Proposed amendments to Item 402 of Regulation S-K outline additional disclosure requirements designed to implement Section 14(i) of the Securities Exchange Act of 1934 (the “Exchange Act”), as added by Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).

On Wednesday April 29, the SEC held an open meeting and approved by a vote of 3-2 a staff proposal to amend Section 14(i) of the Securities Exchange Act of 1934 to expand disclosure requirements for executive compensation. The proposed amendment was added by Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The proposed rules will require clear disclosure of the relationship between executive compensation actually paid and company financial performance.

Highlights of the Proposed Rules

Publication of a New Table: The proposed rules add a new table to the current disclosure on executive compensation. This new table will include:

• Executive compensation actually paid for the principal executive officer and the average amount actually paid to the remaining named executive officers. For purposes of the table, compensation actually paid is total compensation as disclosed in the summary compensation table with adjustments to the amounts included for pensions and equity awards.
• The total executive compensation reported in the summary compensation table for the principal executive officer and an average of the reported amounts for the remaining named executive officers.
• The company’s total shareholder return (TSR) on an annual basis as presented in the existing stock performance graph. The definition of TSR is provided for the stock performance graph in Item 201(e) of Regulation S-K.
• The TSR of the companies in a peer group or index, using either the peer group identified by the company in its stock performance graph or in its compensation discussion and analysis.

Additional Disclosure: In addition to the new table, companies will be required to provide a clear explanation for the relationship between compensation actually paid and the company’s TSR performance. An explanation of the company’s TSR performance and the TSR performance of the peer group or index is also required. Companies will have the flexibility to provide this explanation as a narrative, in a graph or by using both.

Adjustments to Calculate Compensation Actually Paid: Companies will need to make two adjustments to total compensation reported in the summary compensation table to calculate compensation actually paid. The adjustments relate to equity award values and pension values. Companies will be required to disclose the adjustments to the compensation reported in the summary compensation table in a footnote.

First, the reported grant date value of equity will be subtracted from reported total compensation and the fair value of equity vesting in that year and re-valued on the date of vesting will be added to calculate compensation actually paid. Companies will need to disclose the vesting date valuation assumptions if they differ materially from the assumptions used for financial statements as of the grant date.

In the second adjustment, the reported change in pension value will be subtracted from reported total compensation and the change in pension value attributable to the actuarially determined service cost for services rendered by the executive during the applicable year will be added.

Time Period Covered: The disclosure will be required for the last five fiscal years, provided a company was subject to disclosure rules during this period.

Interactive Data Format Required: Companies will be required to tag the disclosure in an interactive data format using eXtensible Business Reporting Language, or XBRL.

Covered Companies: The proposed rules apply to all reporting companies, except that foreign private issuers, registered investment companies and emerging growth companies are exempt.

Transition Period: The proposed rules provide a phase-in for all companies. In the first year, companies will be required to provide the information for three years. The fourth and fifth years of disclosure will be added in each subsequent year’s annual proxy filing that requires this disclosure.

Rules for Smaller Reporting Companies: These companies are required to provide disclosure for only the last three fiscal years, rather than for five fiscal years. Smaller reporting companies will not be required to include peer group TSR, since they do not disclose either a stock performance graph or a compensation discussion and analysis. In addition, smaller reporting companies will not be required to make adjustments to pension amounts because they are subject to scaled compensation disclosure requirements that do not include disclosure of pension plans. The requirement to tag disclosure in an interactive data format will also be phased-in for smaller reporting companies, so that they will not be required to comply with the tagging requirement until the third annual filing in which the pay-versus-performance disclosure is provided. Initially, smaller reporting companies will provide the information for two years, adding an additional year in the next annual proxy or information statement.

Process: The proposed rules will be published on the SEC’s website and in the Federal Register. The comment period for the proposed rules will last for 60 days after publication in the Federal Register.

CAP’s Initial Assessment of the Proposed Rules

We applaud the SEC’s attempt to improve disclosure and we agree that pay and performance alignment is critical to good governance and effective executive compensation programs. We also agree that some standardization is necessary. Our research indicates that approximately 15% to 20% of S&P 250 companies provide supplemental disclosure of either realized or realizable pay. Currently, there is no standard definition for either formulation of total compensation. Supplemental pay disclosure is frequently compared to TSR performance, but a consistent approach that can be compared across companies does not exist. The proposed rules impose a standard approach, but at what cost?

We are concerned that the proposed rules are too prescriptive and overly complex. Implementation will burden many companies. The proposed definition of compensation actually paid stands out as our biggest concern. The SEC proposal requires companies to re-value equity awards that vest in each year as of the date of vesting. This approach instantly creates timing differences between the stock prices used in the TSR calculation and the stock prices on the date(s) of equity award vesting. Vesting dates occur throughout the year, but occur most frequently in February – April for calendar year companies. As a result, the proposed approach allows for a re-valuation of equity awards at a more current stock price, but that stock price will likely not correlate with the fiscal year end stock price used in the TSR calculation. This is an obvious disconnect.

In addition, the re-valuation of equity awards for most companies will be composed of tranches of different awards that were granted in different years — likely spanning a three to five year period — that happen to vest in a single year. This approach contributes to confusion around the Board’s thinking on pay and performance alignment, rather than increasing clarity. Instead of focusing on the date of vesting, a better approach would be to re-value equity awards granted in a single year using a year-end stock price consistent with the TSR calculations.

Finally, to the extent that a company uses stock options, updating the assumptions used in option pricing models, such as Black-Scholes, to reflect the date of vesting will be time-consuming at best. This means that stock options will not only be re-valued at a new stock price, but that other assumptions, such as expected life, volatility, dividend yield and risk-free rates, must also be updated.

Two other aspects of the proposed rules contribute greatly to the compliance burden. First, the requirement to include compensation of the average of the remaining named executive officers in the new table in addition to the compensation of the CEO will be very complicated for companies to work through. Publication of this average based on equity grants made over a three to five year span to at least four executives for five years potentially requires dozens of calculations. The SEC should have limited the new disclosure to the CEO since that would greatly reduce the compliance burden and arguably allow for a simpler and more targeted explanation of the Board’s thinking. After all, the CEO normally sets the tone for the entire organization!

The second aspect of the proposed rules that increase the compliance burden is the decision to publish five years of information, rather than three years. Arguably longer time frames are positive when assessing TSR performance, but the summary compensation table shows three years of compensation. Most supplemental disclosure of realized and realizable pay out there today incorporates only three years of compensation and performance data. Even though the SEC provides transition relief, building out the new table to cover five years will be burdensome.

We will refine our initial assessment and provide more finely tuned comments back to the SEC during the public comment period. We would not be surprised if the SEC backs off on the date of vesting re-valuation of equity in favor of date of grant re-evaluation. Many will recall that when the proxy disclosure rules were initially proposed, equity award values reflected the amounts recognized for financial reporting purposes. After much public discussion and pushback, the SEC amended the disclosure rules in 2009 to incorporate the grant date fair value of equity awards.

More to come on these points in the next few months! We hope that the SEC achieves consensus on effective pay and performance disclosure before the 2016 proxy season begins.

Key Takeaways

• Compensation Committees face intense scrutiny with respect to executive annual bonus payouts and their alignment with performance
• Over a multi-year period, executives tend to earn an annual incentive payout approximately 90% of the time
• As a general rule of thumb, based on analysis of the past 6 years, the degree of difficulty, or “stretch”, embedded in performance goals translates to:
  • A 90% chance of achieving Threshold performance
  • A 70% chance of achieving Target performance
  • A 15% chance of achieving Maximum performance
• This pattern indicates that threshold and target performance goals are set at attainable levels, but maximum payouts commonly reflect rigorous goals and superior performance
• Annual incentive payouts have generally been aligned with financial performance over the past six years for the companies reviewed

Background

Goal setting is one of the most challenging aspects of the compensation process. Compensation Committees struggle with this critical activity and try to determine if they are “getting it right”. Goals tied to annual incentive compensation face scrutiny from both internal and external stakeholders, pressuring Committees to achieve a balance between the rigor and the attainability of their goals. Appropriate performance targets will motivate and retain executives while driving corporate performance and creating returns for shareholders.

Summary of Findings

Plan Design

Annual incentive plans can be categorized as either “Goal Attainment” plans or “Discretionary” plans. Goal attainment plans contain traditional performance and payout scales that consist of a pre-determined minimum, target and maximum level of performance and corresponding payouts. Discretionary annual incentive plans allow the Committee to determine payouts by using discretion and targets are not necessarily defined up front.

In this study, we found that 71% of the sample companies have goal attainments plans. Discretionary plans are most prevalent among Financial Services companies. Our analysis focuses on those companies with goal attainment plans.

Performance Metrics

In most goal attainment plans, awards are earned based on corporate performance related to two or three metrics. While the metrics vary by industry, some of the most common metrics are revenue and profitability. These metrics are popular because they are indicators of financial health to the investment community. From an internal perspective, revenue and profitability are simple to understand and in the “line of sight” for most executives in that the correlation can be seen between actions/decisions and results. From an external perspective, most shareholders would support an above target payout for executives who are driving top-line growth while maintaining or expanding margins.

Pay and Performance Scales

At companies with goal attainment plans, Compensation Committees must annually approve minimum, target and maximum goals and corresponding payout levels, for each metric in the incentive plan. Among companies included in our research, the most prevalent payout scale awarded executives 50% of target for threshold performance and 200% of target for maximum performance. Companies most often structure payout scales so that executives will earn 100% of their target annual incentive award for target performance and the actual payout is interpolated between threshold and target and target and maximum.

Annual Incentive Plan Payouts Relative to Goals

All Companies

Based on CAP’s review of annual incentive payouts, companies achieve threshold performance goals 90% of time. Annual incentive payouts most often fall between target and maximum. Companies’ annual incentive plans pay at this level 48% of the time or approximately one out of every two years. Executives earn bonuses in the range of threshold to target about 20% of the time, roughly once in every five years. Approximately 10% of the time, companies do not achieve threshold and executives do not earn a bonus. Payouts for the total sample are distributed as indicated in the following charts:

This analysis of the payout distribution is helpful in defining the degree of difficulty, or “stretch”, embedded in performance goals. Our analysis can be summarized with the following rule of thumb where Compensation Committees structure annual bonus performance goals with:

• A 90% chance of achieving Threshold performance
• A 70% chance of achieving Target performance
• A 15% chance of achieving Maximum performance

When the payout distributions are reviewed by year, the percentage of companies that paid target to maximum steadily increased from 2008-2011. This reflects an improvement in the overall economy since the financial crisis in 2008 as well as a greater ability to forecast performance in a more stable environment.

By Industry

While historical payout levels vary by industry, all industries, on average, have most frequently paid bonuses between target and maximum. The Auto and Industrials industries are notable outliers in that executives received zero payouts once in every four years and once in every five years, respectively, likely indicative of industry dynamics and macro-economic conditions more than overly rigorous goal setting. Most cases when Auto companies did not pay annual incentives occurred in 2008, the peak of the financial crisis. Average payouts for each industry are distributed as indicated in the following chart:

Relative to Performance

Over the past 6 years, the number of above target annual incentive payouts in a given year has generally tracked revenue growth and profit margin growth in the same year. In particular, payouts at Industrial and Pharmaceutical companies have aligned directionally with revenue and profit margin growth. This pay and performance relationship is key to aligning executives’ interests with those of shareholders. If the company exceeds anticipated performance, executives will earn above target payout levels without contest from internal or external stakeholders; however, if an executive is able to achieve extraordinary levels of pay without extraordinary performance, Committees risk facing opposition from shareholders and proxy advisory firms.

The chart below depicts the relationship between median revenue and profit margin growth and above target annual incentive payouts.

Conclusion

Threshold and target annual incentive performance goals are intended to be challenging but attainable. Maximum performance goals are meant to be attained only when executives achieve exceptional performance, exceeding internal/external expectations. Our study supports the formulation of a general rule of thumb, based on analysis of the past 6 years, where the degree of difficulty, or “stretch”, embedded in performance goals translates to:

• A 90% chance of achieving Threshold performance;
• A 70% chance of achieving Target performance; and
• A 15% chance of achieving Maximum performance.

This distribution indicates that Compensation Committees have built an appropriate degree of stretch into annual incentive plans overall.

We believe that when Committees set performance goals, they are influenced by prior year performance as well as economic and industry outlooks. Yet when measuring the directional trend over the past six years, we believe that Compensation Committees are adequately aligning internal performance goals with incentive payout objectives, and developing rational stretch above and below target — thus striking the right balance between the size and frequency of annual incentive payouts.