The Future of Executive Compensation Disclosure: Trends and Innovations in ECD Taxonomy

Introduction :

Section 953(a) of Dodd-Frank requires public companies to disclose the relationship between executive compensation and company financial performance in their annual proxy statements. In response, the SEC added Item 402(v) to Regulation S-K in August 2022. For fiscal years ending on or after December 16, 2022, proxy statements must include :

1. A new compensation table showing total compensation, “executive compensation actually paid,” company TSR, peer group TSR, net income, and a company-selected financial measure for the past five years.
2. A description of the relationships between executive compensation and TSR, net income, the company-selected measure, and a comparison of the company’s TSR with peer group TSR.
3. A tabular list of three to seven other financial performance measures.

Key Components of ECD Taxonomy :
1. Base Salary :
     o Annual fixed salary paid to executives.
2. Bonuses :
     o Short-term incentives based on performance metrics.
3. Stock Options and Equity Awards :
     o Long-term incentives including stock options, restricted stock units (RSUs), and performance shares.
4. Non-Equity Incentive Plan Compensation :
     o Cash bonuses tied to achieving specific targets.
5. Pension and Deferred Compensation :
     o Retirement benefits and deferred compensation plans.
6. Other Compensation :
     o Perks such as insurance, travel allowances, and other benefits.
7. Narrative Disclosures :
     o Explanations and justifications for compensation decisions and policies.
8. Performance Metrics :
     o Financial and non-financial metrics used to determine incentive pay.
9. Compensation Committee Report :
     o Statement from the committee responsible for setting executive pay.

Disclosure Requirements :

More specifically, proposed Item 402(v) would require companies to include in a tabular format :

• The total compensation reported in the Summary Compensation Table for the PEO and the “executive compensation actually paid” to the PEO.
• An average of the total compensation reported in the Summary Compensation Table for the remaining named executive officers and an average of the “executive compensation actually paid” to the remaining named executive officers. Footnote disclosure of the names of individual named executive officers and the years in which they are included is also required.
• The company’s cumulative annual TSR calculated in accordance with Item 201(e) of Regulation S-K (i.e., in the same manner as in the Stock Price Performance Graph required in annual reports to shareholders).
• The cumulative annual TSR of the companies in a peer group chosen by the company (which may be the same index or peer group used for the purposes of Item 201(e)(1)(ii) or the peer group used in the Compensation Discussion and Analysis for benchmarking purposes).
• The company’s net income calculated in accordance with U.S. GAAP.
• A financial performance measure chosen by the company that the company has determined represents the “most important financial performance measure” that the company uses to link compensation actually paid to the named executive officers to company performance for the most recently completed fiscal year. If such measure is a non-GAAP measure, disclosure must be provided as to how the number is calculated from the issuer’s audited financial statements, but a full reconciliation is not required.

In addition, the final rules require companies to accompany the new table with disclosure that “use[s] the information provided in the table … to provide a clear description of the relationship” between :

• Executive compensation actually paid to the named executive officers and the company’s TSR across the last five fiscal years;
• Executive compensation actually paid to the named executive officers and the company’s net income across the last five fiscal years;
• Executive compensation actually paid to the named executive officers and the company-selected financial measure; and
• The company’s TSR and the TSR of its peer group.

These descriptions can include narrative or graphic disclosure, or both. If additional voluntary performance measures are added, the disclosure must explain the link between executive compensation and these measures over the past five fiscal years.

Companies must also provide a table of three to seven key financial performance measures that link compensation to company performance for the most recent fiscal year. At least three must be financial measures, but non-financial measures can also be included. If fewer than three financial measures were used, all such measures must be listed.

The narrative/graphical disclosure requirements

After determining the presentation of the PVP table with the required financial measures, companies must provide a clear narrative and/or graphical description of the relationships between executive compensation actually paid and each financial measure. This is to meet the SEC requirement to disclose the “relationship” between executive compensation and company performance for both the PEO(s) and the average of all other NEOs.

The SEC suggests options such as :

• A graph showing executive compensation and changes in financial measures (e.g., TSR, net income) on parallel axes over time.
• Narrative or tabular disclosure showing the percentage change in both compensation and financial measures each year, with a brief discussion on their relationship.

These comparisons are required to be made over a five-year period, although they should be covered by the transitional relief, meaning that in year one only a three-year lookback is required (two for SRCs).

Additional Considerations

• Filings and Timing of Disclosures.
Companies will be required to include the pay versus performance disclosure in all proxy and information statements that are required to include executive compensations disclosures under Item 402 of Regulation S-K for fiscal years ending on or after December 16, 2022. Under the transition rules, companies will only be required to provide disclosure for three years in the first proxy or information statement in which disclosure is provided, adding one additional year in each of the two subsequent years. In addition, disclosure is only required for fiscal years in which the company was a reporting company. The Item 402(v) disclosure will be treated as “filed” for the purposes of the Exchange Act.

• Issuers Subject to the Final Rules.
The final rules require pay versus performance disclosure for all companies other than emerging growth companies (which are statutorily exempt from the requirements pursuant to the Jumpstart Our Business Startups Act), foreign private issuers, and registered investment companies.

• XBRL.
Companies will also be required to tag each value disclosed in the table, block-text tag the footnote and relationship disclosure, and tag specific data points within the footnote disclosures in interactive data format using eXtensible Business Reporting Language, or XBRL.

INSTANCE DOCUMENT CONTENTS

An Inline XBRL document mainly consists of XHTML elements and attributes, along with Inline XBRL (iXBRL) elements to mark required information. Inline XBRL tagging for proxy or information statements is relatively new compared to financial statements. Therefore, old HTML documents like DEF 14A or DEF 14C must first be converted to XHTML before tagging.

Where to put this in the proxy statement?

The SEC allows flexibility in where the PVP disclosure appears, as it is a stand-alone requirement. Companies can place it within the CD&A as a separate section or highlight it in executive summaries. Due to potentially lengthy footnotes, careful consideration of its placement relative to other important content is necessary.

To Whom it will be applicable :

Applies to all reporting companies other than
1. Foreign private issuers
2. Registered Investment Companies
3. Emerging growth companies

Smaller reporting companies

Smaller reporting companies are subject to scaled disclosure requirements. In the table and accompanying comparative description, smaller reporting companies are not required to provide a peer group TSR or any company-selected measure. In addition, the calculation of executive compensation actually paid will exclude the adjustments relating to pensions.

ECD Impact on Stakeholders :
• Investors : Increased confidence and informed decisions.
• Employees : Perceptions of fairness and morale.
• Regulators : Changes in regulatory approaches.
• Public and Media : Influence on media coverage and public perception.

The Current State of ECD Taxonomy
• Regulations and Standards : Executive compensation disclosures are governed by regulations such as the SEC requirements and the Dodd-Frank Act. These standards mandate companies to provide detailed reports on executive pay.
• Disclosure Practices : Most companies disclose executive compensation annually through proxy statements, detailing salaries, bonuses, stock options, and other financial rewards.
• Challenges : Current ECD practices face issues like lack of uniformity in reporting formats, insufficient granularity, and limited integration of non-financial performance metrics. These challenges make it difficult for stakeholders to fully understand and compare executive compensation across different organizations.

Current Challenges in ECD Taxonomy :

1. Lack of Uniformity :
     o Inconsistent reporting formats and methods across different companies make it difficult to compare executive compensation accurately.
2. Insufficient Granularity :
     o Disclosures often lack detailed breakdowns of how compensation components are calculated, leading to a lack of clarity for stakeholders.
3. Complexity and Opacity :
     o The complexity of compensation packages, including various types of bonuses, stock options, and incentives, can obscure the true value of executive pay.
4. Limited Non-Financial Metrics :
     o Current disclosures often focus heavily on financial performance metrics, neglecting important non-financial factors such as environmental, social, and governance (ESG) criteria.
5. Timeliness :
     o Annual disclosures can be outdated by the time they are published, failing to provide timely insights into executive compensation.
6. Regulatory Compliance Burden :
     o Companies face significant administrative burdens to comply with diverse and complex regulatory requirements, which can be resource-intensive.
7. Stakeholder Understanding :
     o The technical nature of disclosures can be difficult for average investors and stakeholders to understand, reducing the effectiveness of transparency efforts.
8. Limited Context :
     o Without comprehensive context, such as industry benchmarks or performance comparisons, stakeholders may struggle to assess the appropriateness of compensation packages.

Suggested immediate action steps for ECD considerations :

• Acquaint the key decision makers with the details of the rules. Senior management, the compensation committee, legal, finance and investor relations will all have a role to play in making strategic and tactical decisions, and then in populating the tables.
• Have each of those groups identify who will be responsible for which aspects of the disclosure, and make sure they have the bandwidth to accomplish each task required within the required timeline.
• Determine a process for identifying the most important performance measures in respect of compensation actually paid for the year based on the weighted relevance of performance measures for 2022 actual compensation.
• Calculate compensation actually paid for anticipated named executive officers (NEOs) on the various measurement dates. Given that calculation of equity fair values on this new basis was not required under prior rules, it will be important to identify who will perform the required valuations.
• Determine a total shareholder return (TSR) peer group, conducting the appropriate back-testing using each of the permissible peer groups. Identify potential disconnects with other disclosures, such as outcomes under relative TSR performance conditions in case the SEC PVP methodology yields significantly different values.
• Secure space in the proxy statement and determine where you intend to locate the PVP disclosures. The disclosure requires a number of supplemental tables, so make sure you have enough room. Start early in updating the CD&A, looking for potential areas of overlap or complication (such as more prominent disclosures related to realizable or realized pay that could be confusing to investors). Ensure the reporting team is prepared for the required XBRL tagging which will be a new requirement for the proxy statement.

Integration of ECD Taxonomy with ESG Reporting :

1. Expanded Disclosure Requirements :
     o ESG reporting frameworks include non-financial metrics like environmental impact and social responsibility.
     o Integration involves disclosing executive compensation practices linked to these ESG metrics, aligning incentives with sustainability goals.
2. Linking Compensation to ESG Performance :
     o Companies tie executive compensation to ESG targets such as carbon reduction or diversity goals.
3. Narrative Disclosures :
     o ECD taxonomy is used to explain compensation decisions in the context of ESG performance, enhancing transparency.
4. Meeting Stakeholder Expectations :
     o Investors seek insight into how compensation aligns with sustainability.
5. Regulatory Compliance :
     o Integration ensures compliance with regulations requiring disclosure of ESG-related compensation practices.

Benefits of Future Innovations in Executive Compensation :
1. Transparency : Enhanced transparency in compensation decisions.
2. Accountability : Increased accountability among executives and committees.
3. Fairness : Promotion of fairness and equity in compensation.
4. Customization : Tailored incentives to individual roles and objectives.
5. Long-Term Focus : Alignment with long-term value creation.
6. Risk Mitigation : Reduction of risks associated with compensation practices.
7. Innovation : Stimulated innovation and creativity.
8. Talent Attraction : Improved ability to attract and retain top talent.
9. Adaptability : Flexibility to adapt to changing business environments.
10. Governance : Enhanced corporate governance practices.

Case Studies and Examples

Leading Companies :
1. Microsoft : Known for its comprehensive and transparent executive compensation practices, Microsoft ties executive pay to performance metrics, including sustainability goals.
2. Salesforce : Salesforce integrates ESG metrics into its executive compensation plans, demonstrating a commitment to social and environmental responsibility.
3. Unilever : Unilever aligns executive compensation with long-term sustainability targets, promoting responsible business practices.
4. Apple : Apple’s compensation strategy includes transparency and clear performance-based metrics, fostering accountability and investor confidence.
5. Danone : Danone has been a pioneer in linking executive compensation to environmental and social performance, emphasizing sustainable growth.

Success Stories :
1. Unilever :
     o Improved Governance : By integrating sustainability targets into executive compensation, Unilever enhanced its governance and commitment to long-term value creation.
     o Stakeholder Relations : This approach has strengthened relationships with investors and other stakeholders who prioritize sustainability, boosting trust and support.
2. Microsoft :
     o Enhanced Accountability : Microsoft’s transparent linking of executive pay to performance, including diversity and inclusion metrics, has improved accountability.
     o Increased Trust : These practices have increased stakeholder trust and aligned executive incentives with company performance and values.
3. Salesforce :
     o ESG Integration : Salesforce’s inclusion of ESG targets in executive compensation plans has reinforced its commitment to ethical practices.
     o Positive Impact : This integration has not only improved governance but also attracted socially responsible investors, enhancing stakeholder relations.
4. Apple :
     o Clear Metrics : Apple’s use of clear, performance-based metrics for executive compensation has made its compensation practices more transparent and understandable.
     o Investor Confidence : This transparency has bolstered investor confidence and demonstrated a commitment to rewarding genuine performance.

Future Outlook :
The evolution of ECD taxonomy is likely to be driven by continued technological advancements, greater integration with ESG metrics, and increasing regulatory requirements. These changes will foster enhanced transparency, accountability, and alignment of executive compensation with long-term organizational goals and societal values.

Further Reading :

WTW Pay vs. performance blog :
The below represents an updated version of an article first published by WTW in August 2022, updated for inclusion in this Executive Compensation Disclosure Handbook February 2023 Edition.

Authors : Heather Marshall, Steve Seelig
On August 25, 2022, the Securities and Exchange Commission (SEC) adopted final rules implementing the pay versus performance (PVP) requirement in the Dodd-Frank Act. First proposed in April 2015 Below we provide discussion of the rules, along with our observations of issues to confront and resolve. While there are many questions around interpretation in the absence of frequently asked questions from the SEC, we cover the key action steps WTW has suggested to companies just starting the process in the fall of 2022. Calendar year companies likely will already have taken these steps on the path to their first disclosure, while others will just be starting their process