The latest rule coming into effect now builds on previous regulation in the Dodd-Frank Act, ostensibly crafted to address the tremendous growth in corporate executive compensation by giving shareholders a say on executive pay packages. The rule will require annual proxy disclosures designed to make the connection between a company’s performance and its executive compensation transparent. These disclosures provide flexibility for companies to share their own narrative on executive compensation, both through the metrics they choose to report and in footnotes and interpretive text. Investors will have access to information including:

• A table providing total executive compensation amounts, along with the annual and cumulative Total Shareholder Return (TSR) of both the company and its peer group over the previous five fiscal years (the full five-year disclosure measurement period is phased in over the next two reporting cycles). The table will also include GAAP net income and a financial metric chosen by the company.
• An additional table with three to seven KPIs (at least three must be financial) also chosen by the company.

While companies may need to scramble to meet these additional requirements, the new rule prompts timely questions for investors: what are the right metrics to evaluate executive pay, and how do they relate to long-term value creation? Furthermore, how can investors assess a firm’s strategy as a whole rather than just looking at financial outcomes, which alone may not reflect the scope of the strategy and meeting long-term objectives?

TSR has been a metric favored by investors because it’s straightforward, but in practice it often contributes to short-term thinking. Data from Equilar points to the fact that while over half of US companies use TSR as a metric to gauge executive compensation, roughly 20% use 1- or 2-year terms, and less than 2% use terms of five years or longer.

Investors have coalesced around TSR because it is useful to the extent that earnings driven by sound operational and investment decision-making converge with stock price over time. However, using TSR as a yardstick to measure short-term performance seems at odds with long-term thinking. That say-on-pay voting outcomes focus on the short term, and almost exclusively on pay quantum, indicates either that the wrong metrics are being applied or the wrong approach to using them.

Evidence indeed suggests that shareholders are currently more focused on pay premiums and payouts in an individual year than a firm’s long-term prospects. Another study also finds no evidence that shareholders are assessing the structure of a company’s remuneration policy comprehensively or penalizing badly structured policies with their binding policy vote.

But if not TSR, then what? To begin to answer this, the issue of time horizons is an important concept to unpack. Recent data from FCLTCompass shows a growing tension as company investment horizons are getting shorter while investor holding periods lengthen (see exhibit). Investors, as a result, will increasingly demand greater attention to long-term performance and more visibility into how firms are positioning themselves to generate long-term value.

How will investors, proxy agencies, or even activists use the data disclosed, and what additional metrics and approaches should be considered? Building on The Risk of Rewards: Tailoring Executive Pay for Long-Term Success, FCLTGlobal is launching a new project on alternative metrics where we will explore optimal approaches to evaluating executive incentives and company performance. To learn more about this work, contact [email protected].