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E-MailDavid Larcker is Professor of Accounting at Stanford University. This post is based on an article authored by Professor Larcker; Brian Tayan, Researcher with the Corporate Governance Research Initiative at Stanford University; and Youfei Xiao of the Stanford Graduate School of Business.
In recent years, companies have begun to voluntarily disclose supplemental calculations of executive compensation beyond those required by the Securities and Exchange Commission in the annual proxy. Our paper, Pro Forma Compensation: Useful Insight or Window-Dressing?, which was recently made publicly available on SSRN, examines the motivation to disclose adjusted compensation and the prevalence of this practice.
Corporate disclosure of executive compensation is regulated by the SEC and is reported in the annual proxy Compensation Discussion & Analysis section and various summary compensation tables. These figures are widely cited by corporate observers, and in many cases used to rank (and criticize) corporations for their pay practices.
However, shortcomings exist with SEC-designated calculations that might make reported compensation figures misleading or incomplete. Compensation packages include a variety of risky pay elements awarded in a given year that vest across multiple years and whose ultimate value—contingent upon the achievement of performance targets or stock price changes—can only be estimated at the time that they are reported. More than one method for calculating compensation exists, and the most appropriate compensation metric will depend on what one is trying to measure: An analysis of “pay-for-performance” of executive pay will rely on the value of compensation that has been earned or realized, while an analysis of the “incentives” inherent in the compensation program will rely on the expected value and mix of compensation currently held by the CEO. The summary compensation figures required by the SEC do not make this distinction clearly.
Companies have begun to voluntarily disclose what might be called “pro forma compensation.” This practice was largely nonexistent five years ago, and the motivation to initiate it is not entirely clear. As with pro forma earnings, a company might disclose adjusted compensation figures because they are more informative about executive incentives than SEC-designated calculations. Alternatively, it might do so to make their compensation practices and payouts appear more favorable than under SEC rules, and mitigate criticism by journalists and shareholders. Because this type of disclosure is relatively new, appropriate approaches for calculating adjusted compensation have not yet been established.
One approach that companies use is to disclose the amount of compensation that the CEO has realized in a current year through the sale of equity awards (stock options, restricted stock, and performance units) that were granted in previous years and compare this amount to the company’s stock price performance to demonstrate pay-for-performance. A shortcoming of using realized compensation to evaluate pay-for-performance is that this approach compares operating and stock price performance in a single year against compensation potentially granted across multiple previous years.
An alternative approach is to calculate the amount of compensation that the CEO earned during the year, without regard to whether this pay was actually realized. So-called realizable compensation includes salary, bonus, and the fair value of equity awards vested or received in the current period. Because realizable pay is calculated based on the current stock price, the value of a compensation plan heavily weighted with equity will diverge over time from its expected grant-date value depending on whether the stock price subsequently increases or decreases. In this way, “realizable” pay will always be highly correlated with performance, as measured by stock price returns.
Realizable pay disclosure is relatively rare. Among approximately 5,000 publicly traded companies 182 (4 percent) made disclosures about realizable pay in the last two years. [1] Of these, 58 explain in the CD&A section of the proxy that their compensation committee conducts realizable pay analysis but these companies do not actually disclose the results of this analysis. Those that do disclose this analysis are fairly evenly split in terms of whether they disclose the dollar value of realizable compensation or the percentile ranking of their CEO’s realizable pay relative to peers. Approximately 10 percent disclose a combination. The time duration used for realizable pay varies, with companies disclosing one-year, three-year, or five-year data.
In general, realizable pay calculations are lower than the originally targeted compensation or total summary compensation that they compare against. Among companies reporting the dollar value of realizable pay, 71 percent disclose that total compensation is lower under this methodology than otherwise reported. The mean (median) different is a 41 percent (40 percent) reduction. By contrast, 29 percent disclose higher total realizable compensation, with a mean (median) difference of 54 percent (40 percent).
The motivation behind a decision to disclose realizable pay is not entirely clear. Companies that disclose realizable pay use a wide array of compensation consultants that is not generally different from the overall population of public companies. They are also not significantly more likely to have received lower say-on-pay support the previous year (88 percent support on average, versus approximately 91 percent for all public companies).
Over time, realizable pay disclosure is likely to increase. Pursuant to the Dodd-Frank Act, the SEC has proposed rules that would standardize disclosure on realizable pay. Companies would be required to disclose “compensation actually paid” (CAP) over the previous five years and compare this value to five-year total shareholder return. It is not clear whether companies will continue to voluntarily disclose adjusted total compensation or whether the SEC’s standards will satisfy both corporate and investor demands.
The full paper is available for download here.
Endnotes:
[1] Sample includes 5,526 companies in 2014 and 4,112 in 2015. Companies reporting realizable pay calculations were identified using a textual search of all proxy statements filed in Edgar as of early July 2015. For firms reporting realizable pay calculations in both years, only the more recent year (2015 disclosure) is used for the analysis in this report.
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