For banks and financial services firms, the 2026 proxy season has been defined by sharp increases in executive pay at the largest U.S. institutions. Below, CAP highlights several key takeaways from proxy seeason and outlines questions compensation committees should consider as they evaluate pay and talent strategy in 2026.

For CEOs of the Largest Banks, $40 Million is the New Benchmark

CEO pay at the largest U.S. banks and financial services firms crossed the $40 million mark for the first time with compensation awarded for 2025 performance. Pay increases were significant and generally tied to strong growth and total shareholder return. BNY Mellon reported the largest increase, with CEO compensation rising 66% year-over-year.

Large increases in CEO pay did not alone seem to warrant pushback from proxy advisory firms and shareholders. ISS and Glass Lewis recommended “Against” Say-on-Pay only at banks that also granted one-time special equity awards to their CEOs in 2025. These banks, including BNY Mellon, Goldman Sachs, and Wells Fargo, received relatively low support from shareholders. Capital One also granted a special award in 2025 related to the integration of Discover Financial and saw a dip in Say-on-Pay support.

CEO Pay is Also Rising Among the Super Regionals

Other large U.S. banks with assets of greater than $100 billion also made significant increases to CEO pay for 2025, with median compensation rising +16%. PNC topped the group with total CEO pay of $35 million for 2025, up from $25 million for 2024. Higher pay levels were driven primarily by significant increases in the grant date value of long-term incentive awards granted in 2026 and, in some cases, reflected the completion of significant acquisitions in Q1 (i.e., Fifth Third’s acquisition of Comerica and Huntington’s acquisition of Cadence Bank).

While CEO Pay Levels Rise, Incentive Design Remains Stable

Most banks did not disclose meaningful changes to their incentive structures for 2026. This stability follows several years in which banks modified incentive designs or adjusted incentive outcomes to recognize the impact of disruption in the industry, beginning with the COVID-19 pandemic in 2020 and continuing with the liquidity crisis and bank failures in 2023. Although banks have not made changes to their core incentive programs, we expect continued consolidation to impact executive pay programs in other ways. For example, many banks use transaction-specific incentives to align executives with the successful integration of the target bank. In Q1 2026, Fifth Third granted special merger-related equity awards to their named executive officers that vest based on the achievement of goals related to the integration of Comerica.

Questions Committees Should Be Asking

• What should our bank’s response be to the rise in CEO pay among the largest companies in the industry?
• How will the potential for continued consolidation impact our bank’s peer group and the market for executive talent?
• In an environment with significant CEO pay increases year over year, does the structure of our compensation program provide us with enough flexibility to pay competitively for 2026 while aligning pay with performance?

Relative Total Shareholder Return (rTSR) continues to dominate the long-term incentive landscape for S&P 500 CEOs, appearing in 58% of performance share unit (PSU) awards. Its appeal lies in its perceived objectivity since it does not rely on financial targets established internally, its ability to create a clear link between shareholder experience and executive payouts, and the ease of communication to investors and proxy advisory firms.

Yet rTSR’s simplicity can be deceptive. While it measures stock price appreciation plus dividends relative to a benchmark, results can be heavily influenced by broader market forces, interest rate shifts, or sector cycles. As a result, companies face two fundamental questions when choosing to implement rTSR into their long-term incentive plans: (1) What design choices will best reflect the company’s performance philosophy? And (2) How much weight should rTSR carry in the plan?

Implementation: Weighted Metric vs. Modifier

The first decision is whether to use rTSR as a primary weighted metric or as a modifier to other financial results.

Most companies give rTSR a prominent role, with 68% using it as a weighted metric, meaning it directly determines a portion of the PSU payout. While 50% is the most common weighting (38% of companies), practices diverge sharply on either side. About one-third lean heavily on rTSR, with 22% weighting it at the full 100%. At the other end, 29% set it below 50% — and only a small minority, 13%, drop below 33%, most often at 25%.

When rTSR is a weighted metric, nearly nine in ten companies measure performance as a percentile rank within their comparator group. The median payout scale begins at the 25th percentile for threshold, reaches the 50th percentile for target, and tops out at the 80th percentile for maximum payout. While the traditional 25th / 50th / 75th percentile performance goal scale remains the single most common approach (31%), it is no longer majority practice, as more rigorous maximum goals have become increasingly common.

For a smaller percentage of companies (7%), rTSR goals are expressed as the percentage difference from an index’s performance rather than as a percentile rank. This approach is straightforward to track and avoids certain complexities (such as adjusting for M&A), but it can lead to irregular outcomes. In index-heavy benchmarks, large constituents can have an outsized influence, for example, the “Magnificent Seven” stocks (Apple, Microsoft, NVIDIA, Alphabet, Amazon, Meta, and Tesla) currently make up over one-third of the S&P 500’s market capitalization.

The modifier approach plays a different role, with 32% of companies applying rTSR as a modifier to results from other metrics. Multiplicative adjustments are the norm (76%), with most designs using symmetric ranges such as ±20% or ±25%, often corresponding with top- or bottom-quartile performance. A smaller group opt for additive adjustments (22%), and a few employ asymmetric ranges that penalize underperformance more than they reward outperformance. Two companies, Chipotle and American Express, apply their rTSR modifiers purely as caps. For Chipotle, the award payout is capped at target if rTSR performance is in the bottom quartile compared to other S&P 500 constituents. American Express has a similar payout cap at 100% of target; however, this applies in all instances where rTSR performance falls below the 67th percentile of a custom peer group, which creates a much higher penalty.

The choice between a weighted metric and a modifier reflects a company’s philosophy on pay-performance alignment. Weighted metrics make rTSR a central driver of payouts, appealing to investors who value direct market alignment. Modifiers keep rTSR in a secondary role, reinforcing other financial or strategic goals without overshadowing them. However, the downside to using rTSR as a modifier is that if results fall short due to the inability to plan with precision, there may well be no payout to modify. Companies choosing to have rTSR as the sole performance measure (22%) may have difficulty setting multi-year goals for financial metrics, and the use of rTSR alleviates this concern by serving as an objective assessment of long-term results.

Comparator Groups

Once rTSR’s role is set, the next question is: Who should we measure against?

Most companies compare their rTSR to the performance of the constituent companies in an index. In the sample reviewed, 61% compare performance against a single index, 37% against a custom peer group, and 2% against both. Among those comparing against an index, approximately half (51%) choose a general industry index like the S&P 500 or Nasdaq 100, while 48% select an industry-specific benchmark. Unsurprisingly, the S&P 500 itself is the single most common comparator index, used by 44% of all companies.

Nearly all companies (96%) measure against just one comparator set. Only a handful compare against multiple groups of companies, 4% use two indices, and only one compares against three. When companies do choose to compare against multiple indices, it is common to use both a general industry group and an industry-specific group, which may lead to different outcomes based on macroeconomic conditions.

The trade-off is clear: indices are transparent and objective but may be less relevant for companies in niche sectors, while custom peer groups can provide a sharper performance comparison and the ability to control the sample size but require more judgment and justification in their selection.

CAP cautions companies using sector indexes to carefully consider the constituents included, as they may be reclassified over time. For example, due to changes in GICS codes during 2023, “Data Processing & Outsourced Services” (e.g., Broadridge Financial) and “Human Resources and Employment Services” (e.g., Paycom Software) are now grouped in the S&P 500 Industrials sub-industry index alongside traditional industrial companies such as Boeing and Deere. This blending of fundamentally different business models can distort performance comparisons within the index, meaning rTSR results may reflect shifts in sector makeup rather than true differences in company performance.

Absolute TSR Caps

One-third of companies build in a safeguard for down markets: an absolute TSR cap that limits payouts when shareholder returns are negative, no matter how strong relative performance is.

The prevailing approach, used by 95% of companies with a cap, is to limit payouts to 100% of target. Outliers to this practice include capping at 125% or 150%, zeroing out payouts entirely, or reducing them by a fixed percentage (e.g., -20%). It is important to note that these caps most often apply only to the rTSR portion of awards, rather than the entire award, although some companies do apply the cap to the full payout.

These provisions resonate with investors because they prevent windfall payouts in down markets and help manage share usage when stock prices are depressed.

Performance Periods

Three-year performance periods are nearly universal in rTSR plans (99.3% of companies). Just one company each uses a two-year or a four-year performance period.

While most measure rTSR cumulatively over the full period, a small subset (3%) calculates rTSR for each interim period and then average the results, a design most often seen when rTSR is the only metric used for PSU payouts. This approach smooths the impact of performance spikes or dips in any single year and reduces reliance on a single measurement window.

Stock Price Measurement Methodology

While rTSR is ultimately a measure of return, how companies measure the starting and ending stock prices varies.

Averaging is by far the dominant approach. 90% of companies smooth volatility by averaging stock prices at the beginning and end of the period, compared to just 10% that use a simple point-to-point calculation.

Companies describe these averaging windows in either trading days or calendar days, with disclosures split roughly evenly (53% vs. 47%). Standardizing them so that 30 calendar days is roughly equivalent to 20 trading days reveals a strong clustering around one month: half of companies use a one-month average. Another 22% use periods between one and three months, most often 45 days (~30 trading days) or 60 days (~40 trading days). About 12% use a three-month period (90 days), while 12% use less than one month, most commonly 20 days (~9% of all companies). Longer averaging windows are rare, with only 4% exceeding three months, including one notable outlier, Ball Corporation, which averages a full year at both the front and back ends of the performance period.

These kinds of design decisions, whether on averaging periods, comparator groups, or rTSR’s role in the PSU design, highlight that even within a framework of well-established norms, companies regularly make adjustments to fit their own circumstances.

Conclusion and Takeaways

Relative TSR design follows well-established patterns, but most programs include elements of customization that stray from the norms. In CAP’s view, the two most critical levers are:

1. Implementation method: weighted metric or modifier, and magnitude
2. Comparator group selection: relevant, competitive, and statistically sound

Understanding prevailing market norms is essential for benchmarking and credibility, but awareness of less common, more unique designs is equally valuable. These “fringe” approaches can be just as effective, and sometimes better, in aligning pay with performance when they are thoughtfully matched to a company’s specific goals and circumstances.

Shareholders can influence a company's executive compensation program through a non-binding advisory vote known as "Say on Pay." While this vote doesn't directly allow shareholders to influence overall compensation policies, companies often maintain outreach programs to address shareholder concerns about specific aspects of the compensation plan. Another way for shareholders to have a say in executive compensation is by gaining a seat on the Board of Directors. However, the purpose of obtaining a seat is not solely for executive compensation reasons but to advocate for broader changes within the company. Achieving this is challenging and less common; investors typically pursue this through a proxy contest, where an investor advocates for change in company strategy and may raise executive compensation as an issue.

Investors who seek change through a proxy contest are often referred to as “activist investors.” This term describes individuals (such as hedge fund managers) or groups (like alternative investment firms) who acquire a stake in a company’s equity with the goal of increasing shareholder value, typically by gaining one or more seats on the Board of Directors. Once on the Board, these activists push for changes they believe will improve the company’s performance, strategy, or governance. These changes can take various forms, depending on the investor’s objectives. Common goals of activists include:

• Enhance financial performance by advocating for cost reductions, optimizing capital allocation, or promoting share buybacks and higher dividends
• Strategic changes such as encouraging the company to refocus on its core business or recommending mergers, acquisitions, or spin-offs of non-core assets
• Seek changes in senior management or the Board of Directors

Activist investors aim for these changes to boost the company’s value, thereby increasing the worth of their own stake. However, they are sometimes criticized for prioritizing short-term gains over long-term stability.

This article updates Compensation Advisory Partners’ (“CAP”) research on 2015 – Activist Investors and Executive Pay. It aims to provide a refreshed perspective, incorporating recent developments related to activist investor campaigns.

What We Found

Between 2020 and 2024, activist investors have increasingly asserted their influence in boardrooms, achieving success in various proxy contests. To gain insight into their strategies, among companies in the Russell 3000 Index, CAP reviewed 48 proxy contests initiated by activist investors, finding that concerns about executive compensation programs were raised in 23 cases. Data indicates that executive compensation was often tied to broader concerns about the companies’ strategic direction, operational execution, and financial performance. Essentially, executive compensation disagreements were not the main and sole rationale for engaging in the contest. Instead, activist investors use these disagreements to highlight deeper underlying concerns with a company’s direction or performance to induce change. For instance, if total shareholder return (TSR) is not used as a performance metric while the company has faced a prolonged period of shareholder value decline alongside rising CEO compensation, activist investors will highlight these issues as signs of a flawed business strategy and misaligned incentive structures. In many cases, concerns about executive compensation support their broader calls for leadership changes, strategic adjustments, and stronger governance practices.

Over the past five years, activist investors have raised concerns about executive compensation in approximately 50 percent of proxy contests annually. Key compensation practices highlighted during 2020–2024 include:

The chart shows that among the 23 companies where activists raised concerns about executive compensation, the most common issue was pay-for-performance misalignment (91 percent). Activists frequently argued that CEO compensation packages were insufficiently tied to company performance, advocating for changes to link pay more directly to long-term shareholder value rather than short-term performance metrics. They also often pointed out that CEO pay was disproportionately high compared to peers. Other prominent issues included excessive CEO compensation (57 percent) and weak corporate governance structures (26 percent). Less frequent concerns included outsized peer comparisons, performance metric adjustments (both 17 percent), high dilution, excessive perquisites, and long-term incentive plan design (all 13 percent). A smaller number of cases raised issues with high director compensation, lack of disclosure, or excessive change-in-control provisions (each 9 percent).

Ultimately, we found that activist investors often leverage executive compensation issues to strengthen their case for securing seats on the target company’s Board of Directors.

Target Companies

Successful Activist Campaigns

Of the twenty-three proxy contests that specifically targeted aspects of executive compensation, eleven ultimately resulted in the activist investor gaining board seats at the target company. The companies1 through 2020-2024, include: Masimo Corporation, Norfolk Southern Corporation, Southwest Gas Holdings Inc2, WisdomTree Inc, Illumina Inc, Pitney Bowes Inc, Apartment Investment and Management Company, Griffon Corporation, Exxon Mobil Corporation, and GameStop Corp.

The most common issue in these contests centers on the apparent misalignment between executive pay and company performance. For instance, activist investors argued that management at Norfolk Southern Corporation received substantial compensation packages despite the company losing millions in shareholder value during the same period. In this case, activists also pointed out that the Board awarded the CEO over $10 million in equity grants, even though the company missed all annual performance targets related to financial performance, customer service, and safety. This issue with executive compensation gave activists an opportunity to criticize the Board for weak corporate governance. Ultimately, their campaign was successful, and they were able to elect three of their nominees to the Board.

Activist investors often tie compensation-related concerns to broader business strategy issues, rallying support from other investors in the process. When shareholders are dissatisfied with their returns, they are more inclined to align with activist investors to drive change. This dynamic was evident in Carl Icahn’s high-profile contest with Illumina, where he not only succeeded in electing a board member but also saw the CEO resign shortly afterward.

Conclusion

There has been a rise in activist investors accumulating stakes in companies with the goal of pushing for change to enhance the company’s value. While our analysis focused on proxy contests specifically addressing executive pay issues (e.g., pay-for-performance misalignment), there are also cases where companies reach settlements with activist investors, avoiding a public confrontation and granting them one or more seats on the Board.

To be well-prepared, Boards and Compensation Committees should take a proactive approach:

• Monitor 13D Filings (Schedule D) to see if an individual or group acquires more than 5 percent of a company’s voting shares
• Ensure the Board has a strategy for effectively engaging with shareholders such as setting up regular communication channels
• Align executive compensation with performance
• Conduct annual reviews of executive compensation programs
• Ensure transparent and clear communication on pay programs / levels and compensation philosophy
• Proactively seek feedback from shareholders throughout the year

The Compensation Committee should collaborate with management to create an executive compensation program that can be defended based on the company’s performance. By taking these steps, companies can better defend their executive compensation programs during a proxy vote and minimize the chances of conflicts with activist investors or shareholders. Being transparent, responsive, and proactive is key to managing shareholder expectations and ensuring a smoother voting process.

Appendix

Summary of Activist Campaigns

1. 1 Masimo Corporation experienced one proxy contest in 2023 and another in 2024.

2. 2 Southwest Gas Holdings Inc. settled with the activist for at least three and up to four Board seats prior to the vote.

CAP analyzed annual incentive plan payouts over the past ten years of 120 large U.S. public companies, with a median revenue of $43B. We selected these companies to span ten major industries and provide a broad representation of market practice. This study is a continuation of studies that we conducted in 2017 and 2020.

Annual incentive plans are an essential tool for companies to incent and reward executives for achieving short-term financial and strategic goals. The goal-setting process has always challenged management teams and committees to achieve a balance between rigor and attainability to motivate executives.

In recent years, economic volatility has placed even more pressure on committees to set appropriate goals. This research is intended to be a guide and a reference point to help evaluate whether goal-setting has led to the right outcomes.

Highlights

Summary of Findings

Plan Design

For the purposes of this study, we categorized annual incentive plans as either goal attainment or discretionary. Companies with goal attainment plans set threshold, target, and maximum performance goals and corresponding payout opportunities for the performance period. Companies with discretionary plans determine payouts at year-end based on a retrospective review of performance results with no predefined relationship between goals and payouts.

Our study focuses on the 89 percent of companies in the sample with goal attainment plans.

Performance Metrics

Nearly three-quarters of the companies in our study use three or more metrics to determine bonus funding, an increase compared to the findings of our 2020 report.

The most prevalent financial metrics used in annual incentive plans were Revenue, EPS, and Operating Income (including EBIT, EBITDA, and Pre-tax Income).

57 percent of companies in our current study use strategic or nonfinancial goals, an increase from 38 percent in 2020. These metrics incentivize behaviors that contribute to long-term success but may not be captured by short-term financial performance results. Specific strategic or nonfinancial metrics vary by industry and company – for example, pharmaceutical companies often use pipeline metrics and oil and gas companies often use safety and environmental metrics.

60 percent of the companies include Environmental, Social, and Governance (ESG) goals as part of their annual incentive award determination. ESG metrics are typically evaluated on a qualitative basis, and less commonly on a quantitative basis.

Performance and Pay Scales

Compensation committees annually approve threshold, target, and maximum performance goals and corresponding payout opportunities for each metric in the incentive plan. Target performance goals are most often set in line with the company’s internal business plan. Executives most often earn 50 percent of their target bonus opportunity for achieving threshold performance and 200 percent for achieving maximum performance. Only two companies in the study provide an award opportunity over 200 percent of target for achieving maximum performance goals, a decrease compared to our 2020 report.

Annual Incentive Plan Payouts Relative to Goals

All Companies

Based on CAP’s analysis over the 10-year period, the degree of “stretch” embedded in annual performance goals translates to approximately:

• A 95 percent chance of achieving at least Threshold performance
• A 70 percent chance of achieving at least Target performance
• A 5 percent chance of achieving Maximum performance

This shows that participants are achieving threshold performance and earning some payout 95 percent of the time and receiving maximum payouts 5 percent of the time by achieving superior results. These findings reinforce the importance of performance goal settings, as companies are spending annual incentive monies equal to at least the amount of their overall target pool about 70% of the time.

In most of the years reviewed in our study, between 60 percent and 80 percent of companies paid bonuses at target or above. There were two exceptions: 2020, when only 55 percent of companies paid bonuses at target or above, and 2021, when 89 percent of companies paid bonuses at target or above. In 2020, bonuses were generally down due to the unanticipated impact of the COVID-19 pandemic on financial results, while in 2021 bonuses increased due to a faster than expected rebound for most companies. In 2022, we saw a return to more typical payout distributions with 65 percent of companies paying bonuses at target or above.

Impact of COVID-19 and Adjustments Made in 2020-2021

Given the unique economic environment, companies made more adjustments to annual incentive payouts in 2020 and 2021 than in prior years.

In 2020, 27 percent of companies made adjustments to annual incentive payouts. Approximately half of the companies adjusted bonus payouts upward to acknowledge that executives had limited control over the pandemic’s impact on financial results and to recognize efforts in navigating through the challenging environment. The other half of companies adjusted annual incentive payouts downward to realize the unplanned benefit that some companies realized as a result of the pandemic.

In 2021, 13 percent of companies made downward adjustments to annual incentive payouts to recognize that the results exceeded goals because of a quicker-than-expected financial rebound.

The trends seen in the 2020-2021 period reflect a dynamic response to the rapidly changing economic
landscape and emphasize the importance of adaptability for companies when navigating unprecedented times.

By Industry

Payout distributions differ by industry based on a variety of factors, including metric selection, goal setting, and economic influences. Average payouts for each industry are distributed as indicated in the following chart:

Pay Relative to Performance

CAP reviewed the relationship between annual incentive payouts and annual company performance over the ten-year period with respect to growth in the three most common annual incentive plan metrics: Revenue, EPS, and Operating Income. Payouts were fairly aligned with all three metrics over the 2013-2022 period, indicating that companies are rewarding for both growth and operating efficiency. Aligning bonus payouts with profitability also helps ensure that outcomes consider a company’s ability to pay bonuses.

The chart below depicts the relationship between median Revenue, EPS, and Operating Income Growth and the prevalence of above-target annual bonus payouts among the sample.

Conclusion

Our research indicates that over the last ten years companies set performance goals that translated to:

• A 95 percent chance of achieving at least Threshold performance
• A 70 percent chance of achieving at least Target performance
• A 5 percent chance of achieving Maximum performance

While payouts in select years may diverge slightly from others, given economic, industry, or company factors, this overall 10-year lookback provides a pattern and guidelines that companies can use to assess their actual payouts and established goals over the longer-term.

Looking Ahead

The macroeconomic environment remains uncertain, given factors such as the rising interest rate environment, continuing high inflation, a tight labor market, stock price volatility in certain sectors, and supply chain uncertainty.

Companies can use design strategies to help reduce volatility in their plan payouts, including setting wider ranges around target to recognize the challenges of setting performance goals in an uncertain environment, using non-financial goals to tie annual incentive payouts to other markers of company progress, and adding relative measures, which will allow for relevant comparisons even if the overall market is affected by macroeconomic challenges.

Methodology

The 120 companies in our study had a revenue size ranging from $20 billion at the 25th percentile to $88 billion at the 75th percentile. Median revenue was $43 billion.

CAP reviewed actual annual incentive payouts earned for performance over the ten-year period from 2013-2022 to determine the distribution of incentive payments and the frequency with which executives typically achieve target payouts. In this analysis, CAP categorized actual bonus payments (as a percentage of target) into one of six categories based on the following payout ranges:

The challenging stock market conditions of the last two years may have companies questioning their continued use of stock options. Our analysis of stock options granted in 2022 among S&P 500 companies finds that the majority of stock options (54% of all option grants) granted are underwater (i.e., the current stock price is below the option exercise price) and on average, the stock options are 23% underwater. That means that for the average executive holding stock options granted in 2022, the stock price would have to increase by more than 30% for the stock option to have any intrinsic value.

Recent Stock Option Struggles

CAP analyzed CEO equity grants among S&P 500 companies to understand the degree to which stock options were out-of-the-money, given the challenging stock price environment. It should be noted that many companies have moved away from granting stock options. In fact, among the S&P 500, only 43% of CEOs received stock options. This reflects a broad market shift where options have been replaced by performance share units and restricted stock units.

As of November 30, 2023, 54% of these awards are underwater which means they currently have no value. Among these underwater awards, the current share price is 23% below the exercise price, on average. While it is still early in the vesting schedule for these awards, share price depreciation at such levels may leave employees wondering if their options will have realizable value as it will take significant stock price appreciation to get back to break-even.

In looking more closely at the sample, we find that there is a broad range of how far out-of-the-money stock options are across companies. For example, 11% of the stock options are more than 50% out-of-the-money, meaning that the stock price would have to more than double for them to begin to have intrinsic value. A full third of the options granted are more than 30% underwater.

When we look at the underwater stock options by industry, we find that there are differences in the percentage of underwater options and the degree to which they are underwater across industry sectors. For example, all five Communications Services companies had underwater options that were on average 33% underwater. Underwater options were much less of an issue in the Information Technology sector, where companies have recently been rallying and recovering from share price depression.

Handling Underwater Stock Option Concerns

Underwater stock options can create retention issues throughout organizations. In times of economic uncertainty and poor stock market conditions, employees rightfully may worry that underwater stock options will never achieve the upside that was once promised. Executives may feel that their outstanding underwater stock option awards are worthless, which may leave them feeling demotivated to remain at the company for the long haul. Similarly, younger employees who are holding stock options that are deeply underwater may look for more attractive opportunities at high-growth potential organizations. Moving on to a new company may become more appealing, especially if the offer includes a sign-on award at a new employer which may represent a fresh start from an equity compensation perspective. In general, employees may not consider the long-term potential of their stock options and instead focus on the current lack of value.

To mitigate these potential retention concerns, employers need to provide clear messaging to employees about the long-term potential provided by stock options, and potentially consider redesigning their equity grant practices. Among the S&P 500 sample, the most common (84%) exercise term for stock option grants is 10 years. This decade-long time horizon should provide plenty of opportunity for the share price to recover, and potentially grow far beyond the exercise price. On the flip side, currently depressed share prices also mean that the next annual stock option awards will be granted at a lower exercise price and therefore should have more upside potential over the new term.

If employees have been put off by multiple cycles of underwater options, another alternative to consider is redesigning and rebalancing the equity compensation mix. Among the S&P 500 sample, stock options represent 19% of the average equity compensation package. Excluding CEOs who do not receive options, the average CEO receives 38% of equity compensation in stock option awards. Most S&P 500 companies use multiple equity vehicles and place more weight on full-value share awards in their long-term incentive plans, which is a market best practice and shields executive compensation packages from excessive macroeconomic risk. While stock options continue to make sense at growth-stage companies, the associated retention and recruitment risks in times of share price depression may cause mature companies to fall behind in the war for talent.

Conclusion

Periods of economic uncertainty raise many compensation issues as companies look to properly incentivize and retain key talent despite depressed stock prices. While stock options remain appropriate for incentivizing employees at growth-stage companies, mature organizations must strike the right balance of equity compensation to navigate the retention and recruitment risks during these periods. With extreme stock market volatility expected to continue in the coming years, companies may benefit from emphasizing equity compensation based on multi-year financial goals and relative stock price performance rather than boom-or-bust stock option grants. Whether or not an equity program redesign is under consideration, clear communication about the future potential of equity awards, including underwater options, remains vital.

A little more than 12 years after the 2010 Dodd-Frank Act was signed into law, the SEC has issued final rules on the topic. This was expected after the SEC re-opened the comment period on Pay Versus Performance disclosure in January. Intended to standardize the presentation of existing information related to the relationship between executive pay and company performance for investors, the final rules may also pose a new and significant burden on some companies with respect to their equity valuation processes and are substantially different from the proposed rules.

Dodd-Frank 953(a) requires issuers to show “…the relationship between executive compensation actually paid and the financial performance of the issuer…” The SEC’s definition of “compensation actually paid” is far removed from how many would interpret this term, particularly for equity-based compensation. It has decided to use an approach for equity-based compensation similar to “realizable pay” and essentially “marks to market” outstanding and unvested equity awards on a “fair value” basis from the grant date to the vesting date. This approach effectively accrues the equity value over the vesting period, with the heaviest impact on value likely to be in the year of grant. It is a fundamentally different approach from the proposed rules of 2015 where the value of equity would have been recognized in its entirety upon vesting, similar to existing definitions of “realized pay.”

The Pay Versus Performance requirements are meant to enable shareholders to directly compare executive compensation with company financial performance over a multi-year period. In the SEC’s view, assigning the burden of computing this relationship to investors is costly and inequitable. Therefore, the SEC implemented rules to standardize information presentation without, in its view, imposing unusual additional expense on issuers.

The new required disclosures are effective for filings at the next annual meeting for companies with fiscal years ending on or after December 16, 2022, so for calendar year companies, the next proxy will have to include the new disclosure.

CAP submitted comments to the SEC on the 2015 Proposed Rules, and our statement can be found here.

Overview of Final Rules under Section 953(a)

The final rules require companies to prepare a table disclosing compensation actually paid to the Named Executive Officers (NEOs) next to Summary Compensation Table totals and key metrics, over a five-year history (Exhibit 1). The metrics required to be disclosed in the table are as follows:

• Company’s indexed total shareholder return over the period1
• Indexed total shareholder return of peer group
• GAAP net income
• A financial metric of the company’s choosing

To supplement this tabular disclosure, companies will need to describe the relationship between compensation actually paid and each of the financial metrics included in the table, using a graphical and/or narrative approach. Finally, companies must provide a list of three to seven metrics they deem most important in making executive compensation decisions, which may include non-financial measures, if a minimum of three are financial metrics (Exhibit 2).

Exhibit 2

The rules require a three-year history in the proxy statement for fiscal year ended on or after December 16, 2022, a four-year history in the 2024 proxy and a full five-year history in 2025 and beyond. Smaller Reporting Companies (SRCs) will have pared-down requirements. The new Pay Versus Performance disclosure may be located anywhere in the proxy or information statement; it does not need to be incorporated into the Compensation Discussion & Analysis.

Pay Versus Performance Table

Compensation actually paid to the Principal Executive Officer(s) and other NEOs is intended to reflect a fair value assessment of compensation lined up with the most recent fiscal year. At a high level, the calculation for compensation for the PEO and other NEOs will be as follows:

• Cash compensation will likely mirror the Summary Compensation Table for most situations
• For companies with a defined benefit pension, the amount in the “change in pension value” will be replaced by the amount that is reflective of only the service cost for the respective year2
• And now for equity…. this is where it gets complicated!!! In contrast to the proposed rules, companies will need to revalue equity at the end of each year and report the change in value. Each in-process award will be “re-valued” (see details in exhibit) and vested awards will be valued based on the vesting date
  • Awards with performance conditions deemed improbable to be achieved will be subtracted from the total, potentially giving shareholders insight into expected performance sooner than they would have received in the past since most companies did not disclose expected payouts until the end of the performance cycle

In response to sentiment that TSR does not capture the full financial picture of a company, and the reality that other metrics are consistently used in long-term performance share awards, the final rules require disclosure of TSR, TSR for the company-disclosed peer group3, GAAP Net Income and a third metric defined by the company. TSR is calculated as the value of a $100 fixed investment over the measurement period. The company-selected measure is intended to be a financial performance metric that the company finds represents the most important performance metric not already shown in the table for evaluating the link between compensation actually paid and company performance.

Key Performance Metrics Table

In the second required table, companies must report at least three and up to seven performance metrics that inform actual compensation decisions during the period. Three of the metrics must be financial performance metrics and any additional metrics may be non-financial measures if the company deems them among the seven most important measures impacting compensation actually paid. The company-disclosed metric in the pay versus performance table must be one of the metrics included in this table. The measures do not need to be ranked, a modification from the proposed rules in response to the complexity of determining rankings.

The SEC believes this disclosure will provide investors with visibility into which performance measures most strongly impact actual compensation paid and help investors assess whether compensation programs appropriately incent executives without undue burden or tedious complexity for issuers. With this list, the SEC aims to help companies reduce the risk of misrepresenting or providing an incomplete picture of pay versus performance alignment.

In practice, we anticipate that the listed metrics will align with the metrics used in the annual and long-term incentive awards. Companies will then have the opportunity to discuss the rationale for the metrics and how they influence compensation.

Description of Relationship between Actual Compensation and Financial Performance

Companies must substantiate the relationship between executive compensation actually paid and net income, and between executive compensation actually paid and the company-selected metric through graphs, charts and/or narrative text. Since GAAP metrics are used in the table and many companies use non-GAAP metrics in their compensation programs, this component is a key opportunity for issuers to provide compelling rationale for the measures and approaches used in their program that differ from GAAP net income.

Equity Valuation Under the Final Rules

The SEC has implemented equity valuation standards that present a departure from normal processes for most companies.

Under the Final Rules, equity awards are valued annually until vest to illustrate mid-cycle changes in fair value. The rules follow a syntax of addition and subtraction to produce a value of total equity earned by the executive that aligns with the financial performance measurement year4. Companies subtract the equity award values reported in the Summary Compensation Table and adjust based on the following:

• Fair value of equity awards granted, outstanding and unvested in the covered fiscal year as of the fiscal year end
• Change in fair value during covered fiscal year of awards granted in prior years that remain outstanding and unvested as of the end of the fiscal year
  • For performance-contingent equity awards, fair value as of the end of the fiscal year based on probable outcome
• Change in fair value from end of prior fiscal year to vesting date for awards granted in prior years that vest in the covered fiscal year
• Fair value on date of vest for awards granted and vested in the same covered fiscal year
• Dollar value of any dividends or other earnings paid on stock or option awards in the covered fiscal year prior to vesting that are not otherwise reflected in fair value assessments of such awards

The implications of this methodology are aptly described in the following table produced by Equity Methods, a leading firm in the equity valuation space. See Equity Methods’ blog post for more detail on this topic and how companies should prepare for this disclosure.

Conclusion

Companies with fiscal years ending on 12/31/2022 will need to disclose this new information in their 2023 proxy statements. Given the complexity of the new rules and the requirement to provide supporting narrative disclosure that explains the relationship between compensation actually paid and financial performance, we recommend you begin the process of putting together the table now, recognizing you will not be able to finalize some items until after the end of 2022. We recommend that you do the following things between now and the end of the year:

• Identify data requirements for the new table (e.g., required equity valuations at the end of the year and at vesting dates, pension plan service cost, TSR, peer TSR, net income, etc.)
• Agree on peer group to be used for TSR
• Establish an approach to be used internally to determine the additional financial metric and the list of the three to seven most important financial metrics
• Reach out to internal/external advisors to help compile required information (e.g., finance/accounting, external equity valuation experts, actuaries)
• Develop initial mock-up of table with placeholders for year-end 2022 compensation and performance values
• Develop draft narrative disclosure describing the historical relationship between compensation actually paid and company performance
• Review draft disclosure with management and Compensation Committee

Given the newly required tables, companies will need to re-think the format of their disclosures to comply with the requirements and make the narrative easy to read for shareholders.