MSCI ESG Research put out a report a couple of weeks ago on the relation between pay and performance and found that there was none.
But then, pay consultancy Pay Governance released its own research on the link between pay and performance — and found that there was a very strong alignment. Can they both be right?
Well, yes, as it happens.
But it all depends on what you mean by ‘pay’, the length of period you are studying and whether you are asking the right questions. In fact, when you dig in a bit deeper, the findings are both very similar — it’s just the conclusions that are different.
Here comes the science bit…
MSCI uses two figures for pay. The one from the Summary Compensation Table, the main table in the proxy statement which includes salary, bonus, perks, pensions and the estimated grant date value of equity awards – a guess at what they might cost in the future. This they refer to as total summary pay; a figure that MSCI uses because “that’s the only total figure actually set by comp committees, the only total figure mandated by current reporting standards, and thus the only total figure actually subject to shareholder approval,” commented Ric Marshall, one of the authors of the MSCI report.
Then they also use ‘realized pay’, which again has salary, bonus, perks, pensions but adds in the money CEOs actually made from equity awards rather than an estimate. Analysis of this latter figure is reserved for a future report, as well as comparisons with a much wider range of performance measures.
Pay Governance also uses two pay figures. The first is ‘realizable pay’ which is equal to the sum of 2012, 2013 and 2014 salary, actual bonus and the value of long-term incentive awards at 31 December 2014 that have been awarded during those years. The second is ‘pay opportunity’ which uses three-year salary, target bonus and target long-term incentive payments. This is similar to but not the same as total summary pay.
Said Ira Kay, one of the authors of the Pay Governance report: “We use only grants made during the specific three-year period to create perfect alignment of the timing of those grants and the TSR [Total Stockholder Return: stock price increase plus reinvested dividends] for the same period. No other pay metric creates that time period alignment. While not a perfect methodology—there is none for pay for performance assessment—we think it is the optimal methodology.”MSCI’s report is based on 10 years of data while Pay Governance’s most recent study is based on three years of data. But Pay Governance also sent me a 10-year study it had put out in 2013 which had similar findings to the MSCI report – that the headline figure voted on by investors has very little correlation with performance but realized pay does.
In short, MSCI’s findings on ‘total summary pay’ are that the lowest paid 20% of CEOs displayed the highest TSR performance, while the highest paid 20% had the lowest TSR performance.
They performed the analysis twice, however, splitting the sample into different industry sectors, with a separate “sector” for megacap companies – the 75 largest companies in the sample.
This analysis showed that: “CEOs who were paid above the median over the 10-year period significantly underperformed those companies where cumulative CEO summary pay was below their peer group median.” It attributes much of this disconnect to the current system of “annual reporting” of pay and calls on the SEC to require disclosure of a number of figures showing cumulative ‘realized’ pay over an executive’s tenure compared to performance, while also disclosing where one-off awards and internal/external hiring might have skewed figures.
While MSCI favours realized pay, which forthcoming findings would indicate has a strong relationship with TSR performance, according to Marshall, Pay Governance’s preference is for ‘realizable pay’. It found that: “Realizable pay for CEOs at better performing companies in terms of TSR is considerably higher, nearly 80% higher, than for CEOs leading companies with lower TSR performance.”
Even more dramatically, high performers were on track to earn 143% of their pay opportunity while CEOs of companies with negative TSR were liable to earn only 61% of their pay opportunity. Like MSCI, Pay Governance also found zero correlation between ‘total summary pay’ and performance.
Pay Governance’s Kay said in an e-mail: “The correlation is zero because the way most boards set CEO pay is NOT based upon recent or contemporaneous TSR. CEO pay is determined based upon market data, setting the pay generally at the median of their carefully chosen peer groups. The value of the stock then goes up and down with future performance, especially stock price.”
In its 10-year study, Pay Governance found approximately the same alignment with TSR performance for both realizable and realized pay over five years; a 10-year comparison was not possible because of the limitations of pre-2007 disclosure. Similarly, summary pay showed little correlation and realized and realizable pay showed good correlation with other measures – firm growth (revenues and assets) and profitability (cash flow, EPS, return on equity and return on assets).
The latter comparisons are especially important because finding that realized and realizable pay is correlated with stock price performance is like saying white is white. Since most pay is in the form of equity, it would be an astonishing finding if it weren’t correlated with equity movements.So, despite the differing conclusions, the takeaways from both reports are remarkably similar. The headline pay figure, the one investors vote on and the one the SEC is going to change, is not a good indication of a company’s pay/performance alignment. Other figures that incorporate pay growth over time are a much better indicator, but should be looked at over longer periods than a single year.
More importantly, it is essential to look at other performance measures than just stock price, which is beset with market noise. And finally, and this is my take, given the short-term horizons of most so-called long-term incentive plans, it is yet more important that performance be measured by a more effective value growth measure than stock price. What this might be depends on the business and the business strategy, but it is not encouraging that the SEC’s soon to be mandated pay/performance disclosures look set to be based on TSR.