Measuring Executive Compensation: Realizable Pay vs. Compensation Actually Paid [Pay Governance]

Executive pay is often judged by a single figure, but that figure can be deeply misleading. In this episode, Doug Chia speaks with Ira Kay and Mike Kesner from Pay Governance LLC about the limitations of traditional compensation reporting and the frameworks that aim to better reflect reality.

They walk through the mechanics of realizable pay, the SEC’s compensation actually paid metric, and the broader challenge of demonstrating pay-for-performance alignment. Along the way, they examine common criticisms of executive compensation, the role of proxy advisors, and what decades of data suggest about whether those criticisms hold up.

What You’ll Learn

• Why the "Summary Compensation Table" is an insufficient metric for evaluating the true alignment between executive pay and company performance.
• The distinction between "Realizable Pay" and "Compensation Actually Paid (CAP),".
• How to navigate the shifting landscape of proxy advisory influence as major institutional investors move toward in-house AI tools and customized voting policies to evaluate "say on pay".
• Strategies for identifying and correcting common causes of pay misalignment.
• The reasons why institutional investors continue to prefer Performance Share Units (PSUs) as a tool for holding management accountable for long-term strategic goals.

To learn more & get resources:

• Podcast & episodes: www.publiccompanyseries.com
• Download the book: www.nyse.com/pcs

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Transcript

[00:00:00] Doug Chia: Welcome to the Public Company Series Podcast. I'm your host, Doug Chia. This podcast is designed to give corporate directors, executives, and governance professionals the insights and tools they need to build boards that are agile, resilient, and prepared for the future. It's based on the book Board Structure and Composition, which is part of the Public Company Series published by the New York Stock Exchange and JP Morgan.

[00:00:32] Doug Chia: Before we get started, if you haven't already, please subscribe to or follow the podcast on your preferred podcast streaming platform. It's the simplest way to stay current on our latest content. We're on Apple Podcasts, Spotify, and YouTube, and we release new episodes on Tuesday mornings. My guests for today's episode are Ira Kay, managing partner at Pay Governance LLC, and Mike [00:01:00] Kesner, also a partner at Pay Governance. Ira

[00:01:03] Doug Chia: and Mike authored the chapter of the book entitled, Demonstrating Alignment of CEO Pay and Performance. Ira and Mike, welcome to the show. 

[00:01:14] Ira Kay: Thank you very much. Great to be here. 

[00:01:17] Doug Chia: I'll set the context for today's discussion and then we'll get into it. For nearly two decades, boards have operated under a compensation disclosure regime that emphasizes a single number: total compensation, as reported in the far right hand column of the summary compensation table in the annual proxy statements.

[00:01:42] Doug Chia: At the time this disclosure requirement was implemented, the goal was clarity and comparability. But as Ira and Mike's chapter of the book makes clear, that one number approach has had an unintended consequence: it doesn't actually tell [00:02:00] shareholders whether pay outcomes align with performance. At the same time, proxy advisors, institutional investors, and the media have built frameworks around that one number, shaping say on pay outcomes and broader perceptions of executive compensation.

[00:02:19] Doug Chia: In response, the policy makers and the market developed all alternative approaches, most notably Realizable Pay, Pay vs. Performance and Compensation Actually Paid. So the core issue that Mike and Ira tackle in this chapter is straightforward but not simple: how do boards actually demonstrate that CEO pay is aligned with shareholder outcomes?

[00:02:46] Doug Chia: In their chapter, Mike and Ira walked through the limitations of traditional disclosure and the one number mindset, the development and use of realizable pay, the SEC's pay vs. performance rules [00:03:00] and compensation actually paid, what the data actually show, and what boards should do when alignment breaks down.

[00:03:08] Doug Chia: Ira, Mike and their colleagues at Pay Governance have also published recent articles about the influence of proxy advisors on, say on pay votes, measuring CEO pay for performance, and investor preferences on performance based equity versus time-based shares. And we'll also cover those timely issues in our discussion today.

[00:03:31] Doug Chia: So with that, let's take a deep dive into this. Ira and Mike, at a high level, your chapter suggests that we've had the data but not the right framework. The summary compensation table gives us a clean number, total compensation, but not necessarily a meaningful one. And originally the concept was that total comp gives us one number for the clarity and comparability, and then the meaning [00:04:00] would be explained by the complimentary narrative disclosures in the CDNA.

[00:04:05] Doug Chia: But in practice, that one number became the focal point, as you can imagine, that's kind of natural. And you just turn to that page to the proxy statement, look at the far right hand column, and there you go. Why did the system evolve into this? What was going on at the time when this was put in place by our friends at the SEC's Division of Corporation Finance?

[00:04:31] Ira Kay: Before the SEC rule came in for the summary compensation table, there was no single number that could be compared, and they came up with a single number that could be compared. And as you said, Doug, it was basically a useless number. Let me give a quick example. If I give you a million stock options with a strike price of $10 and a Black Shoals value of $6, the summary compensation table shows $6 million.

[00:04:59] Ira Kay: And if the stock [00:05:00] price goes down, the real value to the executive W2 or CAP or any of those other numbers that you use would be zero. And so they would show negative TSR negative stock price performance and a zero, and that people would say, oh, there's no pay for performance, when in fact there's very strong pay for performance because the, the value of the options was zero and the stock price went down.

[00:05:25] Ira Kay: So you have perfect alignment, but there was no place where it said that. So controversies within an executive comp that Mike and I have been basically following for decades are, one, the amount of CEO pay that it, it makes income inequality worse, that it's unfair that it demoralizes executives. Um, that's very controversial and basically, in my opinion, none of the criticisms are valid.

[00:05:47] Ira Kay: And the second thing is, is there pay for performance? That's much harder to prove. We've come up with some very clever, um, ideas. We did write to the SEC 50 page document when they were looking to [00:06:00] develop CAP composition actually paid. They took a lot of ideas, but they didn't actually take realizable pay, which Mike and I invented.

[00:06:07] Ira Kay: So that's sort of the story. Um, importantly it put it in Dodd-Frank 2010, they put in the vote, the say on pay vote, and the vast majority led by Barney Frank and a few others thought that it was going to show that the head shareholders hated the approach, and I don't know what they thought, I never saw a number on this, but that 20 or 30 or 40% of the companies were going to fail.

[00:06:33] Ira Kay: Well, in the last 15 years there's, there have probably been 50 or 60,000 say on pay votes. Nobody knows the exact number because nobody tracks that. And about 1% have failed. 500 companies have failed out of 50,000. It's ridiculous. It shows enormous support by the shareholders for the executive compensation model. 

[00:06:55] Michael Kesner: Prior to the implementation of the SEC rules in [00:07:00] 2007, there was a proxy, did report compensation, but there was no total, in fact, you showed the number of shares in the equity column. You didn't show a dollar value for it. So it was a jumble of dollar amounts as well as number of shares. So there was no total, you had to kind of figure it out. So what was novel in 2007 when the rules were first implemented was that there actually was a total, and I think the SEC SET compensation amount actually is pretty valid.

[00:07:33] Michael Kesner: It's great insight into the compensation committee's decision making, and as Ira and I both agree, it's great from a governance perspective to see what the committee considered uh, what the intended pay was, but it really reports a mix of actual pay, salary and bonus and future pay. The grant value of long-term incentives [00:08:00] is valued at the time the grants are made in the proxy year, but the actual value of that award really is dependent, as Ira pointed out on future performance.

[00:08:10] Michael Kesner: And, and so you have a mix of future potential pay and actual pay all sum together. So the reason everybody glommed onto it was it was readily available. It was there for the taking, and so everybody started to try to fit it into different types of approaches. 

[00:08:30] Ira Kay: Academics, hundreds and hundreds of professors.

[00:08:33] Doug Chia: Yeah, I, I used to get a lot of calls about this and I almost thought this is kind of like the lazy man's approach to, they don't want to do the math, they don't want to kind of, you know, contextualize anything. So if you come up with one number, kinda like in baseball, it's just like, okay, batting average, you know, let's just look at the person's batting average and see how good they are.

[00:08:55] Doug Chia: But actually, that's not a really good indicator [00:09:00] of how good, uh, a player or how, you know, a good a hitter this person is. But it, it continued, I guess people thought maybe it's not the greatest, but at least it's something that we can all point to. 

[00:09:14] Michael Kesner: Yes, Doug. And I think, as I mentioned, I think it's great from a governance perspective.

[00:09:18] Michael Kesner: Also in 2007, the introduction of this compensation discussion and analysis or the, uh, CDNA, which spent a lot of time explaining what you were seeing in that summary compensation table. So you hit all this text to go along with the number. So again, everybody just started to focus on it. It really, as Ira mentioned, Dodd-Frank came around three years later, 2010 at at which point they not only introduced say on pay, but they also said we need a pay vs. performance analysis because the current proxy regime doesn't provide shareholders with the proper insight on how pay outcomes relate to performance.

[00:09:59] Michael Kesner: [00:10:00] Unfortunately, it took 13 years before the SEC actually developed and implemented rules, uh, that actually try to fill that gap in the realized pay or realizable pay or outcome-based pay, however you want to describe it, and, and performance. 

[00:10:20] Ira Kay: I've been a Yankee fan for, uh, 65 years, and, um, we wish, as executive compensation professionals, that the summary compensation table was as useful as a batting average.

[00:10:31] Ira Kay: The batting average is definitely more useful than the summary comp because you can't really compare companies and there's no pay for performance. So, as I said, we are the inventors of realizable pay because it was driving the, the clients crazy to just use the summary compensation table. And we used basically mark to market.

[00:10:50] Ira Kay: You know, we used the stock price at the most recent fiscal year to try to value it. And we came up with very, very good alignment. And then we also did [00:11:00] a lot of research, Mike and I, and another one of our colleagues, Ed Sim. We did a lot of statistical analysis of the CAP analysis, composition actually paid.

[00:11:09] Ira Kay: And the interesting thing about that is the SEC basically destroyed the English language by calling it compensation actually paid when it is not actual and it is not paid. So, um, you know, they used an acronym which was ridiculous, but we did use it 'cause it had a lot of utility. And it turns out that the correlation between the summary compensation table and total shareholder return, the single best metric in terms of evaluating a company's performance, it's not perfect, but it is the best. And the correlation with summary compensation table was like 10%, but then if you did it versus realizable pay, it was like 60 or 70%. And if you did it versus CAP, which has some unusual, some features that Mike and I don't like, but it's a lot better than nothing, the correlation was more like in the high 50s, like 58%.

[00:11:59] Ira Kay: [00:12:00] So we, we found, you know, the, the, the golden chalice, you know, we found the, something that was correlated with performance that has turned out to be extremely useful for demonstrating pay for performance. We also, and I think we sent this to you and it's available, we did a very large study on the payouts for the short-term incentive and the long-term incentive and to see if those payouts are correlated with TSR.

[00:12:28] Ira Kay: And they were, um, and there was a lot of criticism from the proxy advisors and some, um, institutional investors where they said, you know, the executives are sandbagging the goals 'cause they're always beating them. And we then took a study and looked at that hundreds of companies and it turned out that if you were above target, which I think most people know what that is, to target payout on SDI or PSUs. If you, if you paid out at 120% of target, it was, um, a [00:13:00] very good probability that your TSR was going to be very strong and above the median of the group. And if you were paying out below and there weren't a lot that paid out below maybe 20 or 30%, but if they were below their TSR tended to be either low or negative.

[00:13:15] Ira Kay: So we feel we have used three different tools to demonstrate this. We, I don't know how many people we've convinced, but um, we certainly haven't convinced the New York Times, but, um, we do in fact believe that there was very strong pay for performance. The executives definitely feel that way, and obviously the shareholders feel that way because they keep voting 98, 97, 96% support for the say on pay votes, and therefore they, they are happy.

[00:13:45] Doug Chia: Let's back up and kind of go through some of these terms uh, for the uninitiated. Maybe some directors who are newer and haven't served on the comp committee. For you, you say that realizable pay [00:14:00] is the gold standard for demonstrating shareholder aligned pay for performance. So what does realizable mean, um, and and how does this differ from just, you know, the compensation that is approved, you know, in any given year?

[00:14:19] Doug Chia: So what does realizable pay mean? 

[00:14:21] Michael Kesner: Realizable pay is the sum of the base salary and actual bonus paid, plus the value of earned performance awards. Uninvested restricted stock mark to market so that it reflects the current stock price, so it reflects actual performance or best estimate of actual performance for uncompleted cycles in the current stock price at the end of the measurement period.

[00:14:50] Michael Kesner: And we usually like to look at five year period of both pay and performance. So it's sort of the cumulative amount of the [00:15:00] compensation I described and the five year TSR. You could use any performance measure for that matter to do the comparison, but realizable pay is trying to show what the actual pay is, or if it's still uninvested, what it's likely to be worth when it pays out in the case of a performance award.

[00:15:23] Ira Kay: So if I could add, uh, on the example that I used before, the million stock options with a strike price of $10 and a black show's value of six, and, um, using the summary competition table, you would conclude from that that there is no alignment. But using realizable pay, the realizable value of those million options at 10 when the stock price goes down to seven or eight would be zero.

[00:15:48] Ira Kay: And so there TSR would be negative. Um, realizable pay would be zero, and there would be basically perfect alignment. If the stock price went to 14, you'd have $4 of, [00:16:00] in the money value times a million is $4 million. Your stock price would've gone up 40%, 14 over 10. And again, you would have alignment. So that is why the vast majority of stock options especially, but other forms of stock that were granted during the period do in fact show fairly strong alignment between the amount of the payout or the amount of the, in the money value or the exercise of the options and the TSR during the identical period. And we thought matching the time period was very important. The compensation actually paid that the SEC uses it is not matched the time period, which is okay, but we think that that's an inferior model.

[00:16:42] Ira Kay: But it, they won 'cause they're the government and um, they, um, ended up with a, a very good number that's highly correlated with realizable pay. And we've looked into that, you know, it's a pretty good model overall. 

[00:16:55] Doug Chia: Yeah. Okay. At some point in the year, my manager comes out and he [00:17:00] is like, okay, um, here's, you know, what your pay is gonna be.

[00:17:04] Doug Chia: Here's your, uh, your salary, little salary increase. Here's your bonus, um, for hitting the targets last year. Um, and here's the kind of equity linked, you know, here are the stock options that you're gonna get. And I try to say, okay, how much should I, you know, I go home and I try to tell my wife, all right, here's how much these guys are paying me.

[00:17:28] Doug Chia: Um, and she's like, wow. You know, and I'm like, well, you know, that's not a real number. That's, that's something that if all goes well over time, it would turn into this. Is that kind of what you're saying? 

[00:17:43] Ira Kay: That's, it's more complicated with stock options, but yes. 

[00:17:46] Doug Chia: Yeah. Yeah. 

[00:17:47] Ira Kay: That's worth zero W2, it has accounting value and economics value.

[00:17:53] Ira Kay: And Mike is a world class expert on that, which is what's in the summary compensation table. And it is very confusing and it's [00:18:00] impossible to explain it to your spouse. 

[00:18:01] Doug Chia: Where is it kind of missing the point where realizable pay kind of clears it up? '

[00:18:09] Ira Kay: Cause it uses the most recent stock price, the most recent fiscal year and stock price.

[00:18:14] Ira Kay: And so if in my example with the options, if it's $6, the realizable would be zero on those options. And if it's $14, the realizable would be 4 million. 

[00:18:24] Michael Kesner: Yeah, Doug, it's both stock price and in the case of performance awards, whether the actual performance or the probable payout, most likely payout. So it's, it's an updated estimate because until it's actually W2 earnings, right?

[00:18:40] Michael Kesner: It's not something you can put in the bank or spend, but it's a good approximation of where you're at. There is another concept, um, we may get into this a little bit later. That's realized pay, which is more like a W2 concept. What did you actually take home? The problem with [00:19:00] that is that in the event, the stock options, for example, they have a 10 year life.

[00:19:06] Michael Kesner: So you might have a very valuable option, but choose not to exercise it. As many executives will hang on to the very end, the, uh, end of the term of the option. So there's a lot of value that realizable pay will pick up, but realize pay ignores because it hasn't been exercised yet. So, you know, if I'm trying to explain to my spouse, yeah, we've got all this value, but you know, unless I exercise it, there's nothing to spend.

[00:19:31] Michael Kesner: You know, that's the way I would probably approach it. But, um, you know, there's a, there is a difference between what you take home versus realizable pay that, you know, can be confusing but explainable. 

[00:19:45] Doug Chia: So, so money that you could actually put in the bank today as opposed to there's some money that I can put in the bank today and we can spend immediately and there's other money that it's not really in the bank, but [00:20:00] it could be one day after, however, 3, 5, 10 years. And then you said that, you know, realizable pay shows alignment. 

[00:20:10] Ira Kay: So basically the million stock options with a spread price of $10, if the stock price goes up, you make a lot of money and it, so, um, the stock price went up 40% and you made, you know, $4 million.

[00:20:26] Ira Kay: If the stock price goes down, you get zero. 'cause stock options have no downside from that perspective. It stops at zero and the, and the TSR was minus 40%. You would have alignment between the payout, under realizable pay or potential payout and the performance of the stock. 

[00:20:44] Michael Kesner: There's another dimension to this that we look at, which is relative realizable pay, you know, your percentile ranking and relative total shareholder return or relative, any particular financial measure of your choice. [00:21:00] And what we consider good alignment would be, you know, it's not gonna be one for one another words, if you're at the 75th percentile on TSR, it's not likely you're gonna be at the 75th percentile on realizable pay.

[00:21:14] Michael Kesner: So within a band, and you know, whether it's plus or minus 20%, it's, you know, we consider to be an acceptable range for alignment. So if you're at the 60th percentile on realizable pay, 75th percentile and relative total shareholder return over the five year period, we consider that pretty darn good. Close to enough.

[00:21:36] Michael Kesner: It's not gonna be one for one. But there are situations where executives are, are well under or well above where they should be on a relative performance basis. That, and there's, we can get into some of the reasons that occurs, but we do like to look at it on a relative scale. Yep. IRA's been using a, an absolute example, but we also like [00:22:00] to consider it on a relative basis.

[00:22:04] Doug Chia: This goes on for a little while and then there's criticism. There's you guys coming out with realizable pay and then you know, a policymaker, whether it's Congress or the SEC, I don't know who originally kind of came up with the idea, but they introduced this pay versus performance and compensation actually paid, and I guess the compensation actually paid is really trying to mimic or follow your concept of realizable pay.

[00:22:36] Doug Chia: But it's not realizable pay. 

[00:22:38] Ira Kay: We got 50 footnotes in the SEC report. 

[00:22:41] Doug Chia: Where did they kind of not get it exactly right? 

[00:22:44] Michael Kesner: Yeah. The problem the SEC had was Dodd-Frank dictated the used compensation they actually paid. So whether it was realizable pay or some variation of it, it was never gonna be [00:23:00] compensation actually paid because that would fall short of measuring all the awards granted, but were unvested and not realized yet.

[00:23:10] Michael Kesner: So the SEC took a comprehensive approach to this, which we think was the right approach, but where they fell short, I think, was they let perfect be the enemy of good. As the adage goes, um, they insisted on using Black Shoals to value options and Monte Carlo to value performance shares, um, for that required tremendous amount of additional work.

[00:23:42] Michael Kesner: And if you have, we have clients in the biotechs, uh, space, for example, that have monthly vesting. So they require that they do Black Shoals value calculations on a monthly basis. And so we have three years worth of options. You know, your 23, [00:24:00] 24, 25 options vesting in 25. You've gotta do 36 Black Shoals calculations.

[00:24:07] Michael Kesner: And, uh. It just required a lot more work to get perfect rather than just using the in the money value as we referred to as the intrinsic value, the spread value between strike price and fair market value, they required Black Shoals was one example where they just went overboard with the amount of detailed calculations that companies had to make.

[00:24:33] Michael Kesner: The other Ira alluded to earlier was that if you're looking at a five-year performance period, realizable pay looks at awards made during that period. CAP takes into account awards that were unvested prior to the five year period, but may have vested during the period, so it pulls in some additional year's compensation grants that really don't include the performance period itself. As Ira [00:25:00] said, it kind of washes out because you're all, the companies are doing it the same way, but in some cases it can create distortions. 

[00:25:09] Ira Kay: A quick historical anecdote about, I don't know, 20 years ago when Michael Eisner, a brilliant guy who was the CEO and transformed Disney, I think his best idea was he raised the prices of the tickets and that allowed him to fund a lot of things, including buying ABC which turned out to be a great buy and so on.

[00:25:29] Ira Kay: But he had stock options when he was promoted, I guess, in like, I don't know, 1990, I think. And he got a lot of stock options. And let's say they were at 30 do, they were like at $12 when he was appointed, if I remember correctly. And they went up to like $50. Um, and so he made like $50 million on his, on his stock option grant.

[00:25:52] Ira Kay: But that year when he exercised, basically I think when they expired, the stock price has [00:26:00] went down about a dollar and Businessweek, put it on its cover. And I remember reading this 'cause I read Businessweek and it said, Eisner doesn't get paid for performance. He got $50 million and the stock price went down 5%.

[00:26:14] Ira Kay: How can that be? And it showed a profound amount of stupidity on the part of the journalists because they did not understand that it was a 10 year thing and he had created enormous value by, um, many of his strategic decisions. And CAP has the same problem that it could be an old option that went into the money, but the recent stock price went down and it looks like it's misaligned and it's not.

[00:26:42] Doug Chia: So let's stick with CAP for a little bit. Compensation actually paid. So you go into the boardroom, you're independent comp consultants, and you talk about, okay, you know, you show 'em the different metrics, the good, the bad, um, you show 'em, okay, here's our realizable [00:27:00] pay, but here's what you actually, here's what you have to disclose, compensation actually paid.

[00:27:06] Doug Chia: Um, but in the book you point out there's actually pretty good correlation in terms of performance. Um, you know, you pointed out correlation between compensation, actually paid and TSR across S&P 500. You know, it's about, you know, 0.56, I guess is the number you had in the book. Um, so you're saying, okay, most companies are reasonably aligned.

[00:27:34] Doug Chia: And so in terms of that 0.56, is that kind of like a deviation or how, how, how is that number interpreted? 

[00:27:43] Ira Kay: Well, the short answer it is, is for correlation is that if the pay went up, the stock price went up most of the time, and if the stock price went down, the pay went down most of the time, not all of the time because of there are grants and there's timing and various [00:28:00] other things, but as I said, the summary compensation table is basically zero relationship to TSR.

[00:28:06] Ira Kay: So that's, um, that's why we put that in there. 

[00:28:11] Michael Kesner: Doug, I think, you know, the, the 56% I think is trying to it mathematically saying that you can explain about 56% of the change in pay CAP based on TSR. That's not a surprising conclusion when you consider that two thirds or more of CEO pay is based on stock price vehicles, it's based on the equity.

[00:28:35] Michael Kesner: So the fact that there was a, a good correlation isn't a surprise because so much is driven by stock price and that's the way incentives are, are are set up. 

[00:28:47] Doug Chia: Going back to compensation actually paid and realizable pay, you know, you're saying compensation actually paid it it does, you know, it is somewhat useful.

[00:28:58] Doug Chia: It's not [00:29:00] perfect. It's not the gold standard, like you said about realizable pay, but it's, it does something for people. Um, but does that, it, does that make, does that reassure us or does that say, Hey, look, this mass some real fundamental problems here? 

[00:29:18] Ira Kay: I think it should be assuring because, um, you know, most of the time if your pay went up, your stock price went up, if your pay went down, your

[00:29:28] Ira Kay: your stock price went down. Now, if you got a mega grant and a particular year and your stock price went down, then that year would not be an example. Um, these are, you know, large numbers that large numbers of companies. But as a general matter, um, this, and given the say on pay votes, um, this is a very robust approach to demonstrating aligned pay for performance.

[00:29:53] Michael Kesner: I think it validates that over the last 20 years, shareholders support at, you know, 99% of [00:30:00] say on pay, 98% of say on pay votes with the average voting about 90% approve. Uh, it supports those decisions that shareholders have made and, you know, they look at a wide range of things. But this data just, I think, demonstrates that that support by shareholders was well earned.

[00:30:23] Doug Chia: I mean, the criticism always is that executive comp, it only goes one way. It just keeps increasing and it's outta control no matter what the stock price does. Um, you know, it doesn't seem to, it never goes down when, when the company has, you know, a subpar year. So you're saying, look, your studies show that that conventional wisdom is actually wrong.

[00:30:47] Doug Chia: That if you really look at the data, that is just not the case. 

[00:30:51] Ira Kay: If you look at the summary compensation table data, it's probably right. 

[00:30:55] Doug Chia: Yeah. 

[00:30:56] Ira Kay: Because it's Grants, new grants. If you look at, 

[00:30:58] Doug Chia: yeah, 

[00:30:59] Ira Kay: realizable [00:31:00] pay, realized pay, W2, CAP, they do have alignments. Summary Compensation Table does not have that kind of alignment at all, and that's demonstrated with the way the ISS put the say on pay model together.

[00:31:14] Ira Kay: They only use the grant value. 

[00:31:16] Michael Kesner: The reality is that the SCT pay is more driven by um, benchmarking and trying to be at the median of market practice, which tends to go up. Um, and while some investors expect that if you have a down year stock price, you're gonna lower SCT pay. That's not what happens in reality, what happens is SCT Pay tracks market, but then outcome based pay tracks performance.

[00:31:45] Michael Kesner: So a company might increase the executive's target pay, but the actual pay is going to reflect future performance. And if they don't perform, they're not going to earn [00:32:00] anywhere near their target pay. And that's how boards I think conceptualize that. You know, they think of SCT is we wanna try to be at a market level and let outcome pay based, pay based on performance, um, reward execs for what they accomplish.

[00:32:19] Doug Chia: Based on the say on pay votes that would indicate that the investors understand, um, the, the limitations of what is actually what is in the proxy statement, at least in the summary compensation table. And they can kind of see through that, or they can do the, they actually can understand what, what the CD&A is talking about.

[00:32:39] Doug Chia: But despite the fact that only, you know, how not, not that many, um, say on pay votes have, you know, failed so to speak. There are, I mean, do you see companies that where pay does actually seem to be misaligned? And if that's the case, [00:33:00] what are you looking at to determine, okay, this doesn't look aligned. You know, you're not looking at a summary compensation table, but you are looking at other things and say, okay, this company things are kind of me messed up here.

[00:33:12] Doug Chia: And you might even be hired to go in and say, and tell these companies, okay, how, here's, here's how to fix it. 

[00:33:18] Ira Kay: Well, the companies that fail get an against from ISS and then fail, um, which is a very small number. About 10% get an against based in almost entirely on the summary compensation table. And then of those, about one and a half percentage points of those 10 percentage points fail below, below 50. More, you know, maybe 5, 6, 7% end up with lower votes, but satisfactory. And, um, it's just not useful. And it doesn't, you know, it's not demonstrating, allowing it to demonstrate and they end up, uh, the next year they pass. And it's not, it's not a useful [00:34:00] technique.

[00:34:00] Ira Kay: The, the key, um, ISS test, the relative degree of alignment where you subtract, you take relative TSRs Mike was talking about, and you subtract relative pay. So if your TSR is minus is 25 and your pay is 75th percentile, 25th percentile minus 75th is minus 50. You, there's a good chance you're gonna get an against from ISS and it's not a valid approach and they know it.

[00:34:27] Ira Kay: And now they've com they're completely disrupting their models because they've figured out that it's, uh, it was not a good approach at all. 

[00:34:35] Michael Kesner: And Doug, I think the biggest contributors to the misalignment when we look at realizable pay, one is the target level of pay was set way too high to start with. So the starting point was like if you had a hundred yard, uh, dash and you gave somebody a 90 yard lead, you know, you've given them such a high target pay that, you know, even if they don't perform well, they're still gonna make a [00:35:00] lot of money.

[00:35:00] Michael Kesner: So that's one of the key contributors. A second is, uh, some companies set overly aggressive or overly easy performance goals, so that executives can't achieve the goal and they don't make any money. Or they set pretty easy goals and then they crush it. That's another contributing factor. Um, the third would be performance ranges

[00:35:26] Michael Kesner: for incentive targets. So we're, uh, if you have a really tight range, a small change in performance, up or down can have a huge impact on payouts. So you can set reasonable goals, but if you don't have a lot of, you know, if you don't have a lot of flex on either side, you know, if you make a little incremental increase, you can get way too big a payout, and if you fall a little short, you can get zero. So those are things that we often see contribute to that misalignment. Some companies also emphasize cash comp a lot more than equity. And [00:36:00] so you know, your cash comp doesn't necessarily fluctuate with stock price, where if there was more balance in that pay package, there'd be more equity that would be influenced by stock price performance.

[00:36:10] Michael Kesner: So there's often two or three things when we see misalignment that we can explain, contributed to or the cause of that misalignment 

[00:36:21] Ira Kay: there. The other sort of important, at least to me, is that you don't see people buying the Russian stock market or the Chinese stock market or the Japanese stock market or the French stock market.

[00:36:33] Ira Kay: They all buy the US stock market. They buy the US stock market because our macro economic policies are spectacular. We have a very robust economy. And our executives get highly rewarded for making their earnings goals, which nine times outta 10 will increase the stock price. And so this is a very robust stock market that attracts funds from all over the world.

[00:36:57] Ira Kay: And it's partly, maybe not, [00:37:00] I wouldn't say fully, but it's partly based upon the executive pay model. I'm actually writing a paper on this that, um, motivates the executives to increase EPS and thereby their stock price. And if you look at, um, how often that happens, it happens a lot. And that's why the United States rebounds so quickly after the tech bubble and after COVID and after the financial crisis, the US economy and the stock market re rebounded extremely quickly.

[00:37:28] Ira Kay: It's because the executives are highly motivated and the executives in England, France, Germany, Spain, Japan, they are not motivated to get their earnings up 'cause they don't really care 'cause they don't get paid. 

[00:37:39] Doug Chia: Well, so, so you've used the term outcome-based couple times. What, what does that mean?

[00:37:46] Michael Kesner: Outcome-based is any approach that looks at what actually was earned or could be earned based on stock price as well as performance achievement. You know, whether, you know, you're a [00:38:00] hundred percent of your target or 130 or whatever it may be. Um, so yeah, it's, it's more a broad, it meant to be more an umbrella term as opposed to SCT. It's really just a contrast to SCT, which is heavily influenced by potential pay, not outcome-based pay. 

[00:38:19] Doug Chia: Yeah. So ba essentially what you probably would, what you would take home at the backend as opposed to what's been approved today, which is priced based on things that are happening today.

[00:38:34] Doug Chia: But you can't actually touch the stuff based on that, that valuation. 

[00:38:38] Ira Kay: And it may have no value. 

[00:38:40] Doug Chia: Yeah, yeah, exactly. So let, let's, you know, you mentioned the proxy advisory firms, um, and recently wrote, uh, a piece about this and kind of, you know, pointing out that certain things are happening in the market right now.

[00:38:55] Doug Chia: And one significant one is JP Morgan, Wells [00:39:00] Fargo, a couple other firms are saying we don't like the way they, they do things anymore, uh, or we never did. And, and so we're going to do something else. We're gonna move it in-house. We can, with AI tools and, and other stuff, we can essentially do what they do in a way that we think makes a lot more sense.

[00:39:21] Doug Chia: Are essentially these guys becoming their own proxy advisors? Is that essentially the idea here? 

[00:39:28] Michael Kesner: Yeah, I do think the large institutional investors have been their own proxy advisors, so to speak. They have their own policies. They're, uh, pretty disciplined in how they approach this, and they've used the proxy advisors maybe as a, a secondary source or review of what they've concluded, but the smaller investors don't have the scale, uh, to do a lot of this themselves because they could be looking at voting up on proxies, over a thousand, you know, [00:40:00] over over a thousand companies with two or three issues each. And it multiplies how many decisions have to be made. So, uh, we're seeing a shift away from the proxy advisory firms and with AI, uh, two firms that we're aware of have kind of announced themselves proxy wise,

[00:40:19] Michael Kesner: aI and Proxy Beacon, which is a product of Tumelo, are out there now working with some of the institutional investors to use AI to help them take their voting policies loaded into the AI model and use it to determine how to vote proxies, probably with a backend review, of course, by humans, but make sure it makes sense.

[00:40:46] Michael Kesner: So, um, yeah, we're seeing a shift. We're also seeing the proxy advisors now move to customization where they will have benchmark policies that currently they use for everybody. You know, that's, that's what they use [00:41:00] to vote all the proxies. They're gonna, they're trying to now work closely with institutional investors to take their policies, embed 'em in the, in a methodology that I assess that can say, based on your methodology, here's how you would vote.

[00:41:16] Michael Kesner: Or Glass Lewis saying they're trying to do the same thing. So, uh, we're seeing this customization occur on proxy, uh, voting recommendations or proxy voting to accommodate the institutional investors' policies. 

[00:41:32] Doug Chia: You know, you pointed out something in terms of how proxy advisory firm, uh, research or recommendations have been used, at least by the largest institutional investors, that they have staff, they do their own work, and then the, the ISS and Glass Lewis reports are, and part of that research, you know, they, they're useful as, um, you know, another data point [00:42:00] out there, but is that gonna continue to happen in terms of, okay, now we can plug stuff into AI or we can use AI to help us, um, analyze and maybe and gather research as well.

[00:42:14] Doug Chia: And so will, will those reports, do you think those will still be part of the inputs as essentially they have been up until now being read by humans and you just, instead of being read by humans, you feed it into AI and see what it comes out with? Or are they saying, okay, we're, we're done with these guys?

[00:42:34] Doug Chia: We don't look at their stuff at all? 

[00:42:36] Michael Kesner: Well, I think some of the large institutional investors are saying, we're just severing ties. We're not going to consider their recommendations or policies anymore. So, you know, some are, I don't know that that will be as widespread. It'll be a slow evolution, I think for that to occur.

[00:42:55] Michael Kesner: I, I think the proxy advisors, um, although some of their [00:43:00] policies and voting recommendations are bit misguided, I mean, they do provide some good insights, so I don't know that they'll completely disappear. But there's certain things that institutional investors are going to value more or emphasize more than what the proxy advisors might have that will influence their decisions.

[00:43:21] Michael Kesner: I think more than just taking a look at what the proxy advisors are recommending, 

[00:43:27] Ira Kay: I'm very worried about this because we had the rules from Dodd-Frank, the say on pay rules. We learned how to advise our clients. They made changes. If they made a a mega grant, they gave a very robust definition of what the goals were and so on and so on.

[00:43:45] Ira Kay: Now it's extremely fragmented. It's gonna be much more subjectivity and I am worried that it's gonna damage the pay for performance model 'cause we're not gonna have a robust approach to assessing whether in fact it is [00:44:00] aligned. 

[00:44:00] Doug Chia: And, and when you say fragmentation, are you referring to the fact that all these investment firms will essentially be kind of using their own thing and, and we don't know what that looks like 

[00:44:14] Ira Kay: and we can't simulate it.

[00:44:16] Ira Kay: We simulate ISS and Glass Lewis. 

[00:44:19] Doug Chia: Yeah. You know, so I, I think that it, it, to me, I'm not sure people are looking at the effect on the actual decision makers of compensation because, you know, when I was in the boardroom. Yeah, part of it, part of the discussion, someone would always ask the question, well, what's ISS gonna think of this?

[00:44:37] Doug Chia: What, what kind of recommendation are we gonna get? I always hate it when that was the first question, but it, it's a logical question to factor in. Um, and so, but companies could essentially, they knew how these guys, you know, kind of programmed things based on historical precedent. And it was kind of like, you know, you can kind of predict where [00:45:00] ISS is gonna come out on some of these things.

[00:45:03] Doug Chia: And now it, it, it's, well, uh, we're not sure we can predict it because like you said, we can't replicate everything. And our proxy solicitors, they, they essentially, a lot of the, the data points they use, uh, they just don't have anymore. If, if you take the proxy advisory firms out of it. So, you know, is that what you're saying, that kind of be careful what you wish for?

[00:45:29] Ira Kay: I think so, yeah. I mean, ISS is gonna have, going to have, we don't know, three or four possible reports with a separate recommendation. Like I had one, two years ago where they had an environmental activist shareholder, they got a four from ISS on their pay for performance, but they didn't like some of their, um, environment, their GHG metrics or whatever they got in against on that separate report.

[00:45:59] Ira Kay: [00:46:00] And we were stunned that they would issue. And we've gotten a few of those and it, and the, um, the vote was about 80% and the board was extremely disappointed. And annoyed at us for not figuring that out, and it would've been impossible to figure it out. 

[00:46:16] Michael Kesner: We will eventually learn how these large institutional investors are applying their policies.

[00:46:22] Michael Kesner: I mean, some, some of 'em have very broad policies on their website, so you get like an inkling, but they're gonna have to be a little more transparent, especially if they're voting against, say on pay as an example. It's gonna be up to us and our clients to figure out exactly how that model works. And I think we will over time, be able to understand the different investors' perspectives and how they're evaluating compensation.

[00:46:55] Michael Kesner: Uh, but yeah, for, for now, there's gonna be a lot of chaos. But, you know, once you [00:47:00] get in against vote, you'll have, uh, a pretty good idea of what, uh, the institutional investor, uh. Did or did not like about your compensation program? So I, I think it, again, it'll be incumbent on us, the proxy, um, solicitors to try to understand how the institutional investors are approaching this.

[00:47:21] Doug Chia: And I guess that's where engagement comes in, because if you don't, uh, essentially you need to go in there and say, Hey, you know, okay, you, we know you voted against us. Explain why. And, and maybe from that you can glean stuff about how their AI model works. Um, of course, some of the large institutional investors already do that, you know, after the fact.

[00:47:41] Doug Chia: They will kind of explain their votes. But, um, I, I think that's a, that's a very small portion of, of them. What about the executive order that is specifically talking about the proxy advisory firm [00:48:00] industry? Uh, do you think that will have some effect on compensation and how it's analyzed? Has it already been having an effect?

[00:48:09] Doug Chia: Um, you know, I'm just trying to make some, make heads or tails of that. 

[00:48:13] Michael Kesner: Well, so far the SEC hasn't acted on the executive order, so nothing's really changed. However, as I mentioned earlier, the proxy advisory firms have moved to customization so that they're moving away from the benchmark policy and trying to work with institutional investors to, uh, include their.

[00:48:32] Michael Kesner: Policies, uh, in order to make voting recommendations. So we've already seen the change and the proxy advisory firms are, you know, fighting for their survival. So they've, uh, a adapted pretty quickly to this new environment here they're under. So eventually, yes, you see Mike come around with some rules on the regulating the proxy advisory firm.

[00:48:56] Michael Kesner: For so far we haven't seen anything. 

[00:48:58] Ira Kay: I don't think it's gonna be [00:49:00] necessary, like Mike says. 'cause they're, they're damaged. We don't, we, we have a debate on this internally. Um, I think they're gonna be very badly damaged, and I don't know whether that's good or bad. 

[00:49:12] Doug Chia: I, I mean, the way I look at it is these firms have to exist. There

[00:49:15] Doug Chia: there's gotta be something out there like that. Um, you know, so long as you're saying people have to vote, then they may need some, um, kind of intermed intermediary or clearing house or whatever you're gonna call it, to actually execute on that. So they'll exist for that purpose. Um, but that's a very low margin business, so they're gonna try to, try to do some consulting out there.

[00:49:39] Doug Chia: Um, let's talk about, uh, you know, let's talk, talk on pay versus performance. Now this, you know, was a creature of legislation. Um, eventually it got implemented by the SEC, um, but immediately people said this is worthless. Um, you [00:50:00] know, the companies and the investors seem to say that this is just, it's more of a compliance exercise.

[00:50:05] Doug Chia: And is that, do you view it that way? Is it still that way? Or are people actually getting some value out of this? 

[00:50:11] Ira Kay: I thought the investors liked it, and our research shows the investors like it. 

[00:50:17] Doug Chia: Okay. 

[00:50:18] Ira Kay: I'm upset about and worried about that SEC meeting that took place a few months ago where they're thinking about getting rid of it.

[00:50:25] Ira Kay: Mike gave the reason they don't want to do the black trolls calculation, which is stupid. That should be eliminated. They shouldn't throw away the baby with that bath water, but it should throw away that bath water, um, and stop that black shoal stuff. And maybe they shouldn't allow the, the, um, grants, like Mike said, from before the period.

[00:50:45] Ira Kay: It makes no sense to have grants from before the the TSR period. Why would you do that? And that's why we do realize, okay, the way we do it, we're the only ones who basically have that insight. I don't know what's gonna happen. I think that this, we are gonna [00:51:00] have the chaos we had before Summary Competition table, which did,

[00:51:05] Ira Kay: it kills me to say this, but I think did create some discipline in this. And the original say on pay did create some discipline. We got rid of excessive pension, got rid of excessive severance, you know, a a bunch of things that were, um, not necessary for pay for performance. And who knows what's going to happen.

[00:51:25] Ira Kay: I'm, I'm worried about it. 

[00:51:27] Michael Kesner: I think the initial effort to comply with the rules, one, the rules were the PVP rules were rushed out. I think they finalized in October, you had to be ready to go with three years of data, uh, in the proxy season that followed in 23. And I think that caused a lot of ill will towards these rules.

[00:51:48] Michael Kesner: I also think that the way the data's set up, it isn't obvious how to use it. You know, you see a, for example, when you have a real volatile stock price, you see [00:52:00] a. $200 million pay, then you see a minus $140 million pay and then you see, you know, like a $12 million. And you know, it's hard to figure out what to do with that kind of volatility in the data.

[00:52:15] Michael Kesner: But TSR is shown cumulatively. You see what the cumulative TSR is, we use cumulative CAP in our analysis and uh, I think there's no nowhere in the table where it shows what the cumulative amount is. And I think there's just a misunderstanding of how to use that data. Um, it's there, it's available. You also, also, it's the timing, the data for my claim comes out when they file their proxy, but I can't gather all the peer data until they file their proxy.

[00:52:50] Michael Kesner: So there's a lag between when I can take all that peer data compared to mine. And do a useful realizable or [00:53:00] CAP type pay for performance analysis. So, um, it, it, I think there's, so we've fallen to, it's just a compliance exercise, like the CEO pay ratio. It's just compliance exercise and people are ignoring it.

[00:53:16] Michael Kesner: But what Ira and I have been trying to do is say, look, now that this data is available, it can be used. It's very useful. And when we show it to clients, it's very powerful. 

[00:53:26] Ira Kay: And if we get rid of it altogether, we're back to 1989. You know, we have nothing. We're using the summary compensation table. 

[00:53:35] Doug Chia: Another thing that, you know, there's kind of a, I guess, conventional wisdom that PSUs, uh, performance share units are, they're falling out of favor for some reason.

[00:53:45] Doug Chia: They were, uh, they were the hot item. I think proxy advisory firms had a lot to do with that. Um, but now people are saying, you know what? There's actually some flaws with this. Um, but, but you've done an [00:54:00] actual study and you've said, no, that's, that's wrong. That's 70, 71%. Uh, you know, investors, uh, prefer performance share units.

[00:54:09] Doug Chia: 86 of 'em want to be at least, at least half of the, the long-term incentive, um, that's granted. Um, so I, I guess you know, now that we have established that the conventional wisdom's wrong, why is the conventional wisdom wrong? And, and that, that these are actually, you know, good things. 

[00:54:29] Ira Kay: I don't wanna name names, but there are people who said that about the shareholders don't like the performance vesting.

[00:54:37] Doug Chia: I was probably part of that guilty crowd, but yeah, 

[00:54:41] Ira Kay: it's not true. I don't know why they thought it. I was very confused by that. I was excited when we did that. You saw, we did a survey of investors using ir and it was, there was no doubt that investors want performance shares. 

[00:54:57] Michael Kesner: Look at it this way. Most every [00:55:00] company has mid and long rage planning processes and plans that they, uh, establish.

[00:55:07] Michael Kesner: Oftentimes, they disclose what their plans are in investor presentations. And PSUs are a great way to hold management accountable for achieving those mid and long range goals where you actually set performance targets and are held accountable for achieving them. So, I mean, I, I hate to invest in a company that can't think beyond, you know, the next quarter.

[00:55:32] Michael Kesner: I want a company that can establish mid rate long range goals and work towards, invest in and make sure that they do everything they can to achieve them. And PSUs is a great way to demonstrate, um, that accountability, uh, by either vesting or not vesting in those awards based on the, uh, pre-established goals.

[00:55:55] Michael Kesner: On the other hand, there are companies that struggle, whether they're cyclical, [00:56:00] they're recently public, that can't establish reliable long-term goals. And so this move to have long, uh, vested, you know, RSUs restricted stock units or restricted shares, um, may make sense for them while they kind of settle in on what they can and can't do from a performance goal setting perspective.

[00:56:25] Doug Chia: The criticisms that I saw coming from the companies were that first of all, okay, you know, you want me to, in terms of performance shares what performance, what, what performance, and then you gotta decide what metrics, and then everybody has their different favorite metric. Um, then, you know, in terms of the disclosure can be really a pain.

[00:56:48] Doug Chia: Um, and, and, and then other people said it's not really fair. Like you were saying that, you know, we are cyclical business and one year is down. And so that blows up the [00:57:00] entire PSU. Um, I guess if you keep awarding these things, then there's kind of like this, uh, you know, cumulative effect that everything should turn out in the wash.

[00:57:11] Doug Chia: But I mean, you guys were in the boardrooms kind of on the front lines talking about PSUs an investor preference for them while a lot of boards were like, we, we don't, this, these things are way too complicated for their own good. 

[00:57:26] Michael Kesner: Complicated is the relative term. I mean, if your senior management team doesn't understand what your three year targets are, I think maybe there's a problem, uh, since they set those goals themselves, or at least they do it through the long range planning process.

[00:57:43] Michael Kesner: So yeah, maybe to the reader or the way it's described. I think the biggest problem with the PSUs is that the goals usually are not disclosed upfront. So in the 26 proxies that you are [00:58:00] reading now, it shows the amount of the 2025 PSU grant, but the goals don't get disclosed to the end of the three year performance period.

[00:58:12] Michael Kesner: And so it's not clear to anybody how rigorous those goals are. If they're rigorous, what they are. I mean, you might mention what the performance measures are, but very few companies front disclose or disclose those goals for for right reasons. Some claim it's potentially gonna cause competitive harm.

[00:58:35] Michael Kesner: Other companies are afraid of disclosing it because it could be seen as long range guidance that they are not comfortable providing. So that's one of the big problems I see with the PSU regime right now is that you really don't know now what management's being held accountable for achieving till after the fact.

[00:58:57] Michael Kesner: So you see the summary comp table [00:59:00] value, and that's all you see right now. And if you, these companies were to disclose those goals upfront, it might alleviate some of the criticism and concerns that maybe your sandbagging or the goals aren't tough. 'cause at the time they're set, generally speaking, based on experience, they're viewed as tough, maybe achievable, but things have to go right for them.

[00:59:25] Ira Kay: And when they do hit them or beat them, their stock price goes up and so the shareholders are happy. What else do we want? 

[00:59:33] Doug Chia: What do you think we're gonna see going forward? And I'm not talking about kind of just this proxy season, I'm talking about kind of fundamentally where, where's the change gonna be and what boards have to be watching out for.

[00:59:48] Doug Chia: Is it, is it the takeover of AI that everyone talks about in every industry? Or is it, you know, what other things? 

[00:59:55] Ira Kay: I think there's going to continue to be scrutiny on very large grants, [01:00:00] in my opinion. It's not really clear to me they need, they're necessary, but the boards are terrified that their superstar CEOs are gonna leave.

[01:00:09] Ira Kay: There are not a lot of examples of that, but it's, you know, they're buying, um, an insurance policy. And so I think just gonna continue to see that maybe with a little more consternation. And I think, um, there's gonna be a little more, um, care and sort of what Mike was saying about, um, making sure that the goals are, are difficult.

[01:00:31] Michael Kesner: Well, there's a lot of uncertainty with the SEC chair wanting to revamp PVP, you know, I don't think they can get rid of it 'cause it's mandated by law, but maybe completely revamping it will create significant uncertainty. We've got this fragmentation of proxy power, voting power, um, with each of the institutional investors potentially having their own models [01:01:00] for pay for performance and proxy voting onsay on pay.

[01:01:04] Michael Kesner: So, um, I think it's gonna be incumbent on companies and the boards to make sure that they're clearly disclosing how they evaluate, pay and performance. And as Ira mentioned, goal rigor. I think those would be two things that would be very helpful in this period of uncertainty for boards to focus on and communicate to their investors.

[01:01:30] Doug Chia: Well with that, Ira and Mike, thanks for joining us today. 

[01:01:34] Michael Kesner: Thank you, Doug. 

[01:01:35] Ira Kay: Thanks for having us. Very interesting. Great seeing you again, Doug. 

[01:01:38] Doug Chia: So that concludes this episode of the Public Company Series Podcast. I'd like to thank Ira Kay and Mike Kesner of Pay Governance LLC, again for sharing their insights on CEO Pay and Performance Alignment.

[01:01:52] Doug Chia: And I encourage you to read their chapter of the book entitled, demonstrating Alignment of CEO Pay and Performance. You can [01:02:00] find it in the book Board Structure and Composition part of the Public Company Series published by the New York Stock Exchange and JPMorgan. You can read and download the entire book at www.nyse.com/pcs and for additional resources and episodes, visit www.publiccompanyseries.com and don't forget to subscribe to receive all new episodes of the Public Company Series Podcast and please rate us and leave a review.

[01:02:29] Doug Chia: I'm Doug Chia, and we'll see you next time.