On December 20, 2011, Institutional Shareholder Services (ISS) released a white paper entitled “Evaluating Pay-for-Performance Alignment: ISS’ Quantitative and Qualitative Approach”. As we discussed in a post of December 21, the Paper introduces ISS’ new approach to evaluating pay-for-performance and is thus the most current and thorough description of the approach ISS’ will now use to evaluate pay-for-performance.
The new approach comprises an initial quantitative assessment and, as appropriate, an in-depth qualitative review to determine either the likely cause of a perceived long-term disconnect between pay and performance or factors that mitigate the initial quantitative assessment. ISS has introduced this new approach because investor feedback received regarding pay-for-performance indicated a preference for a focus on long-term alignment, board decision-making, and pay relative both to market peers and to absolute shareholder returns.
While the Paper is primarily focussed on pay practices of companies in the United States, ISS has indicated that the new methodology is being considered for Canada. Further, given the influence ISS can have on Canadian capital market participants, the content of the Paper may be of interest to Canadian readers.
The Paper explains that ISS regularly polls both clients and other market participants on the issue of executive pay and in response develops evolving methodologies to detect potential pay-performance disconnects of concern to shareholders. ISS’ historic approach utilized a quantitative methodology to identify underperforming companies. In particular, the historic methodology was designed to identify companies with both one and three-year total shareholder return (TSR) below the median of peers in their 4-digit Global Industry Classification Standard (GICS) group. ISS then historically performed an in-depth qualitative review, focused primarily on factors such as the year-over-year change in the CEO's total pay, the five-year trend in CEO pay versus company TSR, and the strength of performance-based pay elements, on companies that it perceived to be underperforming.
In the Paper, ISS states that a substantial majority of institutional respondents to its 2011-12 policy survey (the Survey) confirmed two factors as being particularly relevant to evaluating pay-for-performance alignment: (i) pay relative to peers, and (ii) pay increases that are inconsistent with the company's performance trend. Most issuer respondents to the Survey also indicated that pay versus peers is an appropriate factor and that pay increases in light of company performance should be considered. Further, institutions and issuers have contended that pay−performance alignment should be viewed in a long-term context. These results from the Survey prompted ISS to refine its approach to pay-for-performance evaluations and develop a more sophisticated methodology to drive the quantitative component of the analysis. The Paper strives to articulate, in detail, ISS’ new approach to measuring pay-for-performance alignment.
What ISS Measures
As described in considerable detail in the Paper, ISS measures the following elements as part of its new methodology:
- CEO Pay. ISS focuses on the CEO's pay because the CEO’s pay package sets the "compensation pace" at most companies, and the compensation committee and board of directors are most directly involved in and accountable for the decisions that generate the CEO's pay.
In evaluating pay−performance alignment, ISS focuses on “total compensation” as reflected in the summary compensation table in the applicable issuer’s continuous disclosure documents, by utilizing a standard set of assumptions to value equity-based grants.
- Performance: While there are several ways to measure corporate performance, ISS believes that the key measure for investors in the context of long-term pay-for-performance evaluation is TSR. ISS indicates that, from their perspective, if a company’s business strategy is sound and well executed, the expectation is that it will create value for shareowners over time, as reflected in long-term total shareholder returns. Therefore, TSR, which ISS highlights as being objective and transparent, is the primary metric utilized in evaluating pay and performance alignment. Nevertheless, ISS is careful to note that it does not advocate that companies use TSR as a metric underlying their compensation program.
- Relative and Absolute Alignment Over Time. A substantial majority of institutional respondents to the Survey confirmed two factors as important in determining pay-for-performance alignment: (i) pay relative to peers and (ii) pay increases that are disproportionate to the company's performance trend.
In light of this information, ISS incorporated these factors into the quantitative component of its revised pay-for-performance analysis, as ISS believes that this ensures a balanced evaluation from both relative and absolute pay-for-performance perspectives. In the event that the quantitative assessment indicates significant pay-for-performance misalignment, ISS then completes an in-depth qualitative analysis to determine either the probable cause or any applicable mitigating factors.
Goals of ISS' Quantitative Evaluation of Pay-for-Performance Alignment
The first step in ISS’ evaluation of pay-for-performance has historically been a quantitative assessment of how well a company’s CEO pay has been aligned with its financial performance. This step was designed to identify a potential misalignment of pay and performance, thereby prompting a further qualitative assessment of the company in question.
ISS’ new quantitative pay-for-performance model maintains this approach but is intended to introduce new factors. The three main goals of the new pay-for-performance methodology are:
- Measure alignment over multiple time horizons. As business cycles and compensation plans’ performance cycles span multiple years, the assessment of alignment between shareholders and executives should accordingly see pay across timeframes that approach the length of performance and business cycles.
- Use multiple measures to assess alignment. Since no single quantitative measure can conclusively indicate that pay and performance are aligned, the revised approach seeks to identify multiple measures to assess a company’s pay for performance alignment from a distinct perspective.
- Provide more information about pay-for-performance concerns to investors and issuers. ISS’ current pay-for-performance evaluation is a binary pass/fail performance-oriented test. Its new approach is designed to provide more robust information about pay-for-performance alignment by evaluating and reporting the degree of alignment found.
Measures of Pay-for-Performance Alignment
At the heart of ISS’ new methodology are what the ISS considers to be three measures of alignment between executive pay and company performance. Two such measures are relative measures, designed to evaluate a company’s pay-for-performance alignment in reference to a group of comparable companies and one element is an absolute measure, which evaluates alignment independently of other companies’ performance.
The three measures, which are each discussed in further detail in the Paper, are summarized below.
Relative Measure 1: Relative Degree of Alignment
This measure compares the percentile ranks of a company’s CEO pay and TSR performance, relative to an industry-and-size derived comparison group, over one and three year periods.
This measure is designed to address the question: Is the pay opportunity delivered to the CEO commensurate with the performance achieved by shareholders, relative to a comparable group of companies?
This measure also compares the percentile ranks of a company’s CEO pay and TSR performance, relative to a comparison group of between 14 to 24 companies selected by ISS on the basis of size, industry, and market capitalization, over one and three year periods. For more information on ISS’ process for selecting peers, see Appendix I to the Paper.
Relative Measure 2: Multiple of Median
This measure expresses the prior year’s CEO pay as a multiple of the median pay of its comparison group for the same period.
This measure is intended to address the questions: (a) Is the overall level of CEO pay significantly higher than amounts typical for its comparison group? and (b) Is the company significantly more than comparable companies, even for strong performance?
This measure is calculated by dividing the company’s one-year CEO pay by the median pay for the comparison group.
Absolute Measure 1: Pay-TSR Alignment
This measure compares the trends of the CEO’s annual pay and the value of an investment in the company over the prior five-year period.
For the past two years, ISS has incorporated into its pay-for-performance analysis an appraisal of the last five years alignment of pay and performance. The results of this appraisal are presented in a chart that displays the values of a company’s pay and “indexed TSR” (i.e. the value of a $100 investment at the end of each fiscal year (assuming dividends are reinvested)). This chart is intended to provide ISS analysts and clients with the ability to assess the general alignment of pay and performance for a company over a five-year period.
This new measure of long-term absolute alignment is intended to tackle, as discussed in the Paper, certain challenges created by ISS’ previous approach and address the question: Have shareholders’ and executives’ experiences followed the same long-term trend?
ISS’ new measure is calculated as the difference between the slopes of weighted linear regressions for CEO pay and for shareholder returns over a five-year period. According to ISS, the difference demonstrates the degree to which CEO pay has changed more or less rapidly than shareholder returns over the same period. For detailed information on how the applicable regressions are calculated, see Appendix II of the Paper.
By using regressions to estimate the long-term trends for pay and TSR, ISS’ new method addresses certain pitfalls of its previous approach of evaluating pay and performance over time, including (i) performance over a fiscal year and pay granted over that period are measured in a consistent fashion, on the same scale, and are matched in time; and (ii) volatility of pay and lumpiness of performance are smoothed (but not eliminated).
Back-testing the new methodology
According to ISS it completed extensive back-testing to substantiate its new methodology. In particular, ISS analyzed pay and performance data for 2,500 companies from the years 2006-2010, constructing applicable comparison groups for each company and then calculating each of the three measures in the methodology. Results of ISS’ analysis, including descriptive charts, are presented in the Paper.