On December 20, 2011, Institutional Shareholder Services (ISS) issued the white paper "Evaluating Pay for Performance Alignment: ISS' Quantitative and Qualitative Approach."
The new methodology outlined in the white paper employs a two-step process: an initial multi-component quantitative assessment of alignment between company executive pay and company performance (measured both relative to the company's peers and individually) followed by a qualitative "overlay" to determine whether mitigating factors or other causes may explain apparent misalignments in pay-for-performance.
Relative Alignment ─ Relative Degree of Alignment (RDA).
The first component of the quantitative evaluation measures the RDA, or the percentile rank of the company's CEO pay and total shareholder return (TSR) relative to a group of between 14 and 24 peer-group companies, over the same one- and three-year period. Peer-group companies are selected by ISS based upon size, industry and market capitalization.
Relative Alignment ─ Multiple of Median (MOM).
The MOM measure is a direct comparison of the company's CEO pay to other companies in the peer group. It is calculated by dividing the company's annual CEO pay by the median pay for the peer group. In back-testing of this metric, the highest observed value was just over 25 times peer median.
Measure of Long-Term Absolute Alignment.
This new metric statistically compares CEO pay with TSR trends to determine whether the two are directionally aligned. This analysis does not provide a measure of sensitivity ─ whether pay and performance go up and down together on a year-over-year basis ─ but it does provide a long-term measure of directional alignment. ISS points out that the use of this new regression analysis:
- allows for measuring performance over a fiscal year and pay granted over that same period, providing consistency in both time and scale
- smoothes significant swings (or "lumpiness”) in pay on a year-to-year basis, which otherwise would obscure long-term trends
The results above are used to identify significant outlier companies through a continuous scoring approach. That is, the analysis considers whether:
- a company's particular measure is a sufficient outlier to independently and definitively demonstrate a disconnect between pay and performance, or
- the company's measure, in conjunction with one or both of the other measures, is sufficient to demonstrate a potential disconnect between pay and performance
The qualitative "overlay" assesses "how various pay elements may be working to encourage, or to undermine, long-term value creation and alignment with shareholder interests." The qualitative analysis considers:
- the strength of the company's performance-based compensation
- the company's peer group benchmarking practices
- results of financial/operational metrics
- other special circumstances
The methodology outlined in ISS' white paper will be implemented in the coming proxy season, beginning February 1, 2012.