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.
This story starts with a dig:
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.
Read more of this article »
Time to turn in your papers
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.
The SEC has released proposed rules for disclosing pay for performance, based on the Dodd-Frank law requiring that each company provide “information that shows the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions.”
As my regular readers know, “pay for performance” can be usefully evaluated only when we have appropriate definitions of “pay” and “performance.” Appropriate definitions depend on one’s purpose for making the evaluation. Pay-for-performance can be either an exercise in costing, i.e., seeing if shareholders are getting what they are paying for, or for determining alignment, i.e., seeing if management rewards are consistent with shareholder value creation. These can be different analyses, with the same underlying figures yielding very different conclusions.
Read more of this article »
If you are a corporate director, you might not know that executive compensation at your company is now being evaluated, in part, based on your economic profit (EP). The people doing these evaluations are any of the over 300,000 security analysts with access to the new Bloomberg Pay Index, a daily ranking of executive pay for performance (discussed here by Bloomberg’s Laura Marcinek), This index provides a compensation efficiency score based on the ratio of total pay against EP. For instance, Tim Cook—highlighted by Bloomberg as the best CEO bargain—had 2014 pay of $65 million, which was just 0.2 percent of Apple’s three-year average EP.
Two things stand out about this index. First, these data are directly available to the analysts—many of whom are skeptical of the quality of current proxy advisor recommendations—without the intermediation of their governance groups that may be advising them on their proxies. So, this index is likely to have some impact on proxy voting.
Secondly, this index will underlie an increasing number of media reports on compensation governance. It is already behind a stream of articles commenting on pay for specific executives.
What is truly revolutionary about this index is the EP performance metric Bloomberg uses in determining pay for performance. This use of EP represents a breakthrough for three reasons: Read more of this article »
If I were a wheelwright, I would probably raise an eyebrow at stories like “Philadelphia man invents the wheel.” Since I create organizational incentives for a living, that was my initial reaction to this story, via the NYT:
In August, I wrote about the design and implementation of a profit-sharing plan for my business. I decided to try this because my company has a long history of producing poor (or no) profits…
The plan began with the second quarter of 2013, and here’s how it has worked out: We made a profit in three of the four quarters that followed.
It’s easy to joke about someone reinventing the wheel, but there is a difference between creating wheel, and creating a wheel that doesn’t come off when the road gets a little rough. A good incentive plan only gets that way after considering what, exactly, we want to motivate, and designing the plan to do that using the minimum number of moving parts needed to function effectively. I was impressed with the way this business owner went through that process, and what he ended up with:
If there is a profit, 30 percent of it goes into a profit pool. Half of that pool is split among all of the workers except me (because I keep the other 70 percent), and the other half is split just among the production employees (everyone except the two commissioned salesmen and the bookkeeper). The splits are all even, meaning lower paid and higher paid workers get the same share. If there is no profit in a quarter, there is no payout. A loss in one quarter gets subtracted from the subsequent quarter’s profits before any bonuses are paid out — but I don’t claw back previous bonus payments if there is a loss in a subsequent quarter.
Plans like this are becoming rarer, especially at larger or public companies. Of course, no plan is perfect. This plan was designed to encourage teamwork and a holistic focus on the business. I’m sure this owner will at some point get grief from his most productive people for pulling along the free riders. And he will be dealing with morale and retention issues when the market turns against his company for more than a couple of quarters. Whatever he does to ameliorate or prevent those problems will beget others. That’s life.
Nevertheless, his plan is impressive. This owner did not create sports car wheels for a motorbike, and he did not create the wheels within wheels that many compensation experts would consider “best practice.” He just thought about what he needed to get his business to the next level, and used his authority to do it right and keep it simple.
Pay for performance seems like such a simple idea, and easy to accept as a basis for judging executive compensation. So why does it continue to create such discussion and controversy? Well, consider the following grid:
The key distinction is managerial performance versus company performance. An easy way to understand this distinction is to consider a gold mining company when the gold price has dropped significantly, but our company’s profits and stock price have dropped less than half of anyone else’s in our sector due to extraordinary management. It’s easy to see in such an example that our management has done great, but our shareholders have done poorly. Should such managers get a bonus?
When management and shareholder performance are strong, as in the upper right quadrant, the answer is obvious. When management and shareholder performance are weak, as in the lower left quadrant, the answer is obvious.
But what do we do when our gold company finds itself in the upper left quadrant? If we pay a bonus for this situation, we are open to the accusation of pay without performance by our investors. Our investors might bother to look at relative performance, in which case they might forgive bonus payments up to a point. But there is no way outside investors can gauge what the board can, i.e., that our managers actually did a great job given their situation, and that denying them a bonus may entail a significant risk of losing them to other firms that promise to compensate them for being great managers.
Paying a bonus for lower right quadrant performance is equally problematic. Most shareholders will let you get away with it because they are feeling flush. But those that don’t are on firmer ground in saying it would be pay without performance, that management was simply in the right place at the right time. In this situation, the downside to not paying a bonus is a little more subtle. If we deny managers a bonus for poor relative performance in the face of good absolute performance, then we MUST be willing to pay them bonuses for good relative performance even when the company suffers poor absolute performance. In other words, boards justifiably refusing to pay bonuses when they are in the lower right quadrant will eventually they find themselves in the upper left quadrant having to pay bonuses, or risk almost certain loss of their best managers. And we already highlighted the difficulty in adhering to a policy of consistently paying for relative, as opposed to absolute performance.
True to their pragmatic form, many boards resolve this dilemma by paying for both absolute and relative performance. This makes the plans more complicated, and does not completely eliminate at least some criticism of pay without performance, but it at least attempts a workable compromise. Fortunately, ISS (pdf) and Glass-Lewis provide a least some cover for pay for relative performance, but that only gets you so far.
What would you do?