Holistic Grail of Pay Disclosure

Showing the bigger picture—including pay-for-performance connections—in compensation reports

By Stephen Deane

It is easy to point to bad examples of executive compensation practices and disclosure. But where are the good examples? And how will best practices continue to evolve?

The 2007 proxy season unveiled the first executive compensation reports under sweeping new disclosure regulations for publicly traded companies. The U.S. Securities and Exchange Commission (SEC), which adopted those rules, is keeping the spotlight trained on disclosures with its ongoing review of hundreds of reports. The SEC’s efforts will play a major role in shaping the debate on disclosure best practices.

Meanwhile, three key producers and users of those reports—corporate executives, boards and investors—are still at an early stage in developing a market consensus on best practices. Here is how we believe best practices should—and will—evolve.

Disclosure best practices will be built on the elements of style and content. As the SEC has emphasized, presentation matters. Compensation reports should be visually compelling and easy to follow. Here are four good examples from the 2007 compensation reports (which appear in the proxy statements):

• Schering-Plough tells a strong, company-specific story of its own turnaround. It begins with an executive summary, a rare but much-appreciated feature this year, and displays bar charts and a color-coded “Summary Compensation Table” to show pay-for-performance links.
• Intel shows its pay-for-performance record in a visually compelling way: in a single chart that tracks annual incentive compensation against diluted earnings per share over a nine-year period.
• Caterpillar displays color pie charts to show the various elements that make up its pay mix.

Caterpillar reports its executive compensation mix, including base salary, executive short-term incentive plan (ESTIP), short-term incentive plan (STIP), long-term cash performance plan (LTCPP) and equity

Good writing demands strong content. Companies should use the compensation report as an opportunity to tell their story. A good way to do so is to relate compensation incentives to the business strategy. It is also critical to demonstrate pay-for-performance linkages, meaning companies should say what the metrics and targets are, who the peer groups are and why they were chosen.

• Acco Brands, for instance, discloses its quantified annual incentive-performance targets, explains how the company can achieve those metrics and why it is important to do so.

To complete the picture, companies need to report the actual performance and payouts—and to tie those results back to the predetermined goals.

• MDU Resources, for example, distilled its key pay-for-performance data into a single chart showing the annual incentive-plan targets, actual performance and payouts.

It’s a best practice to present a comprehensive picture of all the compensation components, but even that is not enough. As we raise the bar, the best reports will weave the individual elements of compensation into a holistic picture.

The ideal picture draws the key connections between the components, illustrating how they affect and build on each other. Investors and boards are likely to increase the emphasis on this holistic picture, in which the whole is greater than the sum of its parts.

Good disclosure does not necessarily mean that the underlying pay practices are also good. Nonetheless, the salutary light of disclosure should prompt companies and boards to improve the underlying compensation practices.

Pay for performance stands at the heart of compensation best practices. More than anything, investors want to see that executive pay matches performance. They look to the compensation report to connect the three legs of the pay-for-performance triangle: predetermined targets, actual performance and actual payouts.

Next year we are likely to see increasing shareholder pressure against compensation that is unrelated to performance or even constitutes pay for failure. Likely targets will range from excessive golden parachutes to executive perks such as personal use of airplanes. And expect other practices—such as tax gross-ups and padding supplemental executive- retirement plans with extra years of service—also to come under fire.

As best practices evolve, it’s helpful to keep an eye on the ultimate goals. In a virtuous circle, better disclosures should lead to better compensation practices, which in turn should produce better long-term corporate performance and stock prices.

Let’s also think of compensation best practices in terms of responsibilities—and not just corporate responsibility. With investors entrusting the board to represent them, executive compensation serves as a window into an otherwise closed boardroom. By ensuring that directors fulfill their duties, investors help to fulfill their own responsibilities as owners.

Stephen Deane is a member of Risk­Metrics Group's Governance Exchange Team and author of several reports and studies for ISS Governance Services.