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Source: Financial Times | Agenda: February 22, 2016 article

 

Negative TSR Prompts Hard Look at Exec Pay

By Matthew Scott February 22, 2016

Compensation committees are undergoing serious reviews of pay strategies amid falling stock prices and the realization that total shareholder return (TSR) for a majority of companies could be negative.

With both the S&P 500 and the Dow Jones Industrial Average ending 2015 in negative territory and continuing downward to start 2016, shareholder concerns about executive compensation are starting to intensify as proxy season unfolds. MSCI ESG Research reports that declining stock values have resulted in the average one-year TSR for S&P companies’ falling to negative 2.93%, the first time TSR has been negative since 2009. Since investors have also seen four straight quarters of declining earnings, companies should expect higher levels of scrutiny as to whether executives’ 2015 pay is actually aligned with company performance.

“We’ve had five years of positive TSR growth and now companies need to be prepared for a different environment when total shareholder return is flat or declining,” says Irv Becker, national practice leader for executive compensation at Hay Group.

Shareholder scrutiny is likely to be more acute at companies where CEO pay appears to be relatively high following multiple years of negative TSR and lagging performance.

Becker and other observers suggest negative TSR numbers may even impact some companies’ say-on-pay votes this proxy season.

“If stock prices and earnings are down, it is reasonable to expect that shareholders are going to be in a grumpier mood when it comes time to vote on pay,” says Steve Kline, a director and senior compensation consultant who specializes in pay-for-performance measurement and analysis at Willis Towers Watson. “Shareholders are going to expect to see how the performance declines have washed through the pay practices.”

Experts say compensation committees should review how their current pay plans compensate executives when stock price and performance are declining. Additionally, they should consider how their companies will explain their pay decisions, particularly if they expect questions from concerned shareholders.

High Pay, Low Returns

Companies across many industries will see negative TSR numbers this year and possibly next, so understanding how TSR metrics can affect compensation is an issue for all boardrooms, whether they use it in their pay plans or not.

A Frederic W. Cook report published last December reveals that 54% of the top 250 companies in the S&P 500 are currently using TSR as a performance metric in compensation plans.

On a broader scale, Equilar last month reported that 48.7% of S&P 1500 companies use relative TSR in their pay plans.

For companies already using TSR as a measure in their pay plans, figuring out the clearest way to explain the role it plays will serve as good practice for the SEC’s pay-for-performance disclosure rules, as well as helping boards prepare for engagements with investors.

Opinions about the use of TSR have been mixed as pay plans have moved toward pay-for-performance models.

Institutional investors and proxy advisory firms favor the use of TSR as a way to achieve pay-for-performance alignment with company outcomes over the long term.

Company management believes use of TSR as a metric can be overblown because executives don’t have the same control over stock price as they have over other metrics such as earnings or revenue.

“TSR provides alignment with shareholder returns, but it’s not a direct reflection of how well or poorly management is running the firm,” notes Farient Advisors vice president Dayna Harris.

She points out that broad market sell-offs and other factors can drive stock prices downward, and executives fear their compensation could be cut unfairly.

Equilar’s director of research, Belen Gomez, agrees.

“If [an] executive team hit absolute performance metrics, did everything in its power to prevent disaster for the company, and the loss of value could have been much worse, the company may end up with disgruntled executives and retention could become an issue,” says Gomez.

A look at CEO pay among several companies with negative TSR quickly reveals how complex the pay landscape can be for both management and shareholders.

Ric Marshall, head of MSCI ESG Research, identified a select group of companies for Agenda that have registered negative TSR numbers over one- and three-year periods. (Please see chart.)

Shareholders of these companies have absorbed losses for at least three consecutive years, yet the CEOs’ pay for 2014 appears to be generous considering the period of poor performance. The combination of relatively high CEO pay and three years’ worth of negative TSR should put these companies on notice that they will likely attract shareholder scrutiny.

The numbers suggest “these are companies that are already overpaying for previous bad performance,” says Marshall. “If they continue to follow their past patterns they may not be that responsive [to shareholders, and] they may continue to overpay.”

For example, asset manager Franklin Resources compiled a one-year TSR of negative 32.51% and a three-year average TSR of negative 7.66%. Yet the board approved CEO Gregory Johnson’s $15.9 million pay package in 2014, which included a $3.65 million cash bonus.

By comparison, Franklin Resources’ peer group of asset managers and custody banks registered one-year TSR of negative 11.38%, and a three-year average TSR of negative 49.31%. The annual average CEO pay for the group was $6.2 million.

Even though Johnson received more than twice the average CEO pay for the index and earned a $3.65 million bonus, shareholder support for the company’s 2016 pay plan in a say-on-pay vote held on Jan. 8 was 99%.

“It is hard to understand how they can continue to pay above the average for the entire index even though the last several years of performance have been as bad as they have, both relative to the market and relative to their peers,” says Marshall.

In the case of Chevron, an oil and gas company, negative TSR might be expected, given the way oil prices plunged in the past year. Chevron compiled a one-year TSR of negative 16.21% and a three-year average TSR of negative 7.01%. The integrated oil and gas peer group registered one-year TSR of negative 13.86% and three-year average TSR of negative 2.21%. The annual average CEO pay for the group was $4.6 million.

Chevron addressed its poor performance directly in its 2015 proxy statement. The board justified Chairman and CEO John Watson’s $25.9 million pay package on the basis of his meeting targets other than share price because the entire industry had been impacted by lower oil prices, and thus lower share prices.

In addition, $13.5 million of Watson’s pay is in the form of future equity grants. The remainder is composed of basic salary of $2.1 million, a $3.1 million bonus and $7.2 million in shares that vested during his previous six years with the company.

There are other compensation issues boards have to deal with in a negative TSR environment other than explaining pay to executives and discussing pay practices with shareholders.

As stock prices decline, boards have to think about how they will grant stock in the future.

Boards will have to consider whether to give out more shares at lower prices to match the value of the awards that were given in the previous year. Or boards may decide to grant the same number of shares, regardless of the price. In the former case, some companies may run the risk of running out of shares in their stock plans.

“This is what companies are struggling with right now,” Kline says. “We saw this in 2009 after the market tanked in 2008. Stocks were down 40%, so you had to come up with some creative ways to make stock grants.”

Compensation typically increases in the high single digits annually, but in a negative TSR environment, pay increases may stall.

Andrew Gordon, associate director of research services at Equilar, says executive pay may flatten or even decline, depending on whether boards reduce bonus payments and how lower stock prices affect the grant-date value of equity awards.

However, Becker counters that target compensation is likely to continue its upward rise, whereas realizable pay may go down.

“What the shareholders are going to see in the summary compensation table is increasing comp,” he says. “Many companies will do an additional disclosure that will show the real impact of the share price decline.”

 

An Information Service of Money-Media, a Financial Times Company

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