U.S. Executive Compensation: 2015 Recap, Developments & Trends

For public companies, boards of directors, and practitioners, 2015 was an eventful year in executive compensation. This post presents the key developments and trends we observed during 2015 and their implications for 2016 and beyond.

In 2015, consistent with prior years, an overwhelming percentage of Russell 3000 companies obtained majority “Say-on-Pay” support. In 2015, Say-on-Pay voting entered its fifth year.

• 2,121 companies (97%) passed Say-on-Pay, and 56 companies (3%) failed.
• On average, passing companies had a 92% approval rate, while those that failed had a 39% approval rate.
• On a related note, approximately 80% of Russell 3000 companies hold annual Say-on-Pay votes.

Companies that will have completed six years of Say-on-Pay in 2016 will be required to refresh shareholder approval of their “say-when-on-pay” frequency in 2017. It is our expectation that companies with annual Say-on-Pay voting will continue to recommend and adopt the same frequency.

Institutional investors are demonstrating both a heightened level, and an increased expectation, of engagement on executive compensation matters. As institutional investors and their portfolio managers strive for best-in-class returns, they are focusing on governance and compensation as key enablers of achievement of financial performance and alignment of interests. This focus was highlighted by Vanguard, one of the world’s largest investment management companies, in an unexpected letter to the non-executive board chairs and lead directors of S&P 500 companies last year. Because direct engagement with companies offers the best opportunity for Vanguard and other institutional investors to provide timely and candid feedback, we expect the level of engagement (particularly as it relates to performance-based elements of compensation) to increase. For companies, engagement offers a valuable opportunity to secure key investor support for compensation design in advance of the formal Say-on-Pay vote. Accordingly, engagement is likely to empower companies to shift away from the pressure to conform to homogenized pay practices and implement compensation structures that are specifically calibrated to the company’s compensation philosophy and pay-for-performance strategy.

Rigor of performance goals is becoming the key focus area for proxy advisory firms and institutional investors. With limited exceptions for grandfathered legacy arrangements, the substantial majority of public companies have eliminated “problematic pay practices” (e.g., excise tax gross-ups, single-trigger change of control severance benefits, excessive perquisites) that were the typical targets of external scrutiny. With the phasing-out of these legacy practices, investor focus is shifting to a substantive investigation of pay-for-performance alignment, with particular emphasis on the rigor of performance goals, measurement consistency with generally accepted accounting principles (“GAAP”) and transparency of disclosure. This has heightened the scrutiny of annual and long-term metric selection and goal-setting and related proxy disclosure, as investors (with the benefit of hindsight) attempt to assess the appropriateness of selected metrics and difficulty of achievement of targeted levels of performance.

ISS implemented a “scorecard approach” for evaluating equity plans. In 2015, Institutional Shareholder Services (“ISS”) implemented a new methodology for evaluating equity plan proposals. In contrast to the previous pass/fail approach based primarily on plan cost, the new Equity Plan Scorecard evaluates a variety of positive and negative factors to drive a weighted score. While the final determination of the maximum share request that ISS will support continues to be a “black box,” the Scorecard’s holistic (rather than binary) evaluation of equity plans is a positive development. The Scorecard remains in effect for 2016, with some scoring updates.

Shareholder proposals relating to accelerated equity vesting upon a change in control increased in popularity. During 2015, the most prevalent executive compensation-related shareholder proposal among Russell 3000 companies was to limit change in control (“CIC”) equity vesting acceleration to a pro rata amount based on service, rather than full acceleration. Notably, the number of such proposals increased from 2014, reflecting continued shareholder focus on perceived employee “windfalls” from a CIC transaction. Furthermore, in an important scoring change from last year, ISS’ 2016 Equity Plan Scorecard also focuses on equity plan provisions relating to acceleration of awards in a CIC, including the payout level of performance awards. In our view, “double-trigger” vesting provisions (i.e., if the equity award is assumed by the acquirer, accelerated vesting only applies on a qualifying termination during a specified period following a CIC) is best practice and aligned with shareholder interests.

Performance-based awards continue to be the most common long-term incentive vehicle. Awards based on the achievement of specified performance goals were in place at nearly 90% of large companies and account for approximately one-half of the total grant value for senior executives. A majority of companies continue to use time-based awards as part of a portfolio approach to long-term incentives, allocating slightly more value to stock options than restricted stock, on average. Within performance share designs, total shareholder return (“TSR”), typically measured relative to a peer group or index, is the most prevalent performance metric, in place at over half of companies, followed by profit and return metrics. It is possible that relative TSR has reached the height of its popularity, given some of its complexities and limitations, as its prevalence peaked at 58% in 2014 and decreased to 54% in 2015. We expect TSR to remain a popular metric in long-term incentive design, with the trend likely to be the use of TSR as a weighted component in a portfolio of metrics or as a positive or negative modifier to payouts.

The SEC finalized the CEO pay ratio rule. The Securities and Exchange Commission (“SEC”) adopted a final rule on August 5, 2015 that implements the Dodd-Frank Act requirement that reporting companies disclose the median of the annual total compensation of all company employees other than the company’s chief executive officer (“CEO”), the CEO’s annual total compensation, and the ratio between these two numbers. The final pay ratio rule provides more flexibility than anticipated based on the proposed rule. However, the final rule remains quite broad in that it defines “all employees” to include all full-time, part-time, seasonal, and temporary employees of the company or any of its consolidated subsidiaries, whether located in the U.S. or abroad and without regard to whether they are salaried (unless certain limited exceptions are applicable). Disclosure of the pay ratio will be required for listed companies’ first full fiscal year beginning on or after January 1, 2017 (i.e., it is not required until the 2018 proxy season). We outline in the complete publication several steps that companies may consider taking in the near- to medium-term to facilitate compliance.

The SEC proposed rules on the remaining executive compensation-related Dodd-Frank items. In addition to finalizing the pay ratio rule, the SEC has proposed rules requiring the disclosure of corporate hedging policies, pay-versus-performance disclosure, and the adoption and disclosure of clawback policies. In light of these developments—and although compliance with these rules is not imminently required—we indicate in the complete publication several steps that companies may consider taking now with regard to each of these proposed rules.

Recent trends in director compensation continue. Director compensation programs have become simpler, more transparent, and designed to reward directors based on their level of responsibility while promoting independence and objectivity. As compensation levels have largely caught up to the increased workloads of directors, we anticipate director pay levels to increase at modest levels, with low-to-mid single-digit increases annually for some time. The range between the 25th and 75th percentile compensation levels is narrowing, as differentiation on the downside is limited by competition for qualified individuals and on the upside by investor scrutiny. While a 50/50 split of cash and equity compensation has been the typical mix among mid- and large-cap companies for the last several years, a bias is emerging toward equity compensation at the largest U.S. companies (i.e., 60% equity, 40% cash compensation).

Director compensation lawsuits indicate the continuation of a troubling recent trend. 2015 witnessed a continuing trend in derivative lawsuits challenging director compensation. Two decisions issued by the Delaware Court of Chancery last year further clarify the scope and application of the stockholder ratification defense, under which a Delaware court will apply the more deferential business judgment rule to a director compensation decision if such decision was made pursuant to an equity plan approved by the company’s shareholders. In light of these decisions, we expect many companies will preemptively include a separate, “meaningful” annual director compensation limit in new and amended equity plans that are otherwise being submitted for shareholder approval (i.e., in the ordinary course, we do not recommend seeking shareholder approval solely for purposes of a director compensation limit). To be most protective, a shareholder approved annual total director compensation limit should apply to both cash and equity compensation. That said, the meaningful director compensation limit should provide enough flexibility to address special circumstances (non-executive chair, special litigation or transaction committees, etc.) and reasonable annual increases in compensation until the plan is next taken to shareholders for their approval.

Tax and accounting developments. There were a number of noteworthy tax and accounting developments in 2015 that are discussed in the complete publication.

The complete publication is available here.