In recent years, shareholders, the media and compensation committees alike have increasingly focused on the relationship between executive “pay” and performance. The metric that these groups most often use to calculate “performance”—total shareholder return—is relatively uncontroversial. Yet, how to calculate the “pay” component is not as simple. Until recently, pay-for-performance assessments have focused largely on the pay disclosed in the Summary Compensation Table (SCT) in annual proxy statements, or a close variation thereof. However, in the 2012 proxy season, an increasing number of companies have supplemented their SCT disclosures with reports of “realized pay” and/or “realizable pay,” which, some argue, provide a more accurate depiction of the relationship between pay and performance. This article provides a background on the various definitions of pay and highlights their respective advantages and disadvantages.
Criticisms of SCT Pay
The definition of pay disclosed in the SCT is presumably familiar to most readers and includes salary and bonus compensation earned for the year, grant-date accounting values for equity awards granted during the year, performance cash earned during the year, and change in pension values. Because every annual proxy requires the SCT, the SCT has, for better or worse, become the easiest way to compare pay year-over-year and across different companies. However, a growing group of consultants, public companies and institutional shareholders have found flaws in the SCT definition of pay, particularly when it comes to comparing pay and performance. Their main criticism of SCT pay is that, because grant-date accounting values are used for equity awards, the SCT table reflects a theoretical value of equity awards that ignores whether vesting conditions are ultimately satisfied and how changes in the price of a company‟s stock affect the cash value of equity awards. In other words, while the SCT table reflects the expense of an equity award to a company for purposes of its income statement, it may bear little relation to the payout that an executive ultimately receives.
As a simple illustration of the problem, assume that an option to purchase 100,000 shares of stock is granted to an employee at an exercise price of $10 per share, the price of the company‟s stock on the date of grant. For purposes of the SCT, the option will often be valued using a Black-Scholes formula as provided for under Financial Accounting Standards Board Accounting Standards Codification 718, which takes into account the exercise price, stock volatility, expected dividend yield, time to expiration and interest rates. Assuming that these values are somewhat typical, the option might be valued at around $330,000. But what if the company‟s stock price plunges shortly after the grant, or the vesting conditions are not satisfied and the option can never be exercised? In these circumstances, the option will have no ultimate value to the executive and will not cost the company any out-of-pocket cash. Nevertheless, the SCT will reflect that the executive received compensation of $330,000 as a result of the option grant, and a pay-for-performance analysis using the SCT would suggest that the executive profited while shareholders watched the value of their investment sink. This problem is not limited to over-estimates of pay—if the stock price had gone up significantly, the appreciation would have resulted in additional value for the executive even though the numbers reported in the SCT would not have changed.
Thus, the SCT can be said to reflect a theoretical value of “pay opportunity” on the grant date that ignores events that occur after the grant date. Critics of the use of pay opportunity have recently begun advocating and utilizing alternative definitions— namely, realized pay and realizable pay.
Realized pay (also known as “earned pay”), in contrast to SCT pay, is intended to capture the amount of compensation that an executive actually earns during the period for which pay is being measured. Rather than using the grant-date accounting values, equity compensation—and, for that matter, all other compensation—is included in realized pay at the time that an executive actually realizes the benefit of the compensation. Therefore, stock options are included in pay in the year in which the options are exercised, based on the spread upon exercise. Restricted stock, restricted stock units and performance shares are included in the year or period in which they vest, based on the stock price at that time.
Clearly, realized pay is an attractive alternative because it considers only the gains, if any, actually realized by an executive in respect of equity compensation. If an equity award never vests or an option is never exercised because it is under water, it is not included in the realized pay calculation. Likewise, if a company‟s stock price appreciates significantly, the executive‟s realized pay will be higher. In this sense, realized pay may provide a better method for comparing pay with shareholder returns.
However, realized pay has its own drawbacks. Because it does not include the value of equity and other incentive awards until the compensation is realized by an executive, realized pay can include the value of awards that were granted prior to the period for which pay is measured. For example, if realized pay is being measured for 2012, stock options granted in 2004 would be included in the calculation if they were exercised in 2012. Depending on the time period for which the performance aspect of the pay-for-performance relationship is being measured, there could be a mismatch in timing between the pay and performance factors in the equation. Along the same lines, an executive has, to some degree, the ability to manipulate his or her realized pay, as he or she has control over when to exercise stock options. Despite these flaws, it is indisputable that realized pay includes only the actual compensation realized by an executive, which cannot be said for SCT pay.
Realizable pay, in contrast to realized pay, is intended to capture the value of incentive compensation granted during the period for which pay is being measured, even if the compensation has not yet been realized by an executive. Stock options granted during the time period are included in realizable pay based on their intrinsic value as of the end of the period, regardless of whether or not they have been exercised. Likewise, restricted stock and restricted stock units are included based on their value as of the end of the period, regardless of vesting. With respect to performance awards, if the performance period both starts and ends within the relevant period, the actual payout is included in realizable pay. If the performance period begins in, but does not end prior to the end of, the period for which pay is being measured, realizable pay will include the fair market value of performance shares and the target value of performance cash awards. As year-end values and target values are used when calculating realizable pay even though these amounts may never be earned by an executive, realizable pay has flaws similar to SCT pay. Yet, since realizable pay includes the intrinsic, fair market or target value of in-progress equity and other performance awards, realizable pay is arguably an improvement over SCT pay.
For the reasons noted above, no definition of pay is perfect. However, public companies are taking note that the alternatives to SCT pay may be less imperfect than SCT pay. According to The Wall Street Journal/Hay Group 2011 CEO Compensation Study, which researched 2012 proxy filings, 15 percent of large companies researched provided a discussion of realized pay and/or realizable pay, up from just 5.7 percent in the 2011 proxy season. Among the companies that have provided some form of alternative pay disclosures are Exxon Mobil Corporation, General Electric Co. (GE), Alcoa Inc., Hewlett-Packard Company, RadioShack Corporation and Equifax Inc. The alternative pay disclosures are in addition to, not in lieu of, the SCT disclosures, and are typically included in the Compensation Discussion & Analysis (CD&A) with an explanation of how the alternative definition of pay is more useful than SCT pay for purposes of benchmarking pay and/or assessing the relationship between pay and performance. As an example, GE‟s 2012 proxy statement included the following explanation: “The SEC‟s calculation of total compensation includes several items that are driven by accounting and actuarial assumptions, which are not necessarily reflective of compensation actually realized by the named executives in 2011. To supplement the SEC-required disclosure, we have included an additional table that shows compensation actually realized by each of the named executives in 2011.”
Institutional investors and advisory firms have also made known their preference for the alternative definitions of pay. For example, the California State Teachers Retirement System (CalSTRS) has stated its preference for realized pay: “In the future, CalSTRS hopes we will see more companies include additional tables which describe pay that was actually realized by the executives in an effort to demonstrate a better alignment. In the end, you can‟t take Black-Scholes to the bank ... CalSTRS believes there is an opportunity for the marketplace, issuers and shareholders, to work together in the development of a realized pay model.”1
Pay Governance, an advisory firm for compensation committees, has spoken out in favor of realizable pay. Pay Governance evaluated the pay-for-performance relationship for CEOs at large public companies and found that more than 10 percent of the companies for which International Shareholder Services (ISS) found a pay-for-performance misalignment using ISS‟s definition of pay (which is similar to SCT pay) actually had pay and performance aligned if, instead, realizable pay was used as the basis for the calculation. The conclusion of the analysis was as follows: “There are many ways to measure CEO pay and its alignment with multi-year company total shareholder return (TSR). Based upon our research, we believe that realizable pay is the preferable metric for this comparison. Value delivered—not value granted—should be aligned with performance.”2
Although, for the time being, the definition of pay used in the SCT serves as a standard measure for public companies, there is clearly a growing trend toward using and/or disclosing alternative definitions of pay, largely due to the impact of the perception of pay-for-performance. Public companies should explore these alternative definitions to see if they would suit their executive pay models and goals, both for internally setting and measuring pay and for reporting pay to shareholders. Given that no uniform standards applicable to the calculation or disclosure of alternative measures of pay currently exist, care should be taken in preparing any additional disclosures in accordance with the general securities law requirements so that no materially misleading statements or material omissions are made.