As proxy advisors and shareholders continue to focus on improving the relationship between compensation and shareholder returns, and new pay for performance rules are finalized by the U.S. Securities and Exchange Commission, it is likely that more companies will consider adapting incentives based on Total Shareholder Return (TSR) principles. Ultimately, companies need to balance shareholder value creation with executive motivation and retention when deciding whether a TSR-based incentive plan is appropriate and aligns with the company’s compensation philosophy.
If TSR is utilized in a performance-based award package, companies need to consider the following three factors: whether TSR should be measured on an absolute or relative basis, the appropriate TSR performance hurdle, and whether there will be a cap on payouts based on absolute TSR performance.
1. Absolute versus Relative TSR. Absolute TSR requires the company to set stock price targets that must be achieved to earn a payout. Establishing an absolute stock price level at the beginning of a performance period can be challenging, as a declining stock market could make goal achievement difficult to achieve, while a “buoyant” stock market could make the absolute goal relatively easy to achieve. The challenge with relative TSR is that it requires the company to select a peer group or index that is appropriate for relative TSR performance comparisons. Identifying an appropriate comparator can be particularly challenging for companies in unique markets or industries with just a few competitors.
A well-designed TSR plan might provide that when a company achieves both low absolute TSR and relative TSR, little to no payouts would be allowed (Figure 1, box C); similarly, when absolute TSR and relative TSR performance are high, payouts would be sizable (Figure 1, box B).
In cases of high absolute TSR with low relative performance (Figure 1, box A), some type of reduction in payouts might be appropriate, as the company underperformed the stock market. Similarly, in cases of low absolute TSR and high relative TSR performance (Figure 1, box D), management could be rewarded for out-performing a down stock market.
Competitive practice, however, does not often combine these two concepts. Most plans are based on relative TSR, with no adjustment for absolute performance. The few companies that set absolute stock price (or TSR) goals do not consider relative performance. A few large companies have introduced payout caps when absolute performance is negative, a concept which is discussed below.
2.TSR Performance Hurdle. If absolute TSR is utilized, a company will need to decide a minimum stock price level that must be achieved to trigger a payout (e.g., the current stock price is $15, and a trigger price of $30 is established before a payout can be earned). Determining an absolute stock price, or TSR hurdle, should stretch the executive’s efforts, but should not be demotivating. That said, the performance of the overall stock market or the stock performance of the company’s industry sector can make the $30 target in the example either impossible or easy to achieve, which may not create the intended incentive.
For relative TSR, the company must decide the minimum level of relative performance compared to a peer group or market index that begins to provide a payout. This approach allows companies to avoid the need to set a specific stock price. However, it is important to remember that a relative TSR goal may not provide the intended motivation, as the goal is not as clear cut as the absolute stock price target (and, presumably, the underlying earnings or cash flow that must be achieved to support the target stock price).
A typical relative TSR performance curve for a US-based company is illustrated in Figure 2. The threshold level is often the most debated payout level on the performance curve, although competitive market practice suggests the 25th percentile is the most common threshold performance level. By way of contrast, a UK-based company would typically start payouts at 50th percentile relative performance
3. TSR Caps. In order to reward both relative and absolute performance, some companies with relative TSR plans have placed a cap on payouts when absolute TSR is negative. These caps often limit payouts to 100% of target despite the company’s ability to outperform in a down market, as shareholders lost value during the performance period.
The obvious issue with this approach is the lack of symmetry. Specifically, if the share price increases significantly, but relative TSR is below the threshold level, no payouts will occur. Thus, shareholders will realize a significant increase in stock value and management does not receive a payout (contrast this result with stock options, where management would realize a significant amount of “intrinsic value”). The lack of symmetry and the general belief that out-performance in a down stock market should be rewarded has likely led companies to refrain from imposing caps on payouts.
This may change as shareholders and the proxy advisory firms continue to apply pressure on companies to better align pay and performance. In addition, the SEC proposed rules required under Dodd Frank in July 2015 that when finalized will require disclosure of the relationship of pay and TSR (both relative and absolute). This disclosure could impact the design of incentive plans including TSR-based plans to further align realized compensation with shareholder returns (including the use of TSR caps).
Michael Kesner is principal and Jennifer Kwech is senior manager of Deloitte Consulting LLP’s Compensation Strategies Practice.
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Corporate directors are confronted with a variety of recently proposed governance standards, while activist investor campaigns are challenging both board composition and board effectiveness by targeting individual directors. Given the high level of personal reputational risk and the associated long-term financial consequences now faced by directors, a hard look at the adequacy of company-sponsored director and officer (D&O) risk mitigation and board compensation strategies is timely.
The Bedrock of Certainty Shifts
Shifting stakeholder expectations are codified in the frequently conflicting governance standards published in recent years. Following the National Association of Corporate Director’s own 2011 Key Agreed Principles, there are now draft voting guidelines from Institutional Shareholder Services (ISS) and Glass Lewis & Co.; standards from groups such as the Office of the Comptroller of the Currency (regulator), CalSTRS (investor), the G20, and the Organisation for Economic Co-operation and Development (influencer); and, most recently, the Commonsense Corporate Governance Principles from a group of CEOs led by JPMorgan Chase & Co.’s Jamie Dimon.
This proliferation of standards reflects differing stakeholder expectations and gives direct rise to new risks for directors. With these new risks and expectations emerge associated questions about the adequacy of current governance strategies, company-sponsored reputation-risk-mitigation packages, and director compensation.
Because the board is the legal structure administering governance, the standards that boards choose to guide their oversight have legal force. Furthermore, detailed, prescriptive standards have instrumental force.
For instance, ISS and CalSTRS are promoting highly prescriptive standards. ISS is exploring specific “warning signs” of impaired governance, including monitoring boards that have not appointed a new director in five years, where the average tenure of directors exceeds 10 or 15 years, or where more than 75 percent of directors have served 10 years or longer. CalSTRS expects two-thirds of a board to be comprised of independent directors, and defines director independence specifically as having held no managerial role in the company during the past five years, equity ownership of less than 20 percent equity, and having a commercial relationship with the company valued at no more than $120,000 per year.
The Commonsense Corporate Governance Principles released this summer was an effort to share the thoughts of the 5,000 or so public companies “responsible for one-third of all private sector employment and one-half of all business capital spending.” Certain background facts may lead some stakeholders to discount the Principles. For example, in addition to Dimon, the list of signatories was comprised mostly of executives who hold the dual company roles of chair and CEO. Also, according to the Financial Times, eyebrows have been raised by CEO performance-linked bonuses of about 24 to 27 times base pay at BlackRock and T. Rowe Price, two asset manager companies with executives who were signatories. Coincidentally, these asset manager companies were ranked among the most lenient investors with respect to the executive pay of their investee companies, according to the research firm Proxy Insight.
These standards can be deployed by checklist, and boards can be audited for compliance to the specifics of the adopted standards. But, more importantly, the very existence of these standards lends them authority through expressive force. What they express—or signal, in behavioral economic parlance—is intent, goodwill, and values. Signaling is valuable in the court of public opinion.
Personal Protection Strategies
As reported in NACD Directorshipmagazine earlier this year, activists often wage battle in the court of public opinion to garner public support when mounting an attack against a company. Emphasizing the personal risks, the Financial Times reported in August that “Corporate names are resilient: when their images get damaged, a change of management or strategy will often revive their fortunes. But personal reputations are fragile: mess with them and it can be fatal.”
Make no mistake: this risk is personal. A director’s damaged personal reputation comes with material costs. Risk Management reported in September that the opportunity costs to the average corporate director arising from public humiliation were estimated at more than $2 million.
Among the many governance standards, pay issues are the third rail of personal reputation risks. “If companies don’t use common sense to control pay outcomes, [shareholders have to question] what else is going on at the organization and the dynamic between the chief executive and the board,” an asset manager with Railpen Investments told the Financial Times recently. Clawbacks may be the most disconcerting pay issue because the tactic places directors personally between both the investment community and regulators.
Governance standards just over the horizon may give boards succor, and reputation-risk-transfer solutions may have immediate benefits. Since 2014, the American Law Institute (ALI) has been developing a framework titled, “Compliance, Enforcement, and Risk Management for Corporations, Nonprofits, and Other Organizations.” Members of the project’s advisory committee include representatives from Goldman Sachs & Co., HSBC, Google, Clorox, and Avon Products; diverse law firms offering governance advisory services; law schools; regulators including the Department of Justice; and representatives from a number of prominent courts. According to the ALI, the project is likely to hold an authority close to that accorded to judicial decisions.
The ALI work product remains a well-protected secret, but the project is expected to recommend standards and best practices on compliance, enforcement, risk management, and governance. It can be expected that the ALI standards will reflect the legal community’s newly acquired recognition of the interactions between the traditional issues of compliance, director and officer liabilities, and economics; and the newer issues of cognitive and behavioral sciences. Such governance standards will likely speak to the fact that while director and officer liability will be adjudicated in the courts of law, director and officer culpability will be adjudicated in the courts of public opinion.
Insurance Solutions Available Now
Boards that qualify for reputational insurances and their expressive force can mitigate risks in the court of public opinion. An NACDDirectorshiparticle noted earlier this year, “ . . . these reputation-based indemnification instruments, structured like a performance bond or warranty with indexed triggers, communicate the quality of governance, essentially absolving board members of damaging insinuations by activists.”
Given the increased personal reputational risks facing directors and the long-term financial consequences arising, it may be time for an omnibus revisit of the adequacy of both director compensation and company-sponsored D&O risk mitigation strategies in the context of an enhanced, board-driven approach to governance, compliance, and risk management.
Following the guidelines of the ALI’s project once they are published is a rational strategy. After all, the work product will be one that will have already been “tested” informally in the community comprising the courts of law, and will be designed to account for the reality of the courts of public opinion. And no firm today has natural immunity to reputation damage—even Warren Buffett’s Berkshire Hathaway appears to be in the ISS crosshairs. Reputational insurances which, like vaccines, boost immunity, are available to qualified boards to counter all that is certain to come at them in this upcoming proxy season. And for those who insist on both belts and suspenders, hazardous duty pay may seal the deal.
Nir Kossovsky is CEO of Steel City Re and an authority on business process risk and reputational value. He can be contacted at firstname.lastname@example.org. Paul Liebman is chief compliance officer and director of University Compliance Services at the University of Texas at Austin. He can be contacted at email@example.com.
Total shareholder return (TSR) has become an incredibly important metric for boards to use to determine executive compensation, with over half the firms in the S&P 500 implementing the metric—a number up from fewer than one in five a decade ago. TSR as a metric is deeply flawed, though. It overrates weak companies that merely recovered from depressed valuations, and unfairly demotes elite firms that have slipped, even slightly, or that failed to live up to unrealistic expectations. It’s also distorted by leverage. Say two firms perform exactly the same. The one with more debt and less equity produces a higher TSR on the upside and a lower one on the downturn. TSR also is silent about how managers can actually make better decisions. It is a way to keep score, not a formula to win the game.
Enter the Corporate Performance Index (CPI). The CPI is a four-pronged test that accurately sums up the totality of corporate performance from a shareholder point of view in a composite percentile score. CPI is correlated to TSR rankings at a rate of 60 percent, so it adds weight and credibility to the TSR verdict for most companies while revealing what’s behind it. The other 40 percent of the time, CPI provides a different—and usually far more accurate—assessment of how well a company is performing.
The four ratios used in CPI are interesting in their own right. They are:
Wealth creation: the firm’s total market value premium to its book capital, stated per unit of sales (we call the valuation premium MVA, for market value added);
Profitability: the firm’s economic profit, expressed as a profit margin ratio to sales (the term we use for economic profit is EVA, standing for economic value added; it is the profit remaining after deducting a full cost-of-capital interest charge on the firm’s debt and equity capital and repairing accounting distortions that run counter to business logic);
Profitable growth: the trend growth rate in the firm’s EVA profit over the most recent three years; and
Strategic position: the long-run growth in EVA that investors have factored into the firm’s share price, effectively a “buy-side” consensus outlook.
There’s an important, consequential link among these metrics. MVA measures the wealth of the owner, and is the difference between the money put into a business and the value coming out of it. Boards should monitor MVA because shareholder returns come directly from this metric. TSR, in fact, is simply the rate of wealth creation, per unit of value. It comes from increasing the MVA premium over time. Market value added, in turn, comes from EVA. It is mathematically equal to the present value of the EVA profits the market forecasts a firm will earn. This means that increasing EVA is ultimately the real key to driving TSR, making it an ideal tool to manage a business and make better decisions.
CPI, then, is a distillation of EVA and MVA into an overall index of financial excellence. It assigns the highest scores to firms that have achieved the best records of profitable growth, that preside over the most valuable and profitable business franchises, and that are strategically best positioned to continue robust growth above the cost of capital for years to come, compared to peers. Firms like those are truly excellent, no matter what their recent TSR may be, and firms with low or declining CPI scores are really in trouble, even if TSR looks good.
Boards should turn to CPI and the underlying ratio metrics as a complement to TSR. Firms with high CPI scores can use it to repel undeserved say-on-pay criticism and activist overtures, while low scorers can stay on high alert. There’s also a case that TSR’s role in long term incentive plans should be diminished, and that managers should be rewarded instead for increasing the firm’s EVA profits over time. Turning instead to CPI could lead to better decisions, better incentives, better return to shareholders, and an even greater alignment between pay and performance.
Bennett Stewart is an expert in shareholder value and corporate performance management, and CEO of EVA Dimensions, a financial technology firm, and creator of the EVA and CPI frameworks used by the Dow Chemical Company and others.