Beginning in 2012, ISS proposes to use a new methodology to evaluate pay-for-performance alignment, which will identify companies that have demonstrated strong, satisfactory, or weak alignment between TSR and CEO pay over an extended period.  The new methodology incorporates a quantitative analysis, followed as applicable by further qualitative analysis.

The quantitative pay-for-performance analysis utilizes three factors; together they provide a useful signal to pay-for-performance alignment over sustained periods (one, three, and five years), including both high and low performing companies that provide proportionate (or disproportionate) pay and pay opportunities to the CEO.  The analysis measures three factors in two categories:

1. Relative Alignment– Two factors are analyzed to determine the pay-performance alignment within a group of companies similar to the company in market cap, revenue (or assets), and industry:note
   
   
   The peer group is generally comprised of 14-24 companies that are selected on the basis of market cap, revenue (or assets for financial firms), and GICS industry group, via a process designed to select peers that are closest to the subject company in terms of revenue/assets and industry and also within a market cap range that is reflective of the company's life cycle maturity phase
   • The degree of alignment between the company's TSR rank and the CEO's total pay rank within the peer group, as measured over one-year and three-year periods (weighted 40/60, to put more emphasis on the longer term);
      
   • The multiple of the CEO's total pay relative to the peer group median, which may identify cases where a high performing company may nevertheless be overpaying.
      
2. Absolute Alignment– this factor measures long-term alignment between pay and company performance, as:
   
   • Alignment between the trend in the CEO's pay and the company's TSRs over the prior five fiscal years – i.e., the difference between the slope of annual pay changes and the slope of annualized TSR changes during the prior 5-year period.

Peer Alignment and Absolute Alignment may be weighted 50/50 in this portion of the analysis. Companies that demonstrate strong or satisfactory alignment will generally receive a positive recommendation (in the absence of other pay-related issues), while companies demonstrating weak alignment will receive further qualitative review to determine a final vote recommendation.

The qualitative review considers the following:

• The ratio of performance- to time-based equity awards;
• The overall ratio of performance-based compensation;
• The robustness of disclosure and rigor of performance goals;
• The company's peer group benchmarking practices;
• Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc., both absolute and relative to peers;
• Special circumstances related to, for example, a new CEO in the prior FY or equity grant practices (e.g., biannual awards); and
• Any other factors deemed relevant.

Intent and Impact

As noted above, the proposed approach is designed to better address market needs for robust pay-for-performance evaluations.  Specifically, the new approach:

1. Continues to provide a multifactor analysis to pay-for-performance evaluations, while putting more emphasis on long-term alignment and on pay and performance relative to the company's market peers, as well as the overall alignment of CEO pay and TSR performance trends over five years;
    
2. Identifies Russell 3000 companies with apparent strong pay-for-performance alignment, as well as those with apparent weak alignment;
    
3. Is transparent and allows more consistent evaluation of some factors that have been assessed solely on a qualitative basis under current policy (e.g., five-year pay-relative-to-TSR trends, and CEO pay relative to peer median pay), and
    
4. Continues to incorporate an in-depth qualitative assessment of companies where the quantitative review indicates a pay-for-performance disconnect, considering factors such as the overall ratio of performance-based pay (especially equity-based pay, which may incentivize performance improvement) in the most recent year, other recent changes (such as a new CEO), and operational performance indicators (such as trends in financial returns).

Backtesting of the new methodology indicates strong correlation between the results and shareholder say-on-pay votes in 2011.  ISS does not anticipate a significant change in the number or percentage of negative recommendations issued due to a change to the proposed methodology. However, the set of companies that are identified as having long-term pay-for-performance misalignment may differ somewhat from those that would be identified under the current methodology (which focuses primarily on companies that have underperformed a broad industry group and where a veteran CEO's pay increased in the most recent year).

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:

• Do the factors utilized in ISS' proposed pay-for-performance evaluation approach align with those that your organization believes should be considered?
   
• Does the proposed new approach give adequate consideration to long-term alignment?
   
• Will the proposed new approach be beneficial to your organization in identifying companies with strong pay-for-performance alignment?
   
• What additional factors, if any, should ISS consider and display to improve investors' ability to evaluate companies' long-term pay-performance alignment?

To submit a comment, please send via e-mail to policy@issgovernance.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.