Improve Pay-for-Performance Alignment By Modeling Realizable Pay Outcomes

May 8, 2019 Michael Garcia and Scott Allen

When evaluating the effectiveness of executive compensation programs, analyzing realizable pay has become a best practice. Companies are increasingly faced with the challenge of appropriately defining compensation earned and aligning it with business performance. If the alignment between realizable pay and performance is strong, it may indicate that metrics, goals and targeted pay levels are well calibrated.

Many companies see realizable pay as a way to understand what value is actually being gained for executives within the pay program to help assess the overall alignment of executive pay and performance. Realizable pay is an estimate of the value of compensation delivered, and it provides a better gauge of the link between pay and performance than simply reviewing target pay. That is because realizable pay takes into consideration actual bonuses earned, equity values that reflect the change in share price subsequent to the grant date, and long-term performance incentives earned.

Realizable pay analysis in relation to a company’s peers can support the following objectives:

  • Provide insight into the appropriateness of incentive plan goals
  • Test the relative degree of historical pay and performance alignment
  • Help satisfy the SEC’s desired level of analysis in the CD&A

Simply put, realizable pay is the actual value of compensation earned once incentive plans have paid out, and any gains or losses on equity grants are taken into consideration. It is intended to reflect the impact of performance on target pay over a multi-year period.

Some of the key elements include:

  • Cash compensation: Actual base salary plus annual incentive/bonus paid for the year’s performance
  • Long-term equity compensation: The calculations used to value elements of long-term compensation are:
    • Restricted stock/units – current fair market value
    • Stock options – current intrinsic value
    • Performance shares – actual plan payout at stock price at the end of the measurement period (for closed cycles). For outstanding cycles, the target numbers of shares are typically used at a stock price at the end of the measurement period (some variants can be applied such as the average of actual payouts)

Realizable Pay vs. Pay Opportunity

Pay opportunity, or pay granted, is the amount of pay for awarding target compensation. The components consist of the target value of short-term incentives and the grant value of equity (e.g. stock options, restricted stock and performance shares). A comparison of realizable pay vs. pay opportunity is useful in evaluating pay that is dependent upon performance. High performance can drive above-target delivery of performance-based pay, making realizable pay higher than pay opportunity. The inverse is also true.

Pay-for-Performance Alignment

Figure 1 below shows a typical pay-for-performance alignment analysis, which focuses on past pay outcomes and historical performance. For a company and its peers, pay and performance are plotted as a scatter plot, with realizable pay on the x-axis and performance on the y-axis, both of which are represented as relative percentile rankings. When the percentile rankings are relatively close to each other, pay and performance are considered to be strongly aligned.

Super Realizable Pay

The newest analysis in Aon’s Compensation and Governance Professional (CG Pro) tool focuses on modeling realizable pay outcomes. To gain a more holistic view of realizable pay, it enables users to assess realizable pay and performance on a go-forward basis. Different assumptions on the levels of growth can be applied to both realizable pay and performance to model future outcomes. Based on these results, we can assess the impact of changes in pay or performance on relative pay-for-performance alignment vs. peers. From both a performance planning and incentive design perspective, more powerful insights can be gained in assessing pay-for-performance alignment prospectively.

Steps include:

  1. Understanding your position: The process starts with an assessment of the current pay-for-performance alignment position. For any given peer group, CG Pro provides the alignment analysis for any type of financial or market-based metric, over several multi-year periods. The initial modeling evaluates a company vs. its peers, on both an absolute value and percentile ranking basis. In addition, a comparison of realizable pay vs. the pay opportunity granted is analyzed to review if pay outcomes based on performance is greater than or less than the target grant level of pay.

  1. Choosing your targets: The Super Realizable Pay tool is a simulator that provides the ability to make adjustments to both realizable pay and financial performance, enabling users to assess the impact of different performance levels on the realizable pay rankings. Pay-for-performance sensitivity scenarios can be conducted for the following alternatives:
    • Retrospective pay-for-performance: Simulations can be conducted to review how realizable pay would have been at different performance levels. This level of back-testing confirms if pay decisions are sufficiently aligned with performance results. In addition, the impact of incentive plan leverage can also be tested. For example, the relative impact of realizable be can be tested at the threshold, target, and maximum performance levels and evaluated along with the full distribution of performance outcomes.
    • Prospective pay-for-performance: Future performance goals at target, threshold and maximum can be used to evaluate the potential relative performance impact. This may be another element in designing the future target and range for an incentive plan and evaluating the strength of performance alignment. Forward-testing of new incentive design parameters can ensure if potential pay outcomes are aligned with desired competitive positioning under various performance scenarios.

  1. Adjusting your pay components: In addition to simulating the overall change in realizable pay to view the pay-for-performance alignment impact, each of the individual realizable pay components can be further broken out and tested. Sensitivity analyses can be done for any combinations of base salary, bonus, non-equity incentive plan payouts, long-term incentives, and other compensation. Different scenarios can be performed to understand which pay components can be adjusted to achieve a target realizable pay level for the pay-for-performance alignment analysis.

Next Steps

The pressure is on to provide comprehensive disclosure of pay-for-performance and effective communications for compensation programs both internally and externally, especially as proxy advisory firms and compensation database providers come up with different analytics and alternative definitions of compensation.

Aon’s CG Pro goes beyond the typical pay-for-performance alignment analyses to analyze the nuances that exist in the components of realizable pay. The new CG Pro report on super realizable pay along with the Pay and Performance Curve report in CG Pro bring an unprecedented scope of data, analytics, and insights for incentive plan goal-setting and aligning pay outcomes with performance. Both the Super Realizable Pay report as well as our Pay and Performance Curve report in CG Pro bring an unprecedented scope of data, analytics, and insights for incentive plan goal-setting and aligning pay outcomes with performance.

If you have any questions for our executive compensation experts about designing better incentive plans or would like a demo of Aon’s CG Pro to learn more about these capabilities, please contact us now.

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