Why Relative TSR Will Not Align Pay and Performance Disclosure
by Daniel Rodda | November 24, 2015
Earlier this year, the Securities and Exchange Commission released a proposed rule that would implement the 2010 Dodd-Frank requirement to disclose the relationship between executive compensation actually paid and performance, with performance largely defined by the company’s total shareholder return (TSR).
The proposed rule includes disclosure of how a company’s TSR compares to peers. This has led some commentators to suggest that any company not using relative TSR as a performance measure should strongly consider adding it. However, companies should not rush to change their incentive plans, as using relative TSR will not ensure perceived alignment under the proposed rules.
The Proposed Disclosure Requirements
Under the proposed rule, companies would have to provide tabular disclosure in their annual proxy statements that compare executive compensation totals from the summary compensation table with compensation actually paid, as well as TSR and the TSR of a group of peer companies. Additionally, companies would need to provide a narrative disclosure describing the relationship between these elements. The disclosure would initially cover three years, but would later cover five years’ of data.
Compensation actually paid, as defined in the proposed rule, would have two primary differences from the total shown in the summary compensation table: the grant-date value of equity awards would be replaced by the value of awards on the vesting or payout date; and the change in the present value of accumulated pension benefits would be replaced by the present value of pension benefits earned based on one additional year of service. Both changes may provide better insight into compensation delivered by shifting focus from long-term incentive opportunities to payouts, and removing “noise” created by changes in pension interest rate and mortality table assumptions.
The tabular disclosure of TSR under the proposed rule will be cumulative from the beginning date of the disclosure. For example, the first year covered by the table will show one-year TSR results, while the third year in the table will show three-year results.
Peer TSR must be based on either the peer group used in the stock performance graph, typically disclosed in a company’s 10-K, or a compensation peer group disclosed in the compensation discussion and analysis. Peer group results must be weighted based on each company’s market capitalization.
Pay and TSR Disclosure Disconnects
While it may seem that companies using relative TSR as a primary performance measure would show clearer alignment of pay and performance than others under the proposed disclosures, there are several reasons why that may not be the case, including:
- Misalignment of time periods. Payouts from relative TSR performance plans will typically be shown next to TSR results from a different time period. Take, for example, an award based on relative TSR performance for 2016 through 2018 that vests in early 2019. The payout would be reflected in actual pay for 2019, but the TSR shown in the table for 2019 would in most years not reflect 2016 through 2018 results. Instead they would reflect one-year, two-year, three-year, four-year, or five-year re-sults, depending on the year of disclosure.
- Differences in the calculation of TSR results. Most relative TSR performance plans determine payouts based on the company’s percentile ranking relative to the peer companies, not based on the market-cap-weighted results that would be shown under the proposed rule.
- Impact of other pay components: Even if a company grants long-term incentives through a relative TSR performance plan, other components of pay—salaries, annual incentives, retirement benefits—will not depend on or match relative TSR performance results.
Evaluating the Use of Relative TSR Plans
All companies, whether or not they use relative TSR, will be challenged to disclose why the table required under the proposed rule does not fully reflect the relationship between pay and performance. While relative TSR can be an effective incentive, companies should not implement relative TSR plans solely in an attempt to improve their potential disclosure under the proposed rule. Companies should continue to evaluate which performance measures and plan designs will be most effective at their organization to meet their compensation objectives and drive the creation of value.
Daniel Rodda is a lead consultant in the Atlanta office of the executive compensation consulting firm Meridian Compensation Partners.
This story is from the November/December 2015 issue of NACD Directorship magazine.