Time to rethink performance shares?

This is the year that the two leading proxy advisors separately ask clients whether to abandon their favoring of CEO ‘performance shares’ over simpler stock incentives. That is significant because both Institutional Investor Services (ISS) and Glass Lewis for years have heralded three-year performance metrics for equity grants as a measure of good compensation practices. The problem is that it does not seem to work. And it does seem to be expensive.

ISS and Glass Lewis should be commended for listening to concerned investors, like ourselves, and openly inviting views on the merits of simpler, more transparent and longer-term equity grants as replacement for popular but complex performance-conditioned grants. Both agencies have transparently published their consultations online, for which they also deserve credit. See ISS’ Annual Global Benchmark Policy Survey (questions 15-20) and Glass Lewis’ 2024 Investor Client Policy Survey (question 22).

We have officially been among the skeptics on performance shares since we published a position paper on CEO compensation in 2017. Both ISS and Glass Lewis note that some investors, and maybe a growing number, question current practice.

Paradoxically, performance share units (PSUs) have at the same time grown in popularity among US listed firms, often in the belief that investors prefer this incentive design.

PSUs growing the pay, but are they working?

Indeed, based on data, the growth in PSU grants is arguably the strongest factor behind the growth in US CEO pay since the financial crisis. From 2017 to 2023, granted PSUs made up almost 90% of the growth in the nominal combined value of CEO pay, as reported, across our US portfolio constituents.

This statistic understates the actual quantitative importance of PSUs. PSUs are conventionally included in total pay figures on the assumption that the granted PSUs will vest at target performance. Our analysis of observed vesting levels for PSUs over the last seven pay years demonstrates that PSU vesting is markedly skewed to the upside of the target level for CEOs who served through the three-year vesting period. We used ISS pay data taken from companies’ proxy statements and matched them with BoardEx CEO data and our US portfolio. Any investor running the numbers will make the same finding. Hence, the increased usage of PSUs by American firms has increased the cost of compensating CEOs more than what immediately meets the eye.

That would maybe have been a price worth paying for investors if PSUs increased financial performance. The so far limited academic research on the topic, however, indicates that ‘performance shares’ lead to significantly worse returns for shareholders.[1] Marc Hodak found that S&P 500 firms using PSUs consistently underperformed sector peers without PSUs over rolling three-year periods between 2008 and 2017. When we run the 2017-2023 numbers on our US equity holdings (USD 628 billion, 1803 companies including almost all S&P 500 constituents) we make the same finding. The outperformance of the stubborn minority of firms without PSUs remains when controlling for company size, beta and other factors.

An alternative: simple, longer-term equity

Our 2017 position was influenced by our experience as practitioners in stewardship, but also by a rich academic literature indicating agency problems in target setting and benefits of CEO stock ownership.[2]

We suggest that companies incentivize CEOs on the long term by settling much of the compensation in stocks that are locked for 5-10 years. Such simple stock incentives would replace or reduce the more complex and shorter-term PSUs. We argue that PSUs tend to be complex and non-transparent. In practice, they often expose the CEO to shifting and short-term milestones with a risk that management is distracted into making suboptimal decisions. The three-year metrics tend to disturb the exposure to the performance of the underlying shares.

On the other hand, longer-term simple equity incentives align management better with shareholder interests. This approach shifts attention towards the wealth effect for the CEO of stock performance over a number of years, and away from the nearer-term management of results against more or less fitting metrics. Simple, unconditioned stock grants provide complete transparency on incentives and quantum, letting the compensation committee better control the cost of compensating the chief executive.

Despite the common classification of incentive equity grants as ‘time-based’ or ‘performance based’, we would argue that, over the long haul, all shares are performance shares. Stock return is not a perfect measure of management effectiveness, but over extended time periods we seldom see strong stock performance without strong management.

The opportunity for change

The proxy advisories’ policy consultations this summer and fall are an opportunity to adjust course and no longer view performance shares as favorable compared to simple equity incentives. It is also an opportunity to suggest that equity grants with longer time horizons are viewed more favorable than those with shorter time horizons. Moves towards stretching the time horizon should be supported, whether it takes the form of post-employment stock-holding requirements, lengthening of the longest vesting period for grants vesting in tranches, lengthening of the weighted average vesting period in each grant, moves to ‘cliff vesting’ from less-rigorous ratable vesting (i.e. all grants vest at the same time rather than gradually up until that time), etc. A policy or practice whereby the CEO demonstrably holds onto all or most of the allotted after-tax shares should also be viewed favorably.

Consistent with this view, in our day-today voting and engagement practice, we are more likely to support if the vesting schedule extends to at least five years, or if a long-term and meaningful equity exposure for the CEO is secured in comparable ways. In our discussions with compensation committees, we encourage the ways of lengthening of time horizons listed above.

Proxy advisories’ love affair with performance metrics, however, pose headwinds for companies wanting to align CEOs by paying in simple, long-dated equity. Discussions this fall amongst investors and with their advisors will be followed closely.

Our responses to ISS and Glass Lewis are available here:

ISS Annual Global Benchmark Policy Survey | Norges Bank Investment Management (nbim.no)

Glass Lewis 2024 Policy Survey | Norges Bank Investment Management (nbim.no)

1Hodak, Marc, 2019, Are Performance Shares Shareholder Friendly? Journal of Applied Corporate Finance 31, 126-130.(go back)

2See, inter alia, Lilienfeld-Toal, Ulf von and Ruenzi, Stefan, 2014, CEO Ownership, Stock Market Performance, and Managerial Discretion, The Journal of Finance, Vol. LXIX No. 3, June 2014, 1013-1050.(go back)