Bengt Holmstrom, a co-winner of the 2016 Nobel Economics Prize, rails against the complexity of executive pay. He’s right about that. He blames compensation consultants, but that is attacking a symptom, not a cause. The underlying cause is the proliferating regulation—formal and informal—of compensation governance. This regulation creates constraints on how Boards can design executive compensation programs. Boards rationally react to those constraints by building plans of ever-greater complexity.
The source of compensation regulations is popular disdain for high CEO pay. The intent of the regulations is to tamp down that pay, but that’s like putting nails in a board to stop a marble from rolling down. You don’t stop the marble; you just make its path more complicated.
Nevertheless, Prof. Holmstrom is a worthy scholar, one whose research has done much to inform my discipline, even if unfortunately few practitioners have actually heard of him, or heeded his conclusions.
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.
I spilled the beans regarding the titular question this Fall at an NACD event.
The talk was split into two TED-sized portions of about 20 minutes each. Part I is what the research suggests about pay practices, i.e., which practices are effective, which are probably a waste of money, and which actually hurt the shareholders. Part II explains the causal mechanism behind the most surprising research finding–that today’s bonus plans, on average, add no value to corporate performance.
The feedback was extremely gratifying. A couple of directors described the discussion about bonus plans and proxy advisory standards as “a tour de force.”
Massey Energy was one of a handful of mining and energy companies that tied its chief executive officer’s bonus to safety performance in 2010. Today, former CEO Donald Blankenship goes to trial on charges stemming from a West Virginia mine explosion that killed 29 workers, the U.S. industry’s deadliest in almost four decades.
The story goes on to note that in the mining industry there is no correlation between having executive bonuses tied to safety metrics and the actual result of safer mines. In fact, many of the safest companies offer no safety bonuses for their top executives. Nevertheless, all of the people interviewed in the article claim that CEO incentives ought to be tied to safety much more than they are today.
Jennifer Lawrence recently penned an essay about no longer being willing to earn less than her male co-stars. Her feisty critique received an outpouring of feminist support inspired by her willingness to challenge the system. She has a point, of course, about female talent potentially being undervalued relative to male talent. This post is not about that. It is about the question I get most often regarding the extraordinarily highly paid: Does deciding to pursue more money than one avowedly needs make a person greedy?
The ‘greed’ question seems to have hardly come up with regards to Ms. Lawrence. Yet she earned $52 million last year. It is a fair guess that whatever millions she left on the table would not have the slightest impact on her lifestyle, which she readily admits. Her complaint isn’t about the money; it’s about the principle that women should get paid the same as men doing the same job. She wants parity with her peers.
So, maybe it matters why we want more money, e.g., to help others. Maybe that’s the difference between being greedy and not. Read more of this article »
High pay is controversial because there are inherently two, generally opposed, sides to the debate. This was well illustrated in a recent WSJ article about highly paid, star college football coaches. Given the topic, it’s appropriate to label the two sides “offense” and “defense.”
This is a good name for an instinctive reaction that we all have; we are offended by other people’s high pay. It’s a natural response. The moment any of us hears that someone has made millions of dollars, our knee-jerk reaction is “who can be worth millions?” We can’t help it. We also can’t help trying to supplement that emotional reaction with logical arguments. This is almost always done via comparisons to other people’s pay.
Last year, the current Alabama [Crimson Tide] coach, Nick Saban, made $7.2 million, roughly 11 times the salary of Alabama’s president.
Messrs. Saban and Meyer make 50 times that of an average full-time professor at their respective schools; Mr. Harbaugh makes 32 times more than an average full-time professor at Michigan…
Much is made of the fact that Alabama is a poor state with a median household income of $43,253, some $10,000 less than the national average. Public funding for higher education in the state was slashed by $556 million from 2008 to 2013, a 28% drop. Mr. Saban’s salary has risen 80% since he arrived at Alabama in 2007.
What makes these comparisons compelling is that they bring the discussion somewhat closer to the scale of our pay. If we get paid much less than top college coaches, for example—a better than 99 percent bet, even for readers of the Wall Street Journal—then we get to share the outrage that these people are making so much more than we are. I mean, who are these people? Are they really any better than us?
Some people call this reaction an instinct for fairness. Some call it envy. Regardless of the name, it is the first thing that strikes us when hearing “millions.”
And that is why any explanation or justification of other people’s millions can be viewed as a “defense.”
The easiest, and ultimately only way to defend high pay is to reference its negotiated nature. People don’t get what they deserve; they get what they negotiate. This negotiation is invisible to us, a distant, unwritten prequel, by the time we are reading about something like “$7.2 million.” When we say, “I can’t believe so-and-so is being paid that much,” we are really saying one of two things:
(1) “I can’t believe so-and-so was greedy enough to ask for or accept that much,” or
(2) “I can’t believe the person paying them that much really needed to.” Both criticisms represent a kind of an arrogance, if you think about it.
On the one hand, we are accusing the person who made a lot of a moral failing that any of us would likely succumb to if we were in their position. In my experience, the people who complain most loudly about other people’s pay are the least likely to turn down a windfall were it to come their way. On the other hand, we are accusing the person who paid the salary of being stupid, lazy, or corrupt with reference to their compensation decisions. We’re calling the owners, who are generally very successful themselves, financial dolts. On its face, this seems implausible. So, the sensible thing is to first ask the people paying millions what they were thinking.
Former Alabama President Robert Witt (now the chancellor of the Alabama university system), once told CBS’s “60 Minutes” that Mr. Saban was “the best financial investment this university has ever made…”
Mr. Saban had an immediate financial impact on Alabama. In 2007 the school was closing a $50 million capital campaign for its athletic department. After Mr. Saban arrived, the campaign exceeded its goal by $52 million. Alabama’s athletic-department revenue the year before Coach Saban showed up was $68 million. By 2013-14 it had risen to $153 million, a gain of 125%. (The athletic department kicked $9 million of that to the university.) Mr. Saban’s football program accounted for $95 million of that figure, and posted a profit of $53 million.
In other words, they were thinking that offering those millions in salary would pay them back in dividends. That bet doesn’t always work, but it was clearly working for Alabama. And these owners are considering all of the revenue streams likely to be impacted by their hire, the way any professional team owner would look beyond the gate receipts and TV licenses.
Mr. Witt said Mr. Saban also played a big role in the success of a $500 million capital campaign for the university (not merely the athletic department) that took place around the time the football coach was hired…
Ohio State has benefited in a similar way since luring Mr. Meyer, 51, out of a brief retirement in 2012. The university’s athletic-department revenue was up 14% to $69 million during the season last year, one in which Ohio State won the national title. In the aftermath of the title, the school’s merchandise sales totaled $17 million, some $3 million more than the previous year. More than half of that money goes to academics.
So, the defense of high pay is that if we give the recipient a portion of his or her value to the organization, the organization will benefit. That is true whether we are talking about coaches, or players, or real estate agents, or investment bankers. Economists call this paying for the individual’s marginal revenue product, and a principle of economics is that society as a whole is generally better off if every person is paid according to his or her marginal revenue product. Paying too much is a waste; paying too little risks ‘misallocation’ of that person’s talents.
The End Game
Whether we are talking about college football coaches, professional entertainers, or corporate executives, the debate often comes down to what game you’re playing. If you’re playing the game of fairness or envy, then you simply don’t want some people to make too much more than others, regardless of the economic consequences. If you’re playing to maximize overall social welfare, then you allow people to earn a significant portion of what they make for others, and let the chips fall where they may.
One might admit to a mix (or confusion) of motives in order pursue some middle ground. But in football, at least, no one scores in the middle ground.
A few weeks back, Hillary Clinton unveiled her proposed tax complication scheme and other proposals to combat “short-termism.” People generally being more conservative with regards to their own professions than other people’s professions, I was tempted to suggest that trusting Hillary (or any politician) to remedy whatever was ailing corporate America was like trusting a medieval doctor to cure…well, just about anything. You just know that whatever the ailment, the treatment will involve bleeding the patient. But recalling the above-noted bias, I realized that I was merely responding to quackery with quackery, and that I was in no better position to give Mrs. Clinton political advice than she was at giving anyone economic advice.
So I refrained from calling her out on her proposal, including addressing the irony of politicians accusing corporations of short-termism, and left it to the pundits to debate her prescriptions. What I didn’t expect is a spate of articles refuting her diagnosis, i.e., that corporate America was suffering from an acute case of short-termism.
The CEO Pay Ratio mandated by Dodd-Frank is finally here. The rule sounds simple enough: Companies must disclose the ratio of their CEO’s pay to that of their median worker. Interesting information, perhaps, but the SEC supposedly exists for a more lofty purpose than mandating nice-to-know data. It must, by law, act in the interests of investors. In fact, the Administrative Procedures Act requires the SEC to “base . . . decisions on the best reasonably obtainable scientific, technical, economic, and other information concerning the need for, and consequences of, the intended regulation.”
The CEO Pay Ratio rule is, indeed, of great interest to certain people. Union leaders believe that the rule will give them another crowbar with which to negotiate their members’ wages and benefits. Class warriors believe it will give them more ammo to shame corporations into reducing inequality. Fair enough. But the SEC does not normally allow itself to be used by unions for getting involved in labor relations, or by class warriors in anti-corporate crusading. So, why are they bothering with this rule?
Quite simply, because Dodd-Frank requires them to. The CEO Pay Ratio provision was inserted into the law, without debate, at the last minute by Senator Menendez. His rationale, explained after the fact, was, “This simple benchmark will help investors monitor both how a company treats its average workers and whether its executive pay is reasonable.”
How, exactly, will this “simple benchmark” help investors do those things? What number, or range, for this ratio tells an investor that a company is treating its average workers well or poorly, or that a company is paying its CEO reasonably (given that CEO pay is already thoroughly disclosed)? What economic or financial standards can be created using this or other data to enable investors to figure these things out?
As someone who has been asking this over the five years it has been debated, I can assure you that those questions have never been answered, neither by the rules proponents nor by the investors they claim to want to help. That’s because there is no logical basis for believing that the pay ratio can usefully inform investors either with regards to the company’s treatment of workers or the reasonableness of their executives’ pay. Consequently, there is no scientific or economic evidence that this ratio, alone or in combination with any other data, can be used to judge how well the company is being managed, or otherwise be related to company value—i.e., the nominal concern of investors. The Pay Ratio provides no more useful information than the ratio between the company’s highest cost office space versus its average cost of warehouse space, or between its highest cost commodity inputs versus its average cost of materials.
In other words, the SEC is simply being used in an experiment in social engineering. The expectation is that this ratio will shame boards into changing how they pay their CEOs. That goal might have some redeeming value if this experiment hadn’t already been tried, twice. The “shaming” theory was, in fact, largely behind disclosure rules enacted in 1992 and in 2006. A rational person would have looked at these and similar results, and decided it was time to try another hypothesis. Alas, it appears we are not dealing with rational persons. So today, ideology trumps science.
Today was the last day of the comment period for the SEC’s proposed disclosure rules on pay-for-performance. My own submission offers a few relevant points:
1. There are two reasons why investors would care about pay-for-performance: (a) to judge compensation cost and (b) to judge alignment of interests between managers and owners.
2. The SEC proposal does injustice to the first reason, and completely ignores the second.
3. As a result, the proposed disclosure will create a potentially, grossly distorted view of pay-for-performance.
4. If the SEC wants good disclosure on this matter, its requirements must acknowledge the investors’ perspective with some significant changes (which I propose).
5. If they can’t or won’t make those changes (and they probably shouldn’t at this point), the SEC should revert to a principles-based disclosure, and let the market sort out whatever resonates with investors.
I consider this rule one of the most important that the SEC will devise this year. In the long run, pay-for-performance disclosure will have far more impact than the more controversial rules on CEO pay ratios and compensation clawbacks. If the disclosure rule ends up close to its current form, it could be just one more nail in the coffin of public companies.
Let’s say that you hire a captain for your ship, and for, say, tax reasons, decide that instead of running things from the bridge he should run things from the plank. You warn him that if anything goes wrong, he goes into the drink. But rough weather comes along, and you decide you still need him, so you don’t push him over the edge. At this point, you’ve hurt your credibility and pissed off the sharks.
That appears to be what is happening as activist investors increasingly get into the game of second-guessing corporate bonus plans. On the plus side, these shareholders are digging much deeper than the typical, diversified institutional investor possibly could. Marathon Partners, for instance, is criticizing Shutterfly’s plans that reward growth without assurance that it is value-added growth, which looks like a valid criticism.
Jana Partners LLC, which recently took a $2 billion stake in Qualcomm, has urged the company to tie executive pay to measures like return on invested capital, rather than its current yardsticks of revenue and operating income, according to a Jana investor letter. Such changes “would eliminate the incentive to grow at any cost.”
Yes, it would. But return on invested capital could instead create the opposite incentive, i.e., a bias against value-added investment. (If the investors really knew what was what, they would more likely require economic profit as the compensation metric.)
Although companies should generally be given the benefit of the doubt about their plans, they don’t do themselves any favors by trotting out the specter of retention risk when discussing variable compensation. Yet we often hear companies say, or using code words to the effect of, “Hey, we have to be careful that our incentive plans aren’t too tied to performance, because if they don’t pay out, we might lose key talent.”
Notice to Corporate Boards: Nobody buys this explanation.
And, by the way, if your variable compensation plan creates retention risk when it doesn’t pay out, then your compensation program is too weighted toward variable instead of fixed compensation. In other words, your salaries are too low and your target variable compensation is too high. In a well-designed plan, salary should cover the minimum amount of pay that would be needed to keep your executives around when your company is performing poorly.
Alas, too many corporate incentive plans are poorly designed, but not for the reasons usually toted up. These plans are a mess because the most important incentive of all is the incentive created by Section 162m of the tax code to underweight salary and overweight variable compensation. That puts public companies in a bind when incentive plans don’t pay off, which is clearly (and predictably) a recurring problem.
In other words, companies may be wrong-headed for conflating alignment issues with retention issues when arguing for slack in their bonus plans, but they come by this wrong-headedness honestly; it is a logical reaction to the unintended, deeply perverse encouragement our tax laws.
Fortunately, an increasing number of companies are starting to ignore the 162m salary limits. They are realizing that the harm that higher salaries may cause their shareholders in the form of higher taxes is easily outweighed by the benefits of more rational ratio of fixed vs. variable compensation for their management, one that militates against the real retention issues that too much compensation risk might cause.