On the way up: pay levels increase as companies brace for pay volatility
After a record year for companies and their shareholders, CEO pay showed solid increases in 2013 for the first time since 2010. The year served as another example of shareholder perception remaining "front and center" in the thoughts of compensation decision-makers, as the delivery of pay remained highly volatile and performance-based.
A banner year for shareholders yields solid gains in pay levels
The story of 2013 for many companies was record-breaking performance for their shareholders, where a bull market and solid earnings growth drove one of the greatest years in the modern era, with shareholders earning a total shareholder return (TSR) of a remarkable 33.8 percent.
Companies were also more profitable in 2013, with a solid median net income growth of 8 percent. However, the message around performance was tempered by the fact that this greater profitability did not result from significant top-line growth. GDP growth in both the U.S. and globally was fairly stagnant, most measures of productivity were down and inflation was modest, yielding very little top-line growth for most companies. Rather, the path to greater profitability was achieved in large part through enhanced efficiency and low wage growth. On the margin, after years of issuing debt to take advantage of historically low interest rates, companies reaped the benefits of having invested in their core businesses and managed to "do more with less."
As a result of this performance, 2013 saw the first material uptick in pay levels since 2010. Base salaries grew 1.7 percent to $1.2 million, while annual incentive payments increased for the first time since 2010 by 4 percent to $2.3 million, yielding an overall increase of 3.7 percent in median cash compensation to $3.6 million. Long-term incentive (LTI) grants increased as well, growing 3.8 percent to $7.9 million, leaving total direct compensation with a healthy 5.5 percent growth to just more than $11.4 million.
And the winners were...
For the second year in a row, the largest pay increases were seen in the Utilities sector, where pay levels increased 15.9 percent despite a median 0.2 percent drop in net income, and a comparably modest 10.3 percent one-year TSR – all during what was considered to be a volatile weather year. Utilities struggled for a variety of reasons in 2013, including ongoing concerns about the Fed’s tapering of bond purchases, rising interest rates, lower natural gas prices and an improving U.S. economy – all of which drove an increased risk appetite for investors willing to flee the safety of high-yield Utility stocks.
On the other end of the spectrum, Oil & Gas company pay remained nearly flat at negative 0.1 percent, in conjunction with the survey’s lowest net income change at negative 6.8 percent, but a very healthy 27.1 percent return to shareholders. 2013 was a mixed year for the sector, as oil prices and demand peaked, but was counter-balanced by an over supply of new sources of natural gas that, coupled with weak demand, drove gas prices down.
CEO pay in the heavily-watched Financial Services sector saw a major reversal in 2013, where, for the first time since the financial crisis, pay levels increased by a robust 12.9 percent. Many of the banks that make up the Financial Services sector found success in 2013 after a multi-year journey of rebalancing their business portfolio away from the classic capital markets businesses to more stable wealth management offerings. As a result, Financial Services companies made up the highest-performing sector in Hay Group's study, showing greatly improved profitability at 15.4 percent, and the survey’s highest shareholder return of 43.5 percent.
Realized long-term incentive pay remained strong
For the third year in a row, CEOs realized significant compensation in the form of “realized” or take-home equity-based pay. After 2012, when realized pay increased to record levels, 2013 saw realized LTI nearly flat at $7.9 million. Take-home pay from stock option exercises declined as companies used less of them, while realized compensation from time-vested restricted stock and performance awards increased. These historically high levels of realized pay are reminders that today’s pay schemes provide CEOs with potential for much more volatile pay outcomes than in the past.
Long-term performance plans continued their steep incline
Pay designs in 2013 set CEOs up for increasingly volatile pay outcomes. For the third year in a row, long-term performance plans were the most heavily-weighted piece of the entire pay puzzle, making up 32.3 percent of the average CEO’s total compensation, up from 30.3 percent the year before. Performance awards outpaced bonuses – a similarly volatile element that ranked second in pay emphasis – making up 22 percent of the average CEO’s pay package.
Performance awards are considered by shareholders to be the most important element within a CEO’s pay package, as most such plans only vest in accordance with a company’s performance against prescribed objectives. While some companies have implemented these plans as a way to appease their shareholders on their concerns about pay and performance linkages, more and more companies are using these plans to align the senior team around key long-term execution milestones.
Performance awards made up more than half of a CEO’s LTI at 51 percent of the value in 2013, up from 49 percent in 2012. More remarkable still was the large number of companies that continued to add such plans, rising to a record 83 percent of all companies, up from 72 percent in 2012. For the first time in 2013, if a company didn’t have a performance award, it was a true outlier.
Stock options remained the second most heavily-used vehicle, with 62 percent of companies granting them (up from 55 percent in 2012), and making up 27 percent of the total award value. Time-vested restricted stock continues to be used in 56 percent of companies (up from 49 percent in 2012), making up 22 percent of the total LTI value.
With the prevalence of all three vehicles increasing, companies continued the trend of providing their CEOs with a portfolio of long-term incentives. Seventy-nine percent of companies granted more than one vehicle, with the most widely-used combination including all three LTI vehicles, (i.e., stock options, restricted stock and performance awards) at 31 percent. The next most popular combination consisted of stock options and performance awards, which dropped in prevalence from 27 percent to 25 percent. The combination of performance awards and restricted stock remained nearly flat at 18 percent of companies. The least-used LTI program in 2013 was the most widely-used only 10 years earlier, with less than 4 percent of companies using stock options only.
Companies showed reasonable alignment between pay and performance
Once again, top-performing CEOs outearned all others in 2013 by a significant margin. However, bottom performers didn’t necessarily see the declines in pay that many might expect.
The top third of net income performers improved their profitability by a median level of 36 percent, and saw a 7.2 percent increase in cash compensation as a result. However, the lower-third of performers saw their profitability decline by more than 20 percent, coupled with a drop in cash compensation of only 1.1 percent. All told, top performers fared only 8 percentage points better in cash pay increases than low performers, despite huge differences in profitability.
Over the longer-term, when comparing realized LTI pay to three-year shareholder return, top performers outgained low performing CEOs by a substantial margin, but did not outgain middle performers by a significant amount. The top third of TSR performers realized $12.1 million in 2013 for TSR performance of 29.1 percent, while the bottom third made only $3.2 million for 3.1 percent TSR. However, the middle-third realized $8.1 million, despite TSR that was just more than half (at 16.5 percent) of the top performers.
Both results are likely somewhat diluted by the historically strong stock price performance for most of these companies in 2013, which may have been enough to make both shareholders and compensation decision-makers less sensitive to pay outcomes for the year.
Companies continue cutting perks
After 2012 saw significant cutbacks in several of the more newsworthy perquisites, 2013 saw a slower but continued pace of perquisite elimination, as nearly every perquisite declined in prevalence. The perk most eliminated was the spousal travel benefit, falling from 24 percent to 20 percent prevalence. Personal use of the corporate aircraft once again remained the most prevalent perquisite in Hay Group’s study, and was the only perk to be provided by more than half (64.7 percent) of companies.
Companies play the waiting game with regard to pay regulations
On the regulatory front, 2013 generally saw gridlock in Congress that forestalled statutory initiatives relating to executive pay. The year started actively enough with the January 11, 2013 approval by the U.S. Securities and Exchange Commission (SEC) of amendments to the corporate governance listing standards of the New York Stock Exchange and the Nasdaq Stock Market. The main focus of these initiatives was on the independence of compensation committees and their advisors, which largely tracked the final rules adopted by the SEC in 2012. However, as of the writing of this summary, public companies were still awaiting guidance from the SEC on key provisions of the 2010 Dodd-Frank legislation, particularly regarding disclosures on clawback policies, the relationship between executive pay and company financial performance and hedging policies. The main SEC initiative was the September release of proposed rules on the controversial CEO pay ratio disclosure required under Dodd-Frank section 953(b).
Where it’s all headed
Despite all of the progress companies have made in bullet-proofing their pay programs in recent years, companies continued to keep the pressure on paying for performance in 2013. However, the jury is still out on whether or not these programs can withstand scrutiny in a year where shareholders don’t win.
In the four years of mandatory say-on-pay, a bull market has provided ever-increasing returns to shareholders. Over that period, companies have continued to make more money, have grown and have created value ranging from solid to spectacular for shareholders, depending on the year.
In retrospect, the increasing performance volatility baked into today’s executive pay packages could not have come at a better time for CEOs. CEOs continue to realize more pay than they have at any point before, in large part because their equity stakes have vested at materially higher prices than when they were granted, and have often vested at above-target levels. In addition, most companies have had four straight years of high say-on-pay approval outcomes, and may begin to feel that their pay program isn’t at any risk from negative shareholder sentiment. Right now, it seems that everybody is winning.
But the true test of these programs will only be seen during a period of contraction, where growth slows or reverses and/or where shareholders lose value. Given the performance volatility inherent in today’s CEO pay package, a contraction will yield realizable pay values that are far lower than what CEOs are seeing today. It will be in that year where pay programs are put to the test. Will shareholders continue to support a pay program at a 95 percent approval in a year where they’ve lost 15 percent of their value? Will compensation committees who see their executives’ realizable pay decline in that same year look to re-load them the next year, as we saw happen in 2009? Only time will tell.
For 2014, we expect companies to continue to close the narrowing gap between their pay program designs and shareholder perception. We will see greater use of "realizable pay" disclosures that better align the intrinsic value of LTI awards with company performance; continued movement to performance-vested equity plans; and continued eliminations of perquisites. In short, we expect more "performance-based" pay, and even more volatility on potential pay outcomes.
The danger in this trend towards greater volatility is that it may not be right for every company. While pay has undoubtedly become more performance-based, not every company has the type of volatility inherent in their business outcomes to support extreme pay volatility. When the difference between a "poor" and "great" performance year lies in a relatively narrow range, does it make sense for a CEO’s incentives to range from zero to double a large target incentive?
That is the paradox of over-reliance on market practice. Companies want to know how their peers are doing things and what the trends and "best practices" are. However, in that process, the opportunity for a company to create a misalignment with their business becomes dangerously real. Effective pay programs first and foremost tailor to the strategic needs of the company, while doing enough to head off the concerns of shareholders.
About The Wall Street Journal / Hay Group 2013 CEO Compensation Study
Hay Group’s 2013 study focused on the primary elements of compensation for CEOs of the 300 largest U.S. companies to file their final definitive proxy statements between May 1, 2013 and April 30, 2014.
The Wall Street Journal / Hay Group 2013 CEO compensation study
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