How to improve the ISS P4P model

27 October 2017

By Tom Gosling

As I’ve written elsewhere, executive pay is plagued by enduring myths that define the policymaking debate. One of these myths is that there is no link between pay and performance. This is an important accusation; one that brings executive pay, and by extension big business, into disrepute.

There are indeed many problems with how incentive plans are designed and operated. Reform of executive pay design is certainly needed. But most analysis that compares pay with performance is deeply flawed, mainly because it ignores the impact of executives’ existing shareholdings. We analyse this issue in detail in Paying for performance (see the second article listed here) and I set out some of the significant implications in this blog.

Most analysis takes as its starting point the single figure of pay, which broadly represents the amount of pay that is awarded based on performance and service in that year. This single figure, perhaps averaged over several years, is then typically compared with the total shareholder return (TSR) delivered by the company, as either the absolute £ value added, or the % return.

This type of analysis is the basis of CEO “value for money” analysis produced by UK consultants and was the basis of one the most quoted studies of recent times: MSCI’s paper Are CEOs paid for performance? Evaluating the effectiveness of equity incentives, which purported to show a small negative correlation between pay and performance in US companies over the period 2006 to 2015, and which has repeatedly been used to support the proposition that pay for performance is a bad joke. A similar approach underlies the Pay for Performance (P4P) quantitative screening methodology introduced into the UK by the Institutional Shareholder Services (ISS), the prominent proxy agency, in 2016.

Unfortunately these analyses, in common with most of this type, suffer from (at least) two fatal flaws, which render their results largely worthless. In the case of ISS this is a concern, as their methodology is increasingly influential as a screening process in their proxy analysis and voting recommendation process.

First, the analysis is not fully size-adjusted, yet one of the best documented relationships in executive pay is that more valuable companies (in terms of market capitalisation) pay more than smaller ones. The ISS methodology partially mitigates this as size is one of the factors they use for determining peer groups. But size is measured by revenue in most cases, rather than market capitalisation, which is shown to have the most robust theoretical and empirical relationship with pay levels. And sector plays a bigger role than size in peer selection, meaning that groups can be broad and in some cases the analysed company can be some way from the median of the peer group. Given that a doubling of market capitalisation on average leads to a c. 30% total compensation difference, this can create significant distortions.

Second, the analysis ignores previously granted equity, yet in the field of academic research, it is widely recognised that the changing value of shareholdings is a critically important part of a CEO’s incentives. Analysing the performance sensitivity of pay without taking into account shareholdings is like studying investment returns based on dividends but ignoring capital gains. In other words, it makes no sense, and misses a crucial component in understanding the incentives a CEO faces. 

The implications are profound. In our research we  have found that adjusting for size and changes in value of existing shareholdings increases the amount of pay explained by performance from less than 20% (not much) to nearly 80% (a lot). Failing to adjust for size and existing shareholdings would immediately kill the chances of any academic study of pay versus performance getting published in a top quality peer-reviewed journal. The radical differences that arise when the correct analysis is undertaken suggests that the ISS P4P screening is likely to be throwing up deeply flawed results.

Instead, the model should adjust for size and should include the change in value of vested shares and of unvested deferred awards that have already been recognised in the single figure in an earlier year (for example deferred bonuses). The data on company size and shareholdings is available to enable the methodology to be improved. There are debates to be had on the details: should all shareholdings be included or just those up to the shareholding requirement? Should gains be counted as equivalent to losses, or is it the penalty of wealth-at-risk that we should be interested in? But the principle of including impact of shareholdings must be reflected, otherwise a key factor is missed.

There’s a big difference in alignment between two identically paid CEOs, one of whom owns no shares and the other of whom owns 10x salary. Research shows that building large and long-term shareholdings is the best way to align pay with performance over the long term. Executive pay package design should be centred around this objective, disclosure should report it, and ISS’s pay-performance analysis should reflect this truth.

A longer version of this blog can be found as part of my regular series on LinkedIn which you can find by clicking here

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