Okay, this is a fun topic (for me at least) that I’m going to *try* to tackle in 1. It’s 4 am here and I need to be done with this by 5:00 am latest. I’ve been asleep for the past 13 hours. I was exhausted and needed the rest (which was great, but it brought me dangerously close to not shipping today). the next hour or so. 1
Okay, so we need to answer two questions (and sub questions) and then I will wrap up by sharing my thoughts here.
1. What is target/realizable/realized pay?
A. Let’s start with target pay. Really simply put, it’s the annual base pay, short term incentive opportunity (i.e. bonus), and long term incentive opportunity (mostly equity valued at grant date).
B. Realizable pay is annual base pay, short term incentive opportunity (i.e. bonus), vested equity, and finally “in the money” value of 2. I am not crazy about realized pay as a measure of how executive pay aligns with performance because executives can exercise stock options whenever they want – which makes using this valuation as an actual indicator of earned wealth slightly flawed. One wouldn’t say Mark Zuckerberg (Facebook) or Bill Gates aren’t billionaires because they haven’t cashed out the shares they own. This is of course not an apples to apples comparison – their shares have value regardless of when they are cashed out (as long as the company the shares are for doesn’t go bankrupt) – while stock options only have value if they are exercised while the share price is above that at grant date. With that said, once an option is exercisable and “in the money” then as far as I’m concerned it’s earned wealth. The executive simply hasn’t been taxed on it yet.outstanding/unvested equity. 2
C. Realized pay is something that everyone will explain in a slightly different way, but for the purposes of our discussion I’ll say that realized pay is broadly defined as the pay that shows up in your W2 – what you actually earned in a given year. There are some slight differences, but it’s the best definition anyone ever gave me and the numbers line up remarkably well for most companies.
2. Why does this matter?
It matters because the modern regulatory environment has made this a hot button issue. Corporate boards are spending a great deal of time, money and energy to align pay with performance not only to to maximize shareholder value, but also to stay compliant with government legislation. Unfortunately this data isn’t really being shared in an easily digestible, accurate way in proxy statements right now (the summary comp table is a mess – more on that in a moment), which basically leaves shareholders confused around what companies are actually paying their executives and how this aligns pay with performance. These alternative pay disclosures are a way for companies to more clearly communicate their executive compensation strategy to shareholders so that they can make an informed decision when casting their say on pay votes.
I say that this stuff doesn’t matter a lot of the time – largely because a CEO’s pay package is such a negligible expense for most mid+ cap companies – but it 3. I tend to exaggerate when making a point. The why might make an interesting post if I can ever tie it back to HR. actually does. 3 It matters if for no other reason than the fact that the CEO plays a huge role in setting the strategy for the company… and the pay mix/incentives play a huge role in how a CEO sets the strategy.
I am running short on time, so I want to close by sharing this great table from the Center on Executive Compensation illustrating the problems with the summary comp table (which is the current, SEC mandated tool via which companies must disclose executive pay in the U.S.):
…So there are obviously a lot of problems here, but we’ve got what we’ve got. The big question is what alternative disclosures make the most sense to use and when. The Center on Executive Compensation has a great article on this entitled “The Roles of Realized and Realizable Pay in Disclosing Pay for Performance – A Discussion and Conceptual Framework” (March 2013). Fantastic read.
I don’t know which of these makes the most sense to use as a standard measure in alternate disclosure forms going forward. There are some very challenging questions around each methodology.
As stated in my footer (yes, I’m citing my footer) 2 earlier, realized pay has some problems because it doesn’t include options that are already vested unless the executive exercises them (in the process understating how much the executive has actually earned). Conversely, realizable pay isn’t really measuring how executive pay aligns with TSR either, as it includes the value of outstanding equity which is of course contingent on future performance… ergo the executive may or may not get it. Finally, target pay isn’t much better than the SCT (it’s slightly better since it at least doesn’t include pension value… which has nothing to do with performance).
Literally out of time, so let’s wrap up here.
Please share your thoughts in the comments section below.
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