Working Group on Supplemental Pay Disclosure: FAQs

Below are some of the common questions that have been asked of the working group recently including responses from the working group. If you have a question that is not addressed here, please submit your question through the comments page.

Frequently Asked Questions on The Conference Board Working Group Conceptual Framework for Supplemental Pay Disclosure

Why create a conceptual framework for supplemental pay disclosures?

Companies, investors, the media and other stakeholders have intensified their focus on the link between executive compensation and company performance in recent years. This, in conjunction with the growth in the length of required proxy statement pay disclosures has led to significant company experimentation with pay disclosures that provide a different yet supplemental lens than the Summary Compensation Table in an effort to make disclosures more concise through the use of tables and charts.  At the same time, the U.S. Securities and Exchange Commission is developing rules to implement a Dodd-Frank Act requirement that it facilitate clearer understanding regarding a comparison of compensation “actually paid” to financial performance in proxy disclosures.
Based on the number of public companies that included a supplemental pay for performance disclosure in their 2013 proxy statements (estimated at 18% by consulting firm Hay Group and expected to expand in future years) there is clear market demand for a better explanation of the pay for performance relationship than what is currently provided by the required proxy disclosures.  Supplemental pay disclosures offer a promising solution, but the considerable variability in approach makes them less useful for investors seeking increased consistency and comparability.  Without a greater consensus among investors, companies, and outside advisors regarding a consistent approach to such disclosures, their full potential is likely to be constrained.  In accord with the desires of many of these stakeholders, the Conference Board, in conjunction with the Society of Corporate Secretaries and Governance Professionals and the Center On Executive Compensation convened a Working Group of subject matter experts to consider the issue.  The Working Group believes there is an opportunity to develop a more standardized approach to supplemental disclosures.

What are the definitions of pay generally used in company disclosures?

Other than the SEC-mandated Summary Compensation Table, there is no standard method for valuing total CEO pay.  However, there are generally three definitions of pay that are used in company disclosures: (1) the Summary Compensation Table definition of pay, (2) Realizable Pay, and (3) Realized Pay. The Working Group is not suggesting that supplemental definitions of pay should replace the Summary Compensation Table. Rather, each of these definitions of pay serves a different purpose and provides different insights for investors.

What are the differences among the three definitions of pay?

The three definitions are summarized below.

Summary Compensation Table. The Summary Compensation Table definition of total pay is mandated by SEC rules and provides a measure of pay that is comparable across companies.  However, this definition includes a mix of some elements that are actual pay, such as salary and annual incentives, and other elements that are accounting estimates of future potential pay, such as performance shares, restricted stock and stock options.  Further, annual fluctuations in the discount rate for pension calculations is not part of the pay decision by the compensation committee and may significantly distort the Summary Compensation Table measure of total pay, especially during periods of low interest rates.  For these reasons, the Summary Compensation Table definition is of limited use in assessing pay for performance or pay versus alignment with shareholders in the form of total shareholder return.
Realizable Pay. Realizable pay is used primarily to show the alignment between changes in executive compensation granted and outstanding and changes in return to shareholders over a period of time, typically three years.  The group believes that realizable pay may be best for showing the alignment of incentive compensation with shareholder interests over the period of time analyzed and comparing that alignment with peers.  Realizable pay uses a snapshot of pay and performance before the end of the performance period for outstanding awards thereby limiting its usefulness as a measure of the ultimate pay for performance relationship.

Realized Pay. Realized pay is used primarily to show the ultimate relationship between pay actually received at the end of the performance period for specific awards and the performance metrics in the annual and long-term incentive plans that drove the payouts. The group discussed that realized pay may be more effective in assessing total pay actually realized by an executive compared to a particular company’s performance.  Thus, it is helpful as an internal company and compensation committee assessment, as well as for disclosure to investors.  It is difficult to calculate realized pay for peers and the timing of the exercise of stock options may cause more significant year-to-year variability than realizable pay.

Which supplemental definition of pay should companies use, realizable or realized?

Both definitions have a place in pay for performance disclosures. Realizable pay provides a relative comparison to judge alignment of pay with stock price for the company and in comparison to its peers for a finite period.  Realized pay provides an absolute comparison of pay to the company’s performance.  Companies may decide to use one or both of these definitions when adopting a supplemental pay disclosure, as long as they remain consistent over time.

What are the advantages of realizable pay?

The advantages of realizable pay are:

  • Realizable pay shows alignment between the total value of outstanding executive compensation awards and stock price at a point in time, so that investors can better understand the extent of alignment between management and shareholder interests.
  • The comparison of realizable pay and TSR of a particular company to the realizable pay and TSR of its peers may be a useful counterpoint to the ISS Relative Degree of Alignment test since it is a more accurate approach than using the Summary Compensation Table measure of pay in assessing whether pay is aligned with shareholder returns at the end of a period.

What are the limitations of realizable pay?

  • The primary limitation of realizable pay is that it is a point in time measure and may significantly differ from the actual pay received at the end of the performance period, and thereby understate or overstate the pay for performance relationship.
  • Significant variations in the definitions of realizable pay often make comparison among companies difficult.

What are the advantages of realized pay?

The advantages of realized pay are:

  • Realized pay compares the actual pay received to the intended level of pay.
  • Realized pay enables the compensation committee to monitor the robustness of the pay for performance relationship (e.g., through a look-back analysis) by comparing the degree to which performance objectives were achieved to the pay actually received by the executive.
  • Realized pay would appear to be consistent with a literal reading of the language of Section 953(a) of the Dodd-Frank Act which requires disclosure of “compensation actually paid.”

What are the limitations of realized pay?

The limitations of realized pay are:

  • The executive has control over when to exercise a stock option once vesting requirements have been satisfied, requiring a more detailed description of the linkage of gains from option exercises and the change in shareholder return over the period the option was outstanding. However, until a stock option is exercised, an executive does not realize pay from this type of award and the time period over which the stock option is earned maybe as long as 10 years.
  • Some executives may wait to exercise a stock option until after they retire and in some cases restricted stock may not vest until after retirement, and such gains would not be reported in the realized pay disclosure.
  • Realized pay is not easily calculated for peer companies without consistent company
    disclosure of the details of options exercises.

Why do you recommend supplemental disclosures only for the CEO?

In our experience, investors are primarily interested in CEO pay; therefore, we recommend that both the pay for performance disclosure mandated by the SEC and the standard approach for voluntarily adopted supplemental disclosures should apply to the CEO only. However, companies may voluntarily provide supplemental pay disclosures for their other named executive officers if they believe such disclosure would be helpful to investors in understanding the company’s pay for performance story. With respect to SEC requirements, and in light of a crescendo of frequent investor complaints about the increasing length of issuer pay disclosures in proxy statements, any pay for performance analysis required by the SEC should apply only to the CEO.

How should performance be measured within the pay for performance disclosure?

Investors primarily use total shareholder return (TSR) to judge company performance. For this reason, total return to shareholders should be a primary focus of the disclosure of the alignment of pay and the interests of shareholders under both realizable and realized pay disclosures. However, it is not recommended that TSR be the sole metric upon which the pay for performance linkage is demonstrated. For example, in addition to TSR, realized pay disclosures should compare pay to the performance metrics established by the compensation committee. These often include measures of financial performance that executives can more readily impact, that are supportive of the company’s business strategy and that are reflective of the pay for performance linkage intended under the compensation awards granted by the committee. In addition, companies should demonstrate that the operating metrics used in their incentive plans are consistent with long-term increases in shareholder value and with the company’s business strategy.

Why do you recommend that pension values should be excluded from pay for performance disclosures?

The calculations of the annual change in the present value of annual accruals of pension benefits disclosed in the Summary Compensation Table are not directly tied to the achievement of performance objectives and are not directly tied to the pension benefit the executive will receive at retirement. In addition, many companies have frozen their defined benefit plans, including those for executives, and a decrease in the discount rate may require companies to report a large number, even though the ultimate value of the benefit the executive will receive is capped. For these reasons, it does not make sense to include these calculations in a comparison of pay and performance. Further, information detailing pension values are adequately disclosed and can be easily analyzed by those interested in this form of compensation.

Why do you recommend that one-time special awards should be disclosed
separately from the pay for performance disclosure?

Special awards in the form of one-time signing bonuses or inducement awards upon joining the organization are not directly tied to the achievement of performance objectives. Although they should be fully disclosed in the proxy, they should not be part of the pay for performance analysis. They should be disclosed adjacent to the supplemental pay disclosure so that investors can assess their appropriateness. By contrast, the supplemental pay disclosure should include special awards such as inducement grants that include cash or equity awards tied to financial performance or stock price appreciation that vest over a period of years. These awards are performance-based pay.

Why does the definition of realizable pay include outstanding performance-based
awards at target rather than based on estimated performance, or exclude them
altogether since they are not yet earned?

Although disclosure of outstanding awards at target may result in a higher or lower number than what is actually realized by the executive at the end of the performance period, it is the method by which realizable pay disclosures will be most comparable across companies. By providing a consistent basis for comparison, the use of target pay for outstanding awards is also the clearest approach for outside stakeholders to understand. Companies using realizable pay may find it useful to include additional disclosure to explain actual performance to date under awards that are estimated at target.

Why does the definition of realizable pay value options using their intrinsic value
rather than a revised Black-Scholes estimate?

Valuing stock options using their intrinsic value (i.e., based on stock price at year end) gives shareholders an assessment of changes in realizable pay based upon changes in stock price and not changes in other factors that may have an impact on the Black-Scholes value.  Valuations based on a revised Black-Scholes estimate, which is a function of option term, current interest rates, and perhaps most influential of all, volatility rather than merely isolating the impact of stock price movement on pay that may be potentially realized. Although other approaches, such as that used by ISS, include a revised Black-Scholes valuation of outstanding options, the Working Group believes that accounting estimates for stock options should be limited to the Summary Compensation Table.

Why does the definition of realized pay include stock options at exercise rather
than at vest?

Although the decision to exercise options is often a voluntary one by the executive and may occur as long as ten years after the grant date, the fact remains that the executive realizes no compensation until the option is exercised. Since realized pay is a measure of what the executive actually receives, options should not be included until exercised, at which point the gains may be compared to the corresponding return to shareholders over the period the options were outstanding. Supporting this approach is that options are not taxable to the executive until exercised, despite the fact that they are available to be exercised at any point after vesting.

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