0. Pay Versus Performance: SEC Proposed Disclosure Rules
Daniel Coleman – Aon
CJ Van Ostenbridge – Aon
November 2016

1. Pay vs. Performance History
Section 953(a) of the Dodd-Frank Act takes effect
July 2010
SEC proposes an additional disclosure requiring companies to illustrate “Pay vs. Performance” (“PvP”)
April 2015
SEC approves final rules around CEO Pay Ratio Disclosure
August 2015
FASB releases Accounting Standards Update affecting the accounting of share-based payments
March 2016
SEC approves final rules around PvP Disclosure?
2017?

2. Proposed Rules of PvP Disclosure
“Compensation Actually Paid”
Company Performance (TSR)
Year
SCT Total For Principal Executive Officer (CEO)
Compensation Actually Paid to CEO
Average SCT Total for
Non-CEO NEOs
Average Compensation Actually Paid to Non-CEO NEOs
Company TSR
Peer Group TSR
5-year tabular disclosure. However, initial disclosure can be 3 years and build to 5 years, and smaller companies would only need to disclose most recent 3 years
Cumulative TSR for the company and the peer group for the same period as under S-K, Item 201(e) (i.e., the performance graph)
Disclosure would not apply to:
Emerging growth companies
Foreign private issuers
Registered investment companies
The disclosure will be required in any proxy or information statement for which S-K, Item 402 is required (i.e., Summary Compensation Table), but not required to be included (or incorporated by reference into) Form 10-K or Securities Act registration statements
“Compensation Actually Paid” will be calculated using the Total Compensation from the SCT except it will include the value of awards vesting in the year (not the grant date fair value) and service cost of pension plans (not actuarial present value)
Pulled directly from Summary Compensation table
*Disclosure would not apply to emerging growth companies, foreign private issuers, or registered investment companies
**Disclosure will be required in any proxy or information statement for which S-K, Item 402 is required (i.e., Summary Compensation Table), but not required to be included (or incorporated by reference into) Form 10-K or Securities Act registration statements

3. What is Compensation Actually Paid?
Base Salary
Equity Vested During the Year
Service Cost
All Other Compensation
Above Market Earnings
Non-Equity Incentives
Fair Value calculated on the vesting date. Differs from SCT which includes value of equity when granted.
Differs from “Change in Pension Value” disclosed in SCT. Service cost is the measure of the present value of benefits earned only during the year, and does not reflect changes in interest/discount rates, mortality tables, etc.
If more than one CEO in the year, must include aggregate compensation paid to all CEOs in year
SCT Compensation Disclosure
- Change in Pension Value
- Grant Date Fair Value of Equity
+ Service Cost under Defined Benefit Plans
+ Vest Date Fair Value of Equity
Compensation Actually Paid

4. How is TSR Measured?
Cumulative TSR for the company and the peer group for the same period as under S-K, Item 201(e) (i.e., the performance graph)
The measurement period will be the period beginning at the measurement point established by the company’s earliest fiscal year in the table, through and including the end of the company’s last completed fiscal year
The comparison group can be either the industry index and/or selected peers for the performance graph, or the compensation benchmarking peer group
TSR is calculated using spot prices at the start and end of the measurement period, assuming dividend reinvestment
TSR is also market cap weighted for this disclosure, with the market cap weightings be fixed at the start of the measurement period
TSR is also normalized to an initial $100 investment as in the performance graph

5. Valuing Outstanding Equity
Vest date fair values must be calculated for all equity that vests in the given year
Full Value Awards
Vest date value of awards equals (stock price at vest) x (number of shares vested)
However, if the award contains a mandatory post-vest holding period, an updated vest date valuation for the discount for lack of marketability must be performed.
Options
Must follow valuation guidance under ASC Topic 718
Economic assumptions (volatility, risk-free rate, dividend yield) should align with the weighted average values disclosed in the 10-K filing for the year
New concept, start with basics

6. Expected Life Problem
Different methods exist to determine the expected life for options at grant, but these same methods may not be appropriate for options are no longer at-the- money
Option Returns to
In-The-Money
Simulated
Exercise
Different methods exist to determine the expected life for options:
Simplified approach under the SEC’s Staff Accounting Bulletin #107/#110
IRS Revenue Procedure 98-34
Study of historical exercise behavior
Simple Solution: Use an expected life longer than the simplified approach for out-of-the-money options and potentially a shorter one for in-the-money options
More Accurate Solution: Use Monte Carlo simulation or a Hazard Rate Model to project prices and exercise behavior
Potential New Solution: Use the Society of Actuaries Study on Expected Life
Vest Date

7. Fair Value Problem
For options that are deeply into the money, fair values under the Black-Scholes model may not make sense.
An example:
An intrinsic value greater than the fair value would imply it’s more advantageous to exercise now, going against financial theory.
This is the result of a flaw within the Black-Scholes model when there is a negative drift rate (i.e., dividend yield exceeds the risk-free rate).
With interest rates so low right now, if you are a large dividend paying company, this could impact you.
Solution: Accounting guidance allows for special one-time use of different option-pricing models for specific situations. As a result, companies should use a Binomial model (such as the Cox-Ross-Rubinstein model) which assumes option holders would exercise early to receive the value of future dividends in this situation
Could be trimmed for time if needed

8. Market Cap Weighting TSRs
The proposed rules also require the TSRs be market cap weighted. For comparisons to an index, most are already market cap weighted, so no additional work is required. For custom groups or the compensation benchmarking group, TSRs will need to be manually adjusted for market caps.
This puts what may be undue weight on the largest of the peers, drawing a comparison to the biggest companies.
Unfortunately there is no way around this if it is part of the final rules. The best approach is to be prepared to show illustrations against other groups or without market cap weighting if needed.

9. Other Considerations
PvP disclosure must align with fiscal years, but performance equity may payout based on a different period
Misalignment of Periods
Compensation actually paid is measured on an absolute basis, while performance (TSR) is shown relative to peer group
Likely not possible to disclose relative pay, as a company’s peers may disclose at the same time (or after) the company
Absolute Pay vs. Relative Performance
The proposed rules require performance to be measured against the group used in the performance graph within the 10-K or the compensation benchmarking peers, but relative performance equity plans do not compete against the same group
Company measures performance one way, investors see performance measured in different way
Peer Group Disconnect
Keep concept, reduce down text

10. What about the Narrative?
The proposed rules also require footnote disclosure of the amounts deducted and added, along with any assumptions used (like in the equity valuation process)
Also required is the description (narrative or graphic) of the relationship between:
Executive compensation actually paid to the CEO and the average of executive compensation actually paid to the NEOs (other than the CEO)
Cumulative TSR of the registrant for each of the last five completed fiscal years
Comparison of the cumulative TSR of the company and cumulative TSR of the peer group over the same period
We expect lengthy disclosures to help explain the relationship, if not added disclosures (around pay philosophy or performance against other peers)

11. Other Considerations
The Narrative - We expect initial narratives to be very thorough, explaining the positive aspects of the pay-vs.- performance relationship within the disclosure and where the disclosure may have gaps, not limited to but including the prior items.
Many companies may choose to do supplemental analysis against different groups and with different measurement dates to help explain the disclosure
Many narratives will likely include graphic representation as well to help illustrate the relationship through the disclosure as well as any supplemental analysis.
Proxy Advisors – We expect ISS and Glass Lewis to comment on the disclosure but it’s unlikely either adopts this disclosure as their own pay-vs.-performance tests. We do not expect the ISS and Glass Lewis tests to go away, creating yet another comparison companies need to pay attention.
These rules are not final yet, so much could change. The current proposal definitely has gaps so it’s best to stay in front of it.

12. Questions?
Questions?
Contact Us:
Daniel Coleman
CJ Van Ostenbridge
Associate Partner
Consultant
Aon plc
(312)
(415)