Executive Compensation Performance Metrics Will Change Under Tax Reform

On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law, introducing the most sweeping changes to the tax code seen in decades. One of the most notable changes is a reduction in the corporate tax rate from 35 percent to 21 percent.

The obvious impact? Going forward, companies generally will pay less tax while making a larger share of profit available to shareholders. Less obvious is how tax reform will immediately affect financial statements. The change in the tax rate has some complicated ramifications on companies with deferred tax assets (DTAs), deferred tax liabilities (DTL), and significant profits outside the U.S. that are subject to repatriation taxes. The tax reform also changes section 162(m) of the tax code, which affects the deductibility of taxes for senior executives.

Here’s what each of these changes means to outstanding annual incentive and long-term incentive awards.

FEI Daily | 01/23/2018by FEI Daily Staff

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Tax Reform and the Effect on Equity Compensation

In December 2017, the Tax Cuts and Jobs Act was signed into law, and among other changes, reduced the corporate tax rate from 35% to 21%. The act also ended the performance-based exemption to IRC Section 162(m) and expanded the pool of employees to which it applied to include the CFO. In other words, companies will no longer be able to deduct compensation in excess of $1 million paid to their top 5 executives starting in the 2018 tax year.

In 1993, the amount of compensation that corporations could deduct from their taxable income was capped at $1 million for select executive officers (the CEO and the 3 highest paid officers, excluding the CFO). The then-fresh change to the tax code came with a loophole. If the compensation was considered performance-based, then it was exempt from the rule and could be deducted—even if the executive received compensation in excess of the $1 million limit.

January 23, 2018

By Matthew Goforth, Senior Governance Advisor, Equilar

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The Corporate Profit Windfall from the Tax Law Change

The tax reform bill that was signed into law on December 22, 2017 has many implications for individuals and businesses in 2018. Among other things, the bill includes a doubled standard deduction, a higher exemption from the estate tax, and limits on state and local tax deductions. Perhaps the largest change included in the bill is the reduction in the corporate tax rate from 35 percent to 21 percent. Even for companies that are not currently paying the full 35 percent tax rate, the new rate is likely to be a significant reduction in their tax burden. So, what exactly are companies going to do with the increased funds?

There are several possible ways that corporations may allocate their tax savings. Buying back shares, increasing dividends or ownership payments, increasing capital expenditures, hiring more workers, and increasing pay for employees have all been mentioned as ways that the money may be spent.

Around the time the bill was signed, several companies announced bonuses or increased pay for their employees. AT&T was the first, announcing a $1,000 bonus to many of its workers. Fifth Third Bancorp, a regional bank, decided to provide a $1,000 bonus, as well as increase the minimum wage for all its employees to at least $15 per hour. Wells Fargo also said that it would increase the minimum wage for its workers to $15 an hour. Boeing announced improvements to its benefits plan, as well as investments in workforce training and facilities. It is likely that other companies will follow suit in 2018 as they fully understand the tax bill changes.

There have also been indications that the slow pace of wage growth the U.S. has experienced since the recession is beginning to accelerate, and companies would do well to consider these changes in addressing their potential increase in net income from the tax law. The Labor Department reported that hourly earnings rose 2.9% in January, the largest year-over-year increase since June 2009, when the recession ended. Pay is rising at double the national average in metro areas such as Minneapolis, Denver, and Ft. Meyers, with unemployment near or below 3%. Employers in these metro areas are raising pay at or above pre-recession levels, and competition for skilled workers is especially intense. We believe that wage growth in these cities can be viewed as a bellwether for the country as the economy and labor market continue to improve.

Besides pay increases related to the tax reform bill, 18 states and a number of U.S. cities increased their minimum wage in 2018. Many of the states that are increasing their minimum wage are making substantial changes; in fact, the average increase among the 18 states is 4.4%, pointing to increases that go beyond the rate of inflation. Besides those who receive a pay raise directly due to the increases in minimum wage, other workers may be impacted as companies raise the pay for other hourly workers in order to control for wage compression in their pay structure.

Providing one-time bonuses may garner media attention, but the impact is short lived and doesn’t take into account increasing hourly earnings. Indicators are pointing toward increases to general wages for the first time since the recession, and 2018 may be the year that pay increases go beyond the 3% increase that has been typical in recent years. Companies may be wise to revisit their compensation systems in 2018 to ensure their ability to attract new hires, provide competitive pay to existing employees, and strengthen the link between pay and performance. Since the recently passed tax bill focused on substantially reduced corporate tax rates and will result in increased profits, companies who have funds available should consider whether their pay systems need an update in 2018.

-The POE Group
www.POEGroup.com

Tesla’s Elon Musk May Have Boldest Pay Plan in Corporate History

For the last several years, there has been speculation about Elon Musk’s future at Tesla, and whether he would step down as chief executive in the next year or two.

Mr. Musk stoked that speculation as far back as five years ago when he said he wanted to stay through the introduction of the Model 3. Then in 2014, he said, “I’ll have to see, you know, how things are going at that point,” adding, “I will certainly be the C.E.O. for the next four or five years, and it’s T.B.D. after that.”

With the success of Mr. Musk’s various other endeavors, such as Space X, his aeronautics company, it was only natural that investors would expect that the model for Robert Downey Jr.’s Tony Stark character in “Iron Man’’ might move on to a different role at Tesla.

NEW YORK TIMES. JAN. 23, 2018. Andrew Ross Sorkin

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Say-on-Pay Rulebook – “Do’s and Don’ts” from an Investor Perspective

In today’s environment, boards are hard pressed to follow the traditional approach of utilizing pay and benefits as they see fit to “attract, retain, and motivate” the managers who, in their view, will ensure the corporation’s success. Proxy advisors -- and many institutional shareholders -- rely on quantitative models to filter for companies that appear to have pay-performance disconnects or certain unacceptable practices. Both ISS and Glass Lewis follow their filtering with a qualitative assessment that takes into account a variety of company-specific factors; but the advisors and many investors are obligated to follow a consistent framework in applying their policies, sometimes leaving little room for the nuances of business exigencies. The proxy advisors also regularly evolve their policies to reflect new regulations and new thinking (that stock hedging and even pledging by executives and directors raises risks to shareholder value, for example). Even the new CEO-to-median-employee pay ratio that will emerge in 2018 proxies may eventually make its way into advisor and mainstream investor policies, though neither of those groups appears to have formalized public guidelines as yet. 

Carol BowieSenior Advisor, Teneo Governance

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How the Highest-Paid Boards Compare to Peers

Since the enactment of Say on Pay following the passage of Dodd-Frank, executive compensation has been closely watched and scrutinized by corporate shareholders. However, the compensation of those who represent shareholders—the board of directors—often flies under the radar. While no mandated check or balance like Say on Pay currently exists for director compensation, recent events may change the current governance landscape.

As covered in a recent Equilar blog, Institutional Shareholder Services (ISS) published annual updates to its proxy voting guidelines. With respect to director pay, the new guidelines state:

“[ISS will] generally [recommend a] vote against members of the board committee responsible for approving/setting non-employee director compensation if there is a pattern (i.e. two or more years) of awarding excessive non-employee director compensation without disclosing a compelling rationale or other mitigating factors.”

EQUILAR. January 15, 2017

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CEO Pay Ratio Development Considerations

Included in the 2010 Dodd-Frank Act is Section 953(b), the so-called CEO pay ratio rule, which requires publicly traded companies to disclose the ratio of their CEO’s pay to that of their median employee. Companies will be required to report the pay ratio disclosure based on compensation paid in their first full fiscal year beginning on or after January 1, 2017. 

There have been recent proposals to defer or repeal portions of the Dodd-Frank Act, including the CEO pay ratio rule. In fact, a Treasury Department report released on October 6, 2017 recommended that “section 953(b) of Dodd-Frank be repealed and any rules issued pursuant to such provisions be withdrawn.” However, any potential changes to the requirement are not likely to occur before the filing deadline, so companies should prepare to include the disclosure in the next proxy filing. 

We predict that there will be significant discussion in the media regarding the CEO pay ratio once 2018 proxies are filed, so the messaging contained in the proxy will be important. While there is likely to be some attention focused on the methods of disclosure for the pay ratio in each company’s proxy, it’s hard to argue that anything will prove to be more important than the ratio itself. To that point, companies must consider that the media is likely to provide significantly more coverage to disclosures where the ratio of CEO pay to median employee pay is deemed very high. 

Since there is little flexibility in calculating CEO pay, if the goal is to minimize the magnitude of the ratio, then the method of determining the median employee becomes the key. Certainly, having the highest possible median employee compensation would minimize the ratio, but consideration needs to be given to employees’ reaction to the median compensation figure. Employees already understand that the CEO makes a lot more than most employees, but they may be more interested to see how their own pay compares to the median worker. Accordingly, using a method of identifying the median employee that results in a higher pay level may not be the most desirable in all circumstances. 

Suggested Steps 

1. Determine the effective date that will be used to determine the employee population, and thus the median employee. This date can be any date within the last three months of the fiscal year that the proxy is being prepared for. 

2. Compile a payroll report for all employees who were employed on the effective date, including basic information such as name, position, and hire/termination dates. The report will also need to include compensation data such as salary, overtime, and bonuses. Another measure of compensation that would be useful to include is the amount in Box 3 of the employee’s W-2 (Medicare taxable wages). 

3. Once the employee compensation data is compiled, it will be useful to identify the median employee in a couple of different ways. We suggest using total cash compensation, as well as W-2 Box 3 wages, in order to see how the results differ using each method. 

4. After the median employee is identified, compile information on equity grants, company paid benefits, company contributions to retirement plans, and the actuarial change in pension plan value (if applicable) for that median employee. 

5. Prepare the total compensation figure for the median employee the same way that the CEO’s total compensation figure in the Summary Compensation Table (SCT) was prepared. 

6. Determine the ratio of the CEO’s SCT total compensation to the total for the median employee. 

7. Prepare the disclosure, including the median employee’s annual total compensation, the annual total compensation of the CEO, and the ratio of these two amounts. 

8. Consider whether additional ratios and supplemental disclosures are appropriate. Additional information is permitted, so long as the information is accurate and is not given greater prominence than the required disclosure. One possible additional ratio would be total realized pay of the CEO versus the median employee. This would be particularly useful in a year where the CEO had a large equity grant, but realized pay was much less. 

Important Considerations 

 The rules allow for (but do not require) compensation to be annualized for permanent employees who did not work a full year. Consider whether annualizing pay for these employees helps achieve the company’s goals related to the CEO pay ratio disclosure. Note that pay for temporary or seasonal employees cannot be annualized, and pay for part-time employees cannot be converted to full-time equivalent rates. 

 When looking to identify the median employee, do not include independent contractors or anyone who is not considered an employee of the company as of the specified date. The SEC notes that companies should “apply a widely recognized test under another area of law that the registrant otherwise uses to determine whether its workers are employees.” 

 If the employee determined to be the median employee has “anomalous characteristics” in their compensation, then an employee with substantially similar compensation can be substituted. For instance, if the median employee did not receive any 401(k) match or did not participate in the company’s health insurance plan, but the typical employee did receive these benefits, then a substitution could be made. 

 There is not much flexibility in the calculation of the CEO’s pay in the SCT; however, items under non-discriminatory benefit plans that total less than $10,000 can either be included or excluded. If included for the CEO, the same items would need to be included for the median employee. Depending on the end goal, including or excluding something like the portion of health insurance paid by the company could significantly impact the ratio. 

 The final rule published by the SEC does allow for a de minimis exception, which provides that non-U.S. employees can generally be excluded from the calculation if they make up 5% or less of the company’s total employee population. This exemption could prove particularly useful for companies with just a handful of employees outside the U.S. 

Once the ratio of CEO pay to that of the median employee is calculated, it will be important to provide an explanation of the calculation methodology, as well as facts and circumstances behind the compensation of the CEO and median worker at the company. As the date for disclosing the CEO pay ratio grows closer, it will be important for companies to consider how employees, shareholders, and the media will react to the disclosure. Carefully crafted disclosures will assist in minimizing the risk of negative reactions while maintaining compliance with the existing law. 

Joe Kager, POE Group