The Council of Institutional Investors this month overhauled its policy on executive compensation, urging public companies to dial back the complexity of their pay plans and set longer periods for measuring performance for incentive awards.
While acknowledging that boards of directors need to tailor pay packages to company-specific circumstances, the new policy suggests that companies explore adopting simpler plans composed of salary and time-vesting restricted shares that vest over five years or more. Historically, a majority of time-vesting restricted stock awards have vested over three years.
The policy also recommends that companies consider barring the CEO and CFO from selling stock awarded to them until after they depart, in order to ensure that management prioritizes the company’s long-term success.
Perhaps most controversially, the policy suggests that boards and investors step up their scrutiny of performance-vesting shares, which vest upon the achievement of corporate performance milestones. “Steadily rising average pay, even when market performance is mediocre, suggests that pay for performance can be a mirage,” says CII executive director Ken Bertsch.
Boards may not be easily convinced that the suggestion has merit. According to a research report by Marc Hodak of compensation consultant Farient Advisors, published in the Summer 2019 edition of the Journal of Applied Corporate Finance, 83% of S&P 500 companies offered long-term incentives (LTIs) paid as performance shares in 2018. That was up from 50% in 2009.
It may be difficult to sway institutional investors as well. Ironically, while CII, an organization for institutional investors, is calling for greater scrutiny of performance shares, Hodak’s report notes that their increasing prevalence “has been driven largely by the efforts of influential institutional investors and their proxy advisors to promote what they believe to be a more shareholder-friendly award than restricted stock or stock options.”
But according to both CII and the Farient research, there are significant downsides to performance shares.
For one, they can be complex and difficult for investors to understand. “Performance-based compensation plans are a major source of today’s complexity and confusion in executive pay,” CII’s policy states. “Metrics for performance and performance goals can be numerous and wide-ranging. They are often based on non-GAAP ‘adjusted’ measures without reconciliation to GAAP.”
They’re also costly. Farient found that from 2008 through 2017, “CEOs who received a significant portion of their LTI awards in the form of [performance shares] were awarded median grant values that were roughly 35% higher than those for CEOs who received only restricted stock or stock options.”
Worst of all, on average, performance shares don’t in fact work to improve market performance. “It is exceedingly difficult to find any relationship between the bonus rewards received by managers and value created for their shareholders,” Hodak wrote, noting that numerous studies have isolated short-termism as a chief culprit for such non-performance.
He continued, “Long-term goals based on accounting results, such as earnings or return on capital, are likely to become stale as managers get nearer the end of the plan…. Three-year plan targets are likely to be long-since achieved, or no longer achievable, well before the end of the performance period. Furthermore, any interim shift in the strategic landscape, which is highly likely within any three-year period, could make such goals no longer worth achieving.”
Meanwhile, responding to the widening gap between compensation for workers and executives, the new CII policy also recognizes rank-and-file pay as a valid “reference point” for setting executive pay at appropriate levels.
Further, the policy expands the circumstances under which boards should have legitimate discretion to claw back executive pay, covering not only financial restatements but also personal misconduct and ethical lapses that cause material reputational harm.