One of the big problems with the whole idea of pay for performance is how you measure both pay and performance. Because executives receive many different forms of compensation, much of it deferred in various ways and some of it in kind (e.g., various perks), there are serious problems with figuring out exactly how much they are being paid. Conversely, because there are many ways of measuring performance, there are at least as many problems at that end.
In light of the rising influence of proxy advisory services, such as ISS, which purport to use pay for performance metrics in making various voting recommendations, the question of whether outfits like ISS are getting it right has become quite important. A recent paper by Stephen O'Byrne offers some very pertinent criticisms and suggestions in that regard:
Institutional Shareholder Services (ISS) announced a new approach to evaluating pay for performance in late 2011. This paper explains the new approach, highlights four significant weaknesses of the new approach and explains how ISS could substantially improve its Pay for Performance Model, now and in the future. Without making any change in the data it collects, ISS could improve its assessment of pay for performance by: (1) adopting more meaningful measures of the three basic dimensions of pay for performance – pay leverage, pay alignment and pay premium at industry average performance, (2) defining reasonable trade-offs between leverage, alignment and cost, (3) changing its peer group selection methodology so it’s selecting labor market peers, not companies that fall in the same sector but don’t compete for the same talent, and (4) giving examples of simple compensation programs that provide perfect pay for performance. In the future, ISS could provide more value to investors by using "mark to market" pay to calculate better measures of pay leverage and alignment and by using stock ownership and mark to market pay to calculate a more comprehensive measure of the CEO’s shareholder value incentive ("wealth leverage").
CITE: The ISS Pay for Performance Model (May 24, 2012). Available at SSRN: http://ssrn.com/abstract=2289360