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A New Way to Assess Pay for Performance

An interview with Simiso Nzima, Investment Director – Global Equity, Head of Corporate Governance at CalPERS



Simiso Nzima is an Investment Director – Global Equity and Head of Corporate Governance at CalPERS. In this role, he leads a team that is responsible for corporate engagement and proxy voting activities involving 10,000+ global equity portfolio companies in which CalPERS is a shareowner. The team undertakes constructive and confidential engagements with management teams and boards of portfolio companies to encourage them to incorporate environmental, social and governance (ESG) consideration—risks and opportunities—in their strategy development and capital allocation frameworks in order to generate long-term sustainable investment returns for shareowners.

Prior to his current role, Mr. Nzima spent 8+ years managing all aspects of portfolio construction and implementation of the CalPERS internally managed emerging markets equity book of $8B+ using index-oriented and alternative beta strategies, and $10B+ of global equity synthetic exposure. Before 2008, he spent 3+ years as a Corporate Governance Analyst at CalPERS. Prior to coming to the United States in 2003, he spent 3+ years as a Fundamental Equity Research Analyst and Portfolio Manager in his native Zimbabwe.

Mr. Nzima is a member of the Global Equity Leadership team, Governance and Sustainability Subcommittee (GSS) of the CalPERS Investment Office’s Investment Strategy Group (ISG), and Chair of the Proxy Voting Working Group (PVWG) of GSS. He is also a member of the Board of the Council of Institutional Investors (CII).

Mr. Nzima earned an MBA at the University of California at Berkeley, Walter A. Haas School of Business. He also holds a Bachelor of Commerce (Finance) honors degree from the National University of Science and Technology (NUST), Zimbabwe, and the CFA designation.

One of the many regulations resulting from the Dodd-Frank Act of 2010 was a requirement of corporate issuers to clearly disclose the relationship between compensation paid to executives and the financial performance of the corporation. For years, companies went back and forth on the best methodology to effectively disclose their pay stories. Ultimately, the general consensus over the years has been a framework that analyzes performance in relation to pay over a three-year horizon. However, the tide may be tilting toward a longer time frame.

C-Suite recently sat down with Simiso Nzima, Investment Director – Global Equity, Head of Corporate Governance at CalPERS, to discuss this very topic. CalPERS recently announced that it has developed a new compensation assessment framework that shifts from a three-year model to a five-year analysis. Nzima discussed the motivation behind this new framework and what it entails for compensation committees when it comes to constructing executive pay plans.

C-Suite: What was the motivation behind CalPERS introducing a pay for performance framework that shifts from the traditional three-year model to a five-year analysis? In 2018, CalPERS voted against 43% of pay programs—was this a precursor to building out the new framework?

Simiso Nzima: I will start by setting the context. CalPERS is a long-term investor. Our focus is on long-term sustainable value creation by our investee companies, and not on the quarterly earnings treadmill. Our pension fund has an actuarially required rate of return of 7%. For every dollar we pay out in benefits, 59 cents comes from investment returns. Therefore, generating long-term sustainable investment returns is critical to our mission as a retirement system.

During the 2017 proxy season, we identified executive compensation as an area requiring further research. It was clear to us that pay for performance was not working. Historically, we used a three-year pay-for-performance quantitative model and qualitative factors to determine our votes on Say on Pay (SOP) proposals. However, we needed more time to conduct extensive research before making any changes to our historic analysis framework. In the interim, and effective for the 2018 proxy season, we applied deeper analysis to pay and performance outcomes at portfolio companies. This resulted in our voting against 43% of SOP proposals in 2018, significantly higher than our five-year average of 16%.

We then conducted extensive research throughout 2018. Our research considerations included findings from academic and practitioner research, and multiple discussions with global asset owners, global asset managers, compensation consultants, and proxy advisory firms.

From our research, we concluded that three years was too short of a period to evaluate the outcomes of management decisions—hence, our move to a five-year model. Our motivation is to ensure that executive compensation is driven by long-term sustainable value creation and aligns management and shareowner interests. We want value-creating executives and employees to be rewarded appropriately for generating superior returns, and we want them to take a long-term view when making business decisions. For that reason, we believe incentive compensation should be primarily long-term.

CalPERS has introduced this new quantitative analysis in addition to a qualitative analysis. Can you please provide insight on the factors and criteria that go into the qualitative portion of the analysis?

Nzima: Our executive compensation analysis framework is made up of two complementary components—a five-year quantitative model and an assessment of qualitative factors.

Our quantitative model assesses pay outcomes relative to performance outcomes over a rolling five-year period on a relative basis to peers. It looks at total CEO realizable pay and total shareholder return (TSR). Pay and performance outcomes are standardized, and percentile ranked. The model attempts to quickly identify instances where peer benchmarking could be ratcheting up pay—instead of pay being driven by outperformance of peers.

We use total shareholder return (TSR) to measure performance outcomes because TSR is what we experience as investors. We believe that over the long term, the performance of a company’s stock will mirror the performance of its underlying business. As a long-term investor, we invest in companies for long-term returns. It’s that simple.

Our qualitative analysis is centered around the design, structure and practice of compensation plans. It includes factors such as a lack of robust clawback policy, short-term vesting periods for long-term awards, insufficient holding period requirements on equity, excessive severance provisions, excise tax gross-ups, insufficient disclosure of performance goals and metrics, amongst other factors. We review the qualitative factors in aggregate before determining whether the compensation plan aligns with the interests of long-term shareowners. It is unlikely that one factor will on its own drive an against vote.

This is not meant to be a one-and-done framework; we anticipate it to be continually evolving as we gain additional insights from our engagements with companies and other investors.

What has been the reaction following the introduction of the new calculation? How will corporations need to tighten their compensation plans to better align with this framework?

Nzima: We received a lot of media attention following our 43% against votes on SOPs in 2018. The move to a five-year analysis framework is currently playing out in the market, and it is generating conversations with portfolio companies, investors and compensation consultants.

Some are pleased with the long-term focus of our analysis and are generally interested in learning how we will apply the new model in our proxy voting decisions. Others are skeptical about our use of relative total shareholder return (TSR) as a measure of performance and question the use of percentile rankings in the analysis. Others are not happy that we are going beyond the “market-accepted” traditional three-year compensation cycle.

It is instructive to hear companies that do not have three-year business or product cycles complain about the five-year analysis. It is reflective of how ingrained the traditional three-year compensation cycle is in the market. If a company has a long-term incentive plan (LTIP) that pays out in three years, how is that long term? We believe five years should be the minimum, and preferably 10 years. It will take collective effort by investors to get the market to change. CalPERS cannot do it by itself.

We recognize that different industries have different business models and product cycles. In such instances, it may be appropriate for a company to have a three-year performance cycle if the equity awards are required to be held for at least five years. And even then, we prefer that executives be permitted to sell no more than 20% of net after tax vested equity per year starting in the sixth year after grant date. In addition to the longer holding period requirements during employment, we also prefer longer post-separation holding periods—such as two years—to discourage short-term focus ahead of separation.

As the largest pension fund in the U.S., what are the various elements of compensation plans that CalPERS examines when voting on Say on Pay proposals?

Nzima: In general, we examine total compensation (salary, incentive compensation, other forms of compensation, retirement plans and other post-employment benefits) and determine whether it is tied to the experience of long-term shareowners, aligned with business strategy, cost-effective and equitable, risk aware, and supportive of sustainability objectives. The comprehensive details will be in our updated Governance & Sustainability Principles, which we will present to our Investment Committee in August 2019.

An important element of CalPERS Corporate Governance Program is active ownership through engagement—which can become a critical component in the context of executive compensation. In cases where CalPERS might be in opposition to a company’s executive compensation program, we may consider changing our vote based on the company’s commitment to make substantive changes.

In a recent Agenda article, you mentioned that investors often do not hold compensation committees accountable when voting on pay plans. What would be your message to the investor community when addressing pay that is inadequately aligned with performance?

Nzima: All talk and no action has been a very expensive proposition for long-term investors. While on an aggregate basis, market returns over the long term have been good for long-term investors, the aggregate numbers hide the fact that such performance comes from only a small subset of the universe. However, if one looked at compensation figures in isolation, one would wrongly assume that all companies have great returns. Unfortunately, reality shows otherwise.

To illustrate this point, let me use a 2017 research paper by Hendrik Bessembinder, “Do Stocks Outperform Treasury Bills?” which looked at nearly 26,000 stocks in the Center for Research in Security Prices (CRSP) database between 1926 and 2016. It found that 57% of stocks had lifetime holding period total returns that were less than those on one-month Treasuries over the matching period. Furthermore, it found that the best performing 4% of stocks explained the entire $35 trillion net gain in the U.S. stock market since 1926 above what an investor would have earned through holding one-month Treasuries. This means that the remaining 96% of companies collectively matched the returns on one-month Treasuries. Just take a second and think of the implication. How much more would investors have benefited had the other 96% generated returns above those of one-month Treasuries?

While the research paper is about the need for portfolio diversification, it should not escape the eye of keen investors that most individual stocks performed poorly over the long term. While investors can look at the aggregate market returns and feel like they are ahead, the aggregate hides a lot of misaligned pay and performance.

With that as context, it is my view that the investor community should express its dissatisfaction with pay outcomes that are not aligned with company performance by voting against management’s SOP proposals, equity plans and compensation committee members. Investors should have the fortitude to walk the talk. We will not see any change unless investors collectively demand it.

In 2018, more than 90% of SOP proposals received greater than 80% support, and only approximately 2% of them got less than majority support. Why are investors accepting misaligned pay-for-performance outcomes that are bad economics?

Starting with the 2020 proxy season, CalPERS will be voting against compensation committee members the same year a company’s pay plan fails our analysis. Historically, we have voted against the compensation committee members the year after a plan failed to receive majority support and the company was not responsive by failing to make any meaningful changes to the pay plan despite the high opposition from investors.

Is there anything else regarding the new CalPERS calculation or the executive compensation landscape that you’d like to comment on?

Nzima: I just want to be clear that our quantitative model simply measures pay outcomes relative to performance outcomes. We are not endorsing TSR as a metric to be included in compensation plans. As a long-term investor, we believe TSR is an appropriate metric to evaluate the outcomes of management decisions and measure value creation over the long term.

Our compensation principles are intended to provide a framework for companies to consider in designing and implementing their compensation programs. They are not meant to be prescriptive.

We believe the board, through its compensation committee, should determine the drivers of value creation when selecting performance metrics to use. However, the use of too many metrics can lead to complexity—both for investors and management—in terms of understanding what effectively drives value creation at a company. Thus, too many metrics can be a red flag—the proverbial throwing mud at the wall and hoping some sticks. We expect compensation plans to be transparent and provide clear, comprehensive and relevant disclosures that are easily understood by investors, management and employees.

Issue 30: The Test of Time


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