Time for an update on exec comp. Specifically, the SEC now needs to issue a couple of regulations to deal with exec comp disclosures. And, corporate interests have begun to lobby for ways to make these new disclosures, and perhaps many others, more confusing and less useful.

The current debate revolves around how to define “compensation” - what to include and exclude, and how to measure some of the variable elements. In particular, companies today disclose a confusing mash-up of cash and equity comp. They have begun to lobby for either or both of “realized” or “realizable” comp as the definitive measure of what they paid their CEO, CFO, and other top execs. Investors will hear these terms much more in the coming months.

Companies prefer realized comp - in other words, what they actually paid to an executive in a fiscal year. Some observers have described it as what would show up on the executive’s annual W-2 form. This approach at best confuses an already murky set of disclosures. It will also confound attempts to link pay to performance. Finally, it could understate exec comp, and make comp disclosures look much better for executives.

Expected or Realizable or Realized Comp

Today, companies disclose exec comp in the Summary Compensation Table (SCT) of the annual proxy statement. In essence, they show what they plan to pay the executive, at least in terms of the expected value of equity comp. Specifically, companies estimate the future value of options and restricted shares, using their favorite option valuation model. They add the cash (salary, cash bonus, perqs) paid to the exec in the past year, to come up with total comp.

SCT comp leaves much to be desired. It’s unwieldy approach combines past cash payments with future equity value as of the date of the equity grant. (This latter quantity is also called Grant Date Value, or GDV.) It also leaves companies plenty of discretion about how to value future equity.

One suggested path forward entails defining exec comp as realizable comp. That would update the value of past equity comp each year, based on current parameters (share price and volatility, risk-free interest rate, and other options valuation inputs). Companies would then disclose what executives could earn as of the disclosure date.

A second way involves realized comp. Companies would disclose what they actually paid to an executive in the year. This would of course include cash comp, and also the value of equity that they actually received. In addition to cash settlement of in-the-money options, equity value would entail vesting of restricted shares, and options that they exercised rather than took as cash settlement. In this way, companies would disclose an amount close to, if not the same as, an executive’s W-2 comp. Some companies have already started to disclose realizable comp as part of their annual comp disclosures.

The Role of the SEC

This controversy would typically concern only exec comp consultants and HR executives. But, at least two prospective SEC regulations depend on it - pay ratio disclosure (CEO pay to median employee pay) and a description of the company’s pay-for-performance program. Both come from the Dodd-Frank Act, and both depend critically on the definition of “pay”.

Moreover, how the SEC defines pay in the context of these two regulations could also change the basic comp disclosures in the proxy statement. Whatever method the SEC adopts for these two new regulations will likely influence overall disclosure of exec comp, say in the SCT.

W-2 is Interesting, but Not Useful

Corporations have started to advocate for the SEC to define comp as realized pay. One, the Center for Executive Compensation, consists of corporate HR executives, and has a website full of materials that favor realized pay.

While it might be fun to see a CEO’s actual W-2, it hardly helps an investor to understand the connection between exec comp and company performance. Cash paid today can pertain to performance from years before. At least now, investors can identify how future compensation might vary based on performance. With realized pay, investors will have no way to understand how the paid out value of equity changed, up or down, relative to past performance.

Even worse, realized pay can understate what executives receive relative to performance. Realized pay essentially looks backward, and captures the value of equity granted years before. In a growing company (or with normal inflation), future compensation will also grow. Yet, investors won’t know how much it grew until years later. And, they won’t know how to connect that comp to the performance that generated it.

Only comp consultants love the current comp disclosures. It could use considerable work. But, realized pay only helps a CEO to confuse investors.