Do higher gas prices result in better gas?

Posted by Marc Hodak on August 1, 2016 under Executive compensation, Pay for performance, Reporting on pay | Be the First to Comment

If that seems like a silly question, then you would would have reacted as I did to the headline, “Does Higher CEO Pay Produce Better Company Performance?”

The MSCI research cited in the article states:

A report by MSCI sampled 429 large-cap U.S. companies between 2006 and 2015. It found that during that time, shareholder returns of those companies whose total pay was below their sector median outperformed those companies where pay exceeded the sector median by as much as 39%.

If one’s concern were the governance implications of that conclusion, the headline should have read the other way around: Does better company performance result in higher CEO pay? This question gets specifically at alignment between shareholders and CEOs. The MSCI study clearly answered that question as “no.”

The author of that study, Ric Marshall, concluded that companies ought to be more careful in how much equity they grant, since that was the biggest source of total compensation among the CEOs, and in their variation in pay. Mr. Marshall has a point, but for a different reason than one can conclude by looking at pay as reported in public disclosures.

The problem is not the amount of equity per se, but how equity is granted. A company has to pay its CEO enough to be competitive. If it didn’t pay in equity, it would have to make up for it in cash. The advantage of equity as a pay instrument is its residual ‘alignment effect’ after it is granted.

So, from a competitiveness standpoint, when the stock price is high, you can grant less equity (i.e., shares or options) in order to provide a given value of pay. When the stock price goes down, you have to grant more equity to remain competitive. When the stock price plummets because your company underperforms, and you subsequently feel you have to grant a lot more to remain competitive, and then your stock price recovers, your CEO will end up with a lot more award value than the CEO of a competitor whose firm’s stock price dropped much less, before also recovering. And voila, the poorer performing company ends up with a higher paid CEO.

MSCI looked at the 2006 – 2015 period for its study. This period corresponded precisely to the peculiar rollercoaster scenario noted above.

In other words, equity behaves differently than cash, both in how it is granted as well in how it is realized. Grant values and realized values interact with the price of the stock, and those interaction effects can easily lead to mis-alignment.

The solution is not just to grant less equity, as Mr. Marshall suggests; that might not satisfy the need for competitiveness. The answer is to pay executives in a way that doesn’t penalize good performance, or reward poor performance. There are ways of doing this, but it requires boards that are willing to look at more than “what is everyone else doing today” in designing their incentive plans.

Mr. Marshall offered another suggestion, that disclosure rules begin to look at pay over a longer time frame, i.e., the tenure of the CEO. This would get rid of most of the idiosyncratic pay elements, especially those that surround hiring and departure that screw up attempts to compare pay and performance year-by-year. I think this is a very good suggestion.