All Pay Measures Have Their Shortcomings.....

News Brief

By Cydney Posner

As discussed in this Bloomberg article, how to reflect pay for performance has become the "newest battleground in executive compensation." The SEC is currently in the process of developing rules to implement one of the Dodd-Frank mandates, the requirement to show the relationship between the financial performance of the issuer and the amount of executive compensation actually paid, a measure different from the "total pay" reflected in the Summary Compensation Table. Notably, many companies are unhappy with the mandatory concept of "total pay" because it includes changes in pension value and accounting fair value estimates for equity incentives that may not even be close to the amount the executive actually pockets. The meaning of "actually paid" is, however, the subject of some debate. The term is not defined in Dodd-Frank and, according to the article, companies, compensation consultants and institutional investors have all been lobbying the SEC to adopt their preferred interpretations. In the meantime, a number of companies have taken a stab at showing supplemental alternative measures of compensation, typically either "realized pay" or "realizable pay." But even within those two categories, there are widely divergent approaches, which makes comparability very difficult. Moreover, as the article points out, because there are no prescribed definitions, companies trying to paint the rosiest pictures of their pay-for-performance alignments can sometimes paint outside the lines in ways that could be misleading.

To address some of these issues, the National Association of Corporate Directors (NACD) has issued a "Perspectives Paper" regarding pay for performance and supplemental pay definitions. The paper advocates the adoption of four pay-for-performance principles and provides its views on the optimal components of "realized pay" and "realizable pay."

  • STANDARD DEFINITIONS (WITH FLEXIBILITY): To enhance comparability, NACD advocates adoption of standard "baseline" definitions of pay and performance and a standard methodology of presenting the pay-for-performance analysis. Companies should, however, be able to choose to present additional information to enhance communication with shareholders. In particular, NACD "believes that while the baseline definition of ‘performance' should include total shareholder return (TSR), an isolated emphasis on TSR can result in excessive focus on quarterly financial numbers and encourage short-term thinking. In the interest of avoiding over-reliance on any single metric, companies may choose to include other financial and non-financial performance measures that they believe to be relevant."
  • CONSISTENT TIME HORIZONS, ORIENTED TO THE LONG TERM: NACD believes both pay and performance should have a consistent time horizon. Although time horizons will vary depending on a company's business plan, NACD recommends that "companies consider a three- or five-year baseline, as opposed to a one-year baseline, to highlight the connection between the compensation plan and the creation of long-term value." Of course, these incentives are distinct from annual short-term incentive components.
  • NEED FOR DISCLOSURE BEYOND THE CEO: NACD suggests that companies should disclose pay-for-performance data for the CEO individually and for the other NEOs as a group.
  • IMPORTANCE OF BOARD JUDGMENT AND COMPANY CONTEXT: NACD reminds directors that they are "responsible for exercising informed business judgment in carrying out their fiduciary objective of promoting long-term value creation for the corporation, ‘avoid[ing] rote ‘box-ticking' in favor of a more thoughtful and studied approach.' " According to the Executive Compensation Blue Ribbon Commission, "Directors [must] exercise sound judgment in making their compensation decisions and maintain the courage of their convictions despite internal and external pressures….[E]ach member of the committee should have the resolve and skepticism to ask probing questions…to set and adhere to necessary limits, to be an advocate for change when a current practice results in the wrong outcome, and to ask ‘why'—and if necessary say ‘no'—in response to questionable proposals."

NACD also offers recommendations regarding the definitions of realized and realizable pay:


As compared to the "pay opportunity" reflected in the Summary Compensation Table, "realized pay" is "what an executive actually made in a given year," often viewed as "an approximation of W-2 earnings or ‘take-home pay.'" The NACD believes that realized pay should comprise the following components:

  • Base salary.
  • Cash bonus/incentive awards.
  • Gains from stock option exercise during the specified time period (regardless of original grant date).
  • Value of restricted shares or share units if vested during the specified time period.
  • Value of performance shares or share units if vested during the specified time period.
  • Realized pay takes into account investment decisions by the executive to exercise stock options, irrespective of when they were granted. Because the time frames for pay and performance could therefore differ significantly, NACD believes that realized pay would be "unsuitable for use in pay-for-performance analysis." However, according to the Bloomberg article, "[t]here are indications the SEC is looking at realized pay as a possible standard. Keith Higgins, the agency's director of corporation finance, said at a September conference that the language of Dodd-Frank ‘talks about compensation actually paid, which seems like maybe it's realized pay.'" The article also notes that the "Conference Board, a research group with members including large public companies, generally back realized pay, saying it's the best way to show the relationship between a CEO's pay and past performance."


Realizable pay excludes the effect of individual investment decisions, such as exercises of options granted in previous years, and includes components that reflect stock price performance over a period of time, allowing more of a long-term view.

NACD believes that realizable pay should comprise the following components:

  • Base salary.
  • Cash bonus/incentive awards paid.
  • Long-term cash bonus/incentive granted but not yet paid.
  • Change in pension value and non-qualified deferred compensation.
  • Value of executive benefits and perquisites.
  • Stock options: Black-Scholes value of options awarded during the specified time period (whether vested or unvested), using stock price at the end of the time period.
  • Restricted stock: Value of shares awarded during the specified time period (whether vested or unvested), using stock price at the end of the time period.
  • Performance-based equity awards: Value of shares earned during the specified time period, using stock price at the end of the time period.

According to NACD, there are open questions regarding the treatment of long-term equity incentives and the inclusion of what NACD terms "non-compensatory benefits," for example, deferred compensation, changes in pension value and perquisites. NACD advocates the inclusion in the calculation of realizable pay of the earned value of performance-based equity awards, based on the commonly used Black-Scholes option valuation model, during the relevant performance period. NACD also believes that "non-compensatory benefits" should be included in realizable pay calculations.