ISS Publishes "Evaluating Pay for Performance Alignment" White Paper

ISS Publishes “Evaluating Pay for Performance Alignment” White Paper

December 28 2011

Last week, ISS published a white paper detailing its new pay-for-performance methodology.  As in the past, a “significant misalignment” between pay and company performance may cause ISS to vote against a company’s Say on Pay vote.  The new methodology is effective for Annual Meetings on or after February 1, 2012.  We have summarized the key components of the new methodology below. The white paper can be found here.

As previously announced, ISS will use three measures of alignment between executive pay and company performance for its quantitative analysis.  Two relative measures where a company’s pay-for-performance alignment is evaluated in reference to a group of comparable companies, and one absolute measure, where alignment is evaluated independently of other companies’ performance.  The new approach remains focused exclusively on CEO pay, and continues to rely upon TSR as the predominant indicator of company performance.

Measures of Relative Alignment:

  • Relative Degree of Alignment (RDA)
    • Compares the percentile ranks of a company’s CEO pay and TSR performance, relative to an industry-and-size derived comparison group, over one- and three-year periods. (weighted 40%/60% so as to put more emphasis on the longer term)
      • Annualized TSR performance will be measured on the last day of the month closest to the fiscal year-end of the subject company
      • RDA values may range from -100 to +100.  In ISS’ back-testing analysis, RDA measures were normally distributed across the sample.  The median value was approximately zero, meaning that the percentile pay and performance ranks are nearly equal for the median company in the sample.  25% of companies have RDA measures of less than -28 (where lower values represent higher pay for lower performance), while 10% fall below -51.  Approximately half of companies fell in the range between -28 and +30.
  • Multiple of Median (MOM)
    • The multiple of the CEO’s total pay relative to median CEO pay at the ISS selected peer group
      • Total Pay is defined as the sum of the compensation elements reflected in the Summary Compensation Table i.e., salary, bonus and/or non-equity incentive plan compensation, grant date value of stock and stock option awards, annual change in pension value/nonqualified deferred compensation earnings and all other compensation
        • Note that the grant date value of equity is calculated using the ISS binomial option pricing model, not the value disclosed by companies in the Summary Compensation Table
    • The company’s one-year CEO pay is divided by the median pay for the comparison group
      • In ISS’ back-testing analysis, 25% of companies pay more than 1.5 times median and 10% pay more than 2.1 times the median. The highest observed value was approximately 25 times the peer group median

Measures of Relative Alignment: ISS Peer Group Process
The ISS peer group is generally comprised of 14-24 companies that are selected using revenue (or assets for financial firms), market cap, and GICS industry group, via a process designed to select peers that are closest to the subject company, and where the subject company is close to median in revenue/asset size.

  • Initially, ISS determines a potential comparison universe by choosing Russell 3000 companies in the same 2-digit GICS category (Sector) as the subject, between 0.45x and 2.1x the subject company’s revenues (assets for financial companies), and with market capitalizations of between 0.2x and 5x the subject company
    • Peer groups are constructed twice per year, based on data as of December 1 and June 1, as follows:
      • Revenue – Sum of most recent trailing 4 quarters’ revenues
      • Total Assets – Most recent quarter’s total assets
      • Market Capitalization – 200 day average stock price multiplied by shares outstanding
  • Then, ISS selects companies from the comparison universe that are in the subject company’s 6-digit GICS category (Industry), first selecting the companies closest in size, while where possible alternating between companies larger and smaller than the subject company so as to maintain the subject at or near the median of the chosen comparison group.  If the comparison group reaches the minimum 14 members, it is considered complete; up to 24 comparison companies can be selected from the 6-digit GICS category
  • If 14 comparison group members are not selected from the companies in the universe that share the subject company’s 6-digit GICS category, the process is repeated with companies in the comparison universe that share the company’s 4-digit GICS category (Industry Group), maintaining the company at the median position where possible, until 14 comparison companies are selected
    • If 14 comparison companies cannot be selected using the 4-digit GICS, then the process is repeated using the 2-digit GICS category, until 14 companies are selected

Approximately 25 “Super-mega” non-financial companies (defined as over $50 billion in revenue, and at least $30 billion of market capitalization) have insufficient industry peers generated by the standard methodology because they are unique in being among the largest public companies and have very few industry peers close to their size. These firms will comprise a special peer group of “super-mega” companies for purposes of ISS’ quantitative analysis and will be compared to one another for the quantitative pay-for-performance evaluation.  Industry specific performance will also be considered in any resulting qualitative review.

For other subject companies with fewer than 14 generated peers, insufficient peer groups will be expanded by relaxing the revenue (but not market cap) parameters in the peer group selection process, while retaining peers selected under the basic methodology.  Additional peer companies that are both larger and smaller will be added in order to maintain the subject company as close to the median size level as possible.

Measure of Absolute Alignment:

  • Pay-TSR Alignment (PTA)
    • This absolute measure compares the trends of the CEO’s annual pay and the value of an investment in the company over the prior five-year period. The measure is calculated as the difference between the slopes of weighted linear regressions for pay and for shareholder returns over a five-year period
      • The PTA measure is equal to the TSR performance slope minus the CEO pay slope
        • This difference indicates the degree to which CEO pay has changed more or less rapidly than shareholder returns over that period
          • Potential values for PTA are theoretically unbounded, but ISS states back-testing indicated that the range is from just over -100% to just over +100%, with a slightly negative median value

Pay-for-Performance Measures and ISS Policy:
The table below shows the levels, based on ISS’ initial testing analysis, where a company would be considered an outlier (triggering Medium concern) or a significant outlier (triggering High concern).  High concern for any individual factor will result in an overall High concern level for the quantitative component of the pay-for-performance evaluation, and multiple Medium concern levels may also result in an overall High concern.


Outlier: Triggers Medium concern/may trigger High concern if company is an outlier on more than one measure

Significant Outlier: Triggers High concern by itself

Relative Degree of Alignment

-30       ~25th percentile

-50       ~10th percentile

Multiple of Median

2.33x       ~92nd percentile

3.33x       ~97th percentile

Pay-TSR Alignment

-30%       ~10th percentile

-45%       ~5th percentile

ISS also notes that each measure is assessed on a cumulative basis, so that a company with an RDA measure of -28 generates a stronger concern level than a company with RDA of -20, even though neither would trigger a Medium concern.

Qualitative Assessment
All cases where the quantitative analysis indicates the company is a significant outlier (High concern on one relative measure or Medium concern on multiple relative measures) will receive an in-depth qualitative assessment to determine either the likely cause or mitigating factors.  This step in the analytic process may include consideration of some or all of the following:

  • Strength of performance based compensation
    • A review of the ratio of performance- to time-based equity awards as well as the overall ratio of performance-based compensation to total compensation, focusing particularly on the compensation committee’s most recent decision-making
      • Note that time-vested stock options with an exercise price of less than a 25% premium and restricted stock are not considered performance-based by ISS
    • ISS will review both recent cash awards paid and the award opportunities (long-term incentive grants) intended to drive future performance, to evaluate their performance conditions
    • Use of a single metric, or similar metrics, in either or both of the short- and long-term incentive programs may suggest inappropriate focus on one aspect of business results at the expense of others
    • If a company uses non-GAAP metrics, adjustments should be clearly disclosed (along with compelling rationale if such adjustments are nonstandard)
  • Results of financial/operational metrics
    • If disconnect is driven by cash pay, ISS considers the rigor of performance goals (if any) that generated the payouts
    • Recent (GAAP) results on metrics such as return measures and growth in revenue, profit, cash flow, on both an absolute and relative basis may also be examined to assess the rigor of goals and whether the quantitative analysis may be anomalous (if other metrics suggest sustained superior performance)
      • ISS notes that company disclosure about metrics, goals, and adjustments to results, should be “clear and fulsome”
  • The company’s peer group benchmarking practices
    • ISS will examine the disclosed benchmarking approach to determine whether that may be a contributing factor to a pay for performance disconnect
      • Contributing factors cited include company-selected peers that are larger than the subject company and above median pay positioning
  • Special circumstances
    • Examples mentioned include a new CEO in the prior fiscal year and unusual equity grant practices (e.g. bi- or triennial awards), however these circumstances do not automatically exempt a company from receiving an against recommendation

Next Steps: While ISS has indicated that they do not expect the new methodology to have a significant impact on the percentage of against Say on Pay votes ISS recommends, we strongly urge companies to begin testing their pay-for-performance results based on this new methodology.  If you wish to discuss further, please don’t hesitate to contact us.

PDF: SH&P Client Alert: ISS Pay for Perf White Paper