The Compensation Discussion and Analysis (CD&A) should describe in plain English the material factors pertaining to executive compensation. Examples of factors that the CD&A should cover are as follows:

• The compensation program’s objectives

• What the program is designed to reward

• Specific elements of compensation

• Why the company chooses to pay each element

• How the company determines the amount of each element

• How each element, and decisions about each element, fits into the overall compensation objectives and affects decisions about other elements

Ever since 2007, the first year in which the latest executive compensation disclosure rules went into effect, companies have been trying to determine the “right” level of disclosure that would comply with requirements, meet shareholder expectations, and not give talent and business competitors too much information. In the first year, the chairman of the US Securities and Exchange Commission (SEC) lamented the lack of detail and clarity in companies’ Compensation Discussion and Analysis (CD&A). Through a detailed comment letter process, the SEC expected that companies would get “CD&A smarter” after two or three filing seasons.

Here we are with the third filing season behind us. Are CD&As providing a clear, detailed explanation of the rationale for the underlying program design as well as compensation decisions?

In this Perspective, we share Mercer’s analysis of 100 CD&As to assess the level and evolution of disclosures during the past three years.

Observations

Companies struggled during the first year. CD&As included mind-numbing detail about programs (the “what”) but little explanation about the process and rationale (the “how” and the “why”). The regulations were vague on many points and companies were often reluctant to take a broad interpretation of the disclosure rules. Therefore, they erred on the side of less rather than more disclosure. The initial round of SEC comment letters prompted many companies to improve their CD&As. The SEC also modified its interpretations following challenges from companies about the relevance or appropriateness of some of the comments. For example, the SEC seems to have stopped asking companies to explain why a CEO is paid more than other executives.

Nonetheless, despite the transparent example set by many companies and two rounds of comments, some companies still have a mindset that they will wait to get a comment letter before disclosing more than what they regard as the bare minimum. Others are so concerned about getting a comment that they continue to include details that obfuscate how programs really operate. In both cases, the objectives of disclosure are not met. That said, our research indicates that there has been a significant increase in disclosures on key topics. As discussed below, the most controversial area remains disclosure of incentive plan performance targets.

Performance measure related disclosure

The regulations require disclosure of performance measures as well as target levels of performance, unless to do so would result in competitive harm to the company. Where companies rely on the competitive harm exception, they must discuss how difficult it would be for the executive or how likely it would be for the company to achieve the undisclosed target levels.

From the start, companies were generally willing to disclose the performance measures (for example, revenue, earnings per share, return on assets) used in their annual and long-term incentive plans. Prevalence of such disclosures is in the 90 percent range. However, they continue to avoid disclosing the weightings of the measures. Interestingly, many companies are increasingly disclosing the current year’s measures as well: from virtually nil in 2007 to a solid one-quarter in 2009. Under the regulations this is required only if it is material to an investor’s understanding of the program. We expect that companies want to avoid surprises next year.

The disclosure of performance targets (for example, 10 percent revenue growth, $3 earnings per share) is where the battle lines have been drawn. Even if it is after the end of the performance period, companies have resisted disclosing targets, asserting competitive harm or simply being silent.

Despite the controversy, performance-related disclosures increased materially in 2009. Almost three-quarters of companies are disclosing the targets in their annual plans and just under two-thirds are disclosing them for their long-term plans. We believe that companies have come to realize that defending nondisclosure of target performance under the competitive harm exception is difficult, thereby resulting in the significant increase in disclosing performance targets.

Performance measure related disclosure

Market data sources

The regulations require a company engaging in any benchmarking of total compensation or any material element of compensation to identify the benchmark and, if applicable, its components (including component companies).

Prevalence of companies discussing their market data sources has been consistent during the three-year period. However, approximately 20 percent of companies do not discuss or disclose their peer groups, and close to 45 percent do not provide any details on survey data. Detailed information on market data has been a frequent SEC comment request, and in some instances the SEC has also been requesting a list of companies that were part of the broad published survey.

Pay positioning

In the first year of filing, approximately half of the companies disclosed their desired pay positioning for base and total cash compensation. Very soon companies learned that explicit statements on market positioning – such as “we position pay at the 50th percentile” – attracted comments from the SEC asking companies to explain how actual outcomes compared to the positioning and the rationale for any discrepancy. Pay positioning disclosures dropped in 2008, but the SEC continued to ask about positioning as a philosophical matter. Disclosures returned to 2007 levels in 2009 but were usually carefully phrased. In the 2009 disclosures, pay positioning is discussed in terms of “around the median” instead of “at the median.”

Nonetheless, only half of the companies discuss market positioning in their 2009 disclosures even though our experience is that most companies use market positioning as one of the factors for determining executive pay.

Pay mix

Disclosure of pay mix increased by about 30 percent during 2008. Providing information about pay mix is an easy way to communicate the rationale behind fixed versus variable, annual versus long-term and cash versus equity compensation. Furthermore, the recent scrutiny of executive pay has sparked controversy about the mix of pay elements. Not only do we see companies discussing pay mix more often, they are also disclosing the mix and the rationale underlying it more frequently.

Market data sources, pay positioning and pay mix table

Roles of executives in the compensation process

The disclosure of various stakeholders’ roles continues to be high. However, it is surprising that almost 30 percent of companies still do not discuss this topic.

Severance and change in control

The marked increase in severance/change-in-control disclosure, from 67 to 81 percent, is not a surprise given that the issue of excessive severance packages has been in the spotlight during the financial services industry meltdown.

Roles of executives and severance/change in control (CIC)

Stock ownership guidelines

Approximately three-quarters of companies disclose their stock ownership guidelines. However, the number of companies disclosing what counts toward the ownership guideline and the time period for compliance has remained relatively low.

A hot topic among governance observers is holding requirements for shares acquired on exercise of options or vesting of full-value shares. Time frames range from six months to until retirement or even beyond. As shareholders and advisory firms become more vocal on the topic, we expect to see wider implementation of holding requirements in addition to existing stock ownership guidelines.

Stock ownership guidelines

Conclusion

Overall, the state of companies’ 2009 CD&As is far better than that seen in 2007 documents. However, as companies take a closer look at their executive pay programs and make changes (or have already made changes), the need to start writing the CD&A early in the process and involve all stakeholders is more important than ever. In addition, as Say on Pay gains shareholder favor, the CD&A is the medium for understanding executive pay programs, and a lack of clarity therein potentially introduces the risk of misunderstanding the programs and their rationale.