Investors keen to better understand how companies connect executive compensation to financial performance gained a long-sought tool in August when the Securities and Exchange Commission finalized a rule seven years in the making.
A lot has happened in those years, including increasing shareholder attention to ESG factors that investors are now hoping will play a larger role in the executive compensation/financial performance equation.
Approved Aug. 25 and set to apply to the upcoming 2023 proxy season, the new pay-for-performance disclosure rule "makes it easier for shareholders to assess a public company's decision-making with respect to its executive compensation policies," SEC Chairman Gary Gensler said at the time.
"When we are looking at stewardship, we are looking to see if pay is aligned with performance," said Neaaz Mozumder, investment stewardship analyst at Legal & General Investment Management America Inc. in Chicago, "and it gives us something to compare companies."
While it remains to be seen how asset owners and managers will deploy the new rule, "it adds another layer to the process" of learning how much compensation corporate executives really take home, and should mean "seeing things a bit more clearly," said Mr. Mozumder.
While well-designed compensation programs can be "a powerful and effective tool to reward value-creating executives" in alignment with shareholders seeking long-term investment returns, "currently there is a substantial disconnect," said Marcie Frost, CEO of the $444.4 billion California Public Employees' Retirement System, Sacramento, in a March 4 comment letter on the SEC's rule proposal.
More meaningful disclosures addressed by the new rule should bring better alignment of corporate pay and performance practices, "or at least better explanations regarding pay decisions," Ms. Frost said.
Mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the new pay-for-performance disclosure rule was first proposed in 2015 by the SEC, where it languished until Mr. Gensler took over.
The goal of the new rule is to provide shareholders with more information in proxy statements used for voting on executive compensation plans and director elections.
In a key change from existing standards for executive compensation disclosure, the new one focuses on what is actually paid to executives and calls for companies to be more descriptive of their executive compensation process, particularly the relationship between pay and company performance.
Companies must now report total shareholder return for themselves as well as their peer group, along with net income and up to seven financial performance measures relevant to the company. They also have to describe the relationship between those performance measures and the compensation paid to a CEO, as well as other executive officers. It all has to be provided in tables and narratives. After a multiyear phase-in period, the disclosures will eventually cover the five most recently completed fiscal years.
Companies also get to choose a financial performance measure that they consider relevant to their company or industry. That is "an elegant approach of getting a company to actually disclose the information it uses to determine executive compensation," said Ms. Frost of CalPERS in her comment letter. Companies are free to add other metrics, including those related to environmental, social and governance issues, that could be relevant to performance.
Having more metrics disclosed in the context of executive pay is also "another cross-check" on a company's true priorities, said Mr. Mozumder of LGIM America.
ESG metrics are becoming more common in the executive pay-vs.-performance calculation. A review by consulting firm Semler Brossy Consulting Group LLC of public disclosures made between March 2020 and March 2021 found that 57% of S&P 500 companies included an ESG metric in either the annual or long-term incentive plan.
An April 2021 report from Willis Towers Watson PLC found that most of the largest companies in North America and Europe already incorporate ESG metrics into executive pay plans, and their board members see ESG issues as a business risk, the report said, citing pressure from stakeholders on issues ranging from climate change to diversity, equity and inclusion. "There is ample evidence suggesting that companies with a strong ESG profile outperform their competitors," the report said.
The option of adding ESG metrics to the disclosure of executive pay calculations "I think will be a real test of how serious companies are about ESG," Mr. Mozumder said.
Pushback against the new rule began simultaneously with its approval. Opponents raised the prospect of legal challenges for several reasons, including the use of outdated economic analysis from the 2015 proposal. Groups like the Business Roundtable want the SEC to go back to the drawing board.
Marc Hodak, a partner at executive compensation and corporate governance consultancy Farient Advisors LLC, based in Dallas, cautions that the new rule could potentially mislead investors or disguise a lack of alignment between management and shareholders.
That is because the required disclosure ignores equity gains before vesting, which represent real value to the executive, and are important to investors. If managers are granted equity each year, that vesting equity could increase "actual pay" regardless of performance, he said. "The best way to value pay is to look at the value of options over time. That 'realizable value of the equity' is difficult to measure. It's really very complicated to do it right," Mr. Hodak said.
Even if the new SEC rule gets held up, shareholders are not likely to stop pushing for companies to make it clearer how they connect pay and performance, which would also make it easier for investors to compare companies.
A 2022 proxy season preview by ISS Corporate Solutions, a division of International Shareholder Services Inc., found CEOs in the S&P 500 and Russell 3000 received record-high pay increases, but also record levels of shareholder opposition to pay proposals. Median say-on-pay vote support that started declining in 2018 hit an all-time low in 2022. The percentage of companies with failed say-on-pay votes increased to 3.2%, up from 2.6% in 2021 — the highest failure rate since say-on-pay votes became mandatory in the U.S. in 2011.
"Existing disclosures can otherwise often be unnecessarily complex and verbose, without painting the full picture of pay outcomes and how they relate to company performance," said John Hoeppner, Chicago-based head of U.S. stewardship and sustainable investments, and Alexander Burr, ESG policy lead, in LGIM America's SEC comment letter.
They cite an Economic Policy Institute study from August 2020 that found that the average compensation of CEOs of the 350 largest U.S. firms increased 35.7% from 2009 to 2019, based on numbers provided under current standards. Measuring by what is actually paid, that same cohort of CEOs experienced a pay growth of 105.1%, the study found.
"This aligns with our experience as shareholders where we have evaluated compensation plans at public companies that often have material differences between what's disclosed and what's taken home. The intricacies of pay plans, which involve vesting periods, a range of performance targets, as well as board discretion, make it difficult for investors to make cross-company comparisons and time series analysis," the LGIM America letter said. "Executive compensation practices at U.S. public companies still have much room for improvement."
As Jeffrey P. Mahoney, general counsel for the Council of Institutional Investors, an association of employee benefit funds, public investment officials, foundations and endowments with $4 trillion in combined assets, commented to the SEC, "directors' decisions about executive pay speak volumes about the board's accountability to shareowners."
