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.
Against The Tide
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.
Uh, there are no jelly beans in this jar?
James Surowiecki, author of the bestselling “Wisdom of Crowds,” recently penned an article in the New Yorker called Why CEO Pay Reform Failed, regarding the Dodd-Frank mandated “Say-on-Pay” rule.
He correctly notes that Say-on-Pay has, against the hope of its proponents, done “approximately zero” to stop the rise in CEO pay, and that shareholders have almost universally endorsed these pay levels with overwhelming support. He offers some reasons:
“Why have the reforms been so ineffective? Simply put, they targeted the wrong things. People are justifiably indignant about cronyism and corruption in the executive suite, but these aren’t the main reasons that C.E.O. pay has soared. If they were, leaving salary decisions up to independent directors or shareholders would have made a greater difference. As it is, studies find that when companies hire outside C.E.O.s—people who have no relationship with the board—they get paid more than inside hires and more than their predecessors, too. Four years of say-on-pay have shown us that ordinary shareholders are pretty much as generous as boards are. And even companies with a single controlling shareholder, who ought to be able to dictate terms, don’t seem to pay their C.E.O.s any less than other companies.”
In other words, the very things that people are “justifiably indignant about” appear, in fact, to not be justified. But he is writing in the New Yorker where indignation about CEO pay is a matter of religion, so Surowiecki has to find something, anything, to justify it. He concludes that:
(a) Boards of directors are deluded in thinking they can actually distinguish CEO talent, and are thus irrationally paying more for talent they cannot discern, and
(b) Investors have been hoodwinked by an “ideology” that CEO talent is rare, and that higher rewards can lead to better CEOs. (In other words, maybe certain crowds aren’t that smart.)
If this seems like more than a bit of reaching, consider his sources. Read more of this article »
In yesterday’s WSJ, an article reported rising criticism of directors’ pay from institutional investors. Many of the quotes came from one such investor, T. Rowe Price.
Current pay structures don’t give directors enough of a stake in making sure the company does well, and boards need to be more creative about tying their compensation to performance, said John Wakeman, a vice president and portfolio manager at mutual-fund giant T. Rowe Price Group Inc.
“If bad people are going to be on these boards, we’ve got to stop it,” said Mr. Wakeman. “We owe it to our fund holders.”
“When you’ve gone to restricted-stock world, basically directors get paid more or less for showing up,” Mr. Wakeman said.
If Wakeman were referring to the portion of director fees paid in cash, then he would have a point about directors being paid for just “showing up,” but even that ignores the value of getting good directors to show up. Being a good director means working. In the world that Mr. Wakeman and I share, very few people beyond commissioned salespeople are expected to show up with zero guaranteed pay. Does he want directors compensated with purely variable pay?
But in alluding to “pay for showing up,” he is not referring to the fixed fees earned by directors, but to their restricted stock, which accounts for more than half of their total pay. Calling this “pay for showing up” is a curious accusation. To some extent, someone getting restricted stock compensation is almost certain of having something of value at the end of their tenure. But the value of restricted stock goes up and down with the share price. You don’t get any more performance-based than that. In other words, given both its retention and incentive characteristics, restricted stock may be the perfect compensation instrument for directors.
The point of bad people on a board is not how we pay them, but how do we prevent them or get rid of them. It may have been the writer instead of Mr. Wakeman who conflated these appointment versus compensation issues, but such a conflation does not help us determine the right way to either get good directors onto boards or to pay them.
The article also notes that some activist investors are experimenting with incentive pay programs for directors. The clear premise is that directors don’t have enough incentive in their current pay programs, which raises the question: what kind of pay package would be better than a program of fees plus restricted stock?
One can argue that the proportion of that pay mix ought to be more in favor of restricted stock than it is now, or that the stock restrictions should be more demanding, such as requiring that most of the stock be held to retirement. But as someone who has designed these things for many boards, and thinks deeply about compensation design every day, I would caution against too much experimentation. The three basic alternatives to restricted stock are:
1. A restricted stock-equivalent, such as a cash-settled stock appreciation plan that pays off exactly the way restricted stock would. I would favor such a plan only because it creates an income opportunity for those of us who design them. Otherwise, the shareholders get the same retention and alignment benefit as if they award restricted stock.
2. An alternative equity instrument, such as stock options. This would likely create an asymmetrical risk/reward profile for directors versus shareholders–the kind of thing that contributed to Wall Street’s troubles during the financial crisis.
3. A non-equity based incentive plan. This would be asking for trouble, as the Coke example in the article showed. The only body in a company than can certify achievement of performance results is the board of directors. Asking the board of directors to certify performance relating to their own pay creates an inherent conflict of interest. This is a fine recipe for either manipulation of corporate results, or the continual appearance of such manipulation. I would never institute a directors’ non-equity incentive plan for any company I advise (and have actually lost business for my refusal to do so).
The real story, here, is that pay is becoming the magic elixir for fixing all governance problems. We don’t have a significant problem with lack of alignment between directors and shareholders. We just have some companies that don’t perform well, and some of that lack of performance reasonably attributable to lax oversight by the board. Too much experimentation with director pay would only make the problems worse because it would be attacking the wrong problem.
And that means a new flood of stories about CEO pay. In the past, the stories have almost uniformly been of the “can you believe…” variety. Can you believe that CEO whose company stock dropped 20 percent still earned $5 million? Can you believe that CEO who was canned got $20 million on the way out the door? So, I was surprised to finally see an example of intrepid journalism entitled “Pay for Performance’ No Longer a Punchline.” Apparently the relationship between pay and performance is improving.
The shift in how CEOs are paid highlights the growing role of investors in shaping executive compensation—and their push to align pay more closely with corporate results.
While a welcome the change in tone, I think that both the shift to improved alignment and the role of growing investor involvement are overstated. To see why, consider two items about CEO pay that are approximately true:
Read more of this article »
From the Chronicle of Higher Education, an article on What Public-College Presidents Make. Their peculiar take:
Public outcry over presidential pay has intensified, but it appears to have done little to affect what presidents earn at public research institutions.
The underlying premise in this statement is that public outrage should have an effect on pay. This premise is, in turn, derived from the widely accepted managerial power narrative of executive pay, which asserts that the pay of corporate leaders, which could encompass university presidents, is set so arbitrarily that if you simply criticize it, the powers that be will be shamed into reducing it.
This assumption has been repeatedly frustrated by actual history. Still, the purveyors of this narrative stubbornly refused to accept the possibility that boards might be more reluctant to see their chosen president or CEO go away simply in order to make the bad press go away.
It had to happen. At some point, the CEO pay critics second-guessing the board of directors would lead a CEO to say “Screw it,” and leave the shareholders to deal with the aftermath.
Yesterday, Aviva’s shareholders, saw the departure of Andrew Moss, their CEO, after his pay package was voted down. While it’s difficult to interpret any given Say on Pay vote, it’s a fair assumption that these votes respond to headline news about a company. In the case of Aviva, the headline appeared to be “Insurer performing badly; CEO pay goes up.” So, here is what the shareholders have wrought:
Read more of this article »
In a warmup for the upcoming proxy season, we have the following lead in the WSJ:
On the way to bankruptcy court, Lear Corp., a car-parts supplier, closed 28 factories, cut more than 20,000 jobs and wiped out shareholders.
Still, Lear sought $20.6 million in bonuses for key executives and other employees, including an eventual payout of more than $5.4 million for then-Chief Executive Robert Rossiter.
The implication here is that the CEO was paid a bonus for slashing jobs and bankrupting the company. I suppose it would not have been as juicy a story if the lead were:
Lear Corp., an auto parts maker caught in the maelstrom that bankrupted a large swath of the auto industry, was forced to close 28 factories and shed 20,000 jobs in order to stay alive. The company survived, eventually adding back those 20,000 jobs and more, due to the difficult decisions made by its managers working through a trying time.
The employees collectively earned $20.6 million in bonuses for that effort, with the CEO earning $5.4 million of that.
The problem with the second version is that it does not support the narrative that paying a lot to turn around a company might make sense. The latter version also undermines another purpose of this article, which is to report on the allegedly widespread skirting of a law intended to prevent companies from paying “retention bonuses” to managers when the firm is in bankruptcy.
The 2005 measure—an amendment to broader bankruptcy legislation aimed mostly at changing rules for personal filings—severely restricted “retention” bonuses that reward executives for sticking with distressed companies. It was fueled by popular outrage over money paid to executives of Enron Corp. and other companies that imploded.
But in the past few years, some corporations have found perfectly legal ways to escape federal strictures on bonus pay during bankruptcy cases.
That’s because Congress can’t outlaw compensation for services. All compensation, whether it’s guaranteed (as in salaries) or at-risk (as in bonuses) have a retention element to them. So, instead of offering a “retention bonus,” those clever compensation consultants offered an “incentive bonus” with easy targets. Keep in mind, they did this with the full cooperation of the investors on whose behalf they were working. A rule that prevents people from doing what they think is right for them is always going to be tested.
So, to prop up an illogical law, the courts had to get into the business of deciding whether the incentive goals were rigorous enough to qualify the resulting pay as at-risk versus guaranteed. As the judges drew the line out, this policy began to force investors to dilute themselves even more. That’s because the more at-risk the pay actually is, the more compensation investors have to promise their managers they need to retain them. That’s because managers, like investors (or anyone else), must be rewarded for taking risks.
This rule, stemming from outrage over Enron, once again illustrates the old adage that tough cases make bad law. Of course, the people making bad laws get irritated when they feel they are being ignored.
Sen. Charles Grassley, the Iowa Republican who introduced bankruptcy-reform legislation in 2005 that later included the pay restrictions, said: “You can’t use subterfuge to get around the law. It surely needs further inquiry.”
Which is why I am quickly gravitating to the presumption that every law Congress passes is a bad law, and every attempt to improve it makes it worse.
According to BBC News:
The government should not be setting pay rates, Mr Clegg stressed, while making clear he supported top executives being well rewarded if their companies were successful.
What does he mean? Well, we need to take that phrase in the context of the speech where he declares:
We need to get tough on irresponsible and unjustified behaviour of top remuneration of executives in the private sector…What I abhor is people getting paid bucket loads of cash in difficult times for failure.
A politician will say all those things in the same speech because he wishes to whip up the mob that loves bashing the wealthy elite, but he doesn’t want to alarm that elite by saying he actually wants to determine how much they are paid. And he can say these things without worrying that the press will call him on it, and will, more likely, lay out these points as a balanced position rather than a contradictory one.
The press won’t question that “the government ‘getting tough'” necessarily means that
the politicians in charge should use the police power of the state to get the private sector to do what the politicians want them to do. In this case, Mr. Clegg means that the British government should decide how much an executive is allowed to make in a company deemed not successful. This, in turn, means giving bureaucrats the authority to make the distinction of “successful,” which would necessarily have to be applied to every single company. Is a company that loses any market value successful? What about a company that loses value in difficult times?
In other words, having the government “get tough on pay” means having the government set pay rates, at least in some situations, and potentially for any company.
There are citizens who don’t mind the idea of bureaucrats actually setting pay rates in the private sector, and there are some who don’t mind as long as it’s not their pay. But there are many people who would bristle at the thought of government setting pay rates for anyone not in government. By threatening to “get tough” on pay but claiming that they “should not be setting pay,” a politician can have it both ways, and the print media that boasts its role as an agency of letters and, occasionally, as a public watchdog will go right along with.
The severance package of the fired CEO of Sara Lee’s North America division is in the news:
His package is worth about $11.3 million, based on Sara Lee’s share price of $17.10 as of 4 p.m. Eastern on Friday, according to a calculation for The Wall Street Journal by Mark Reilly, a partner at Compensation Consulting Consortium LLC in Chicago. The estimate reflects Friday’s value of his unvested equity and assumes he earns the pro-rated portion of his annual bonus. “It’s a competitve package,” Mr. Reilly said.
That last comment struck me: “It’s…competitive.” I know what the consultant was thinking when he said that. He looked at other severance packages for departing executives of similar responsibility and similarly sized firms, and saw that, on average, they were given severances with similar terms or of similar magnitude. That’s how comp consultants define “competitive.”
The authors of this article have been reporting on executive compensation long enough to learn the lingo of the comp consultants they rely on for the numbers they report. It appears that they simply bought into the notion that paying the same as everyone else is, by definition, “competitive.”
Apparently neither the writers nor the consultant (not to pick on this consultant–most comp consultants use the same lingo) thought about how the word “competitive” looks to the intelligent reader, who could very well view the departing executive’s $11.3 million pay day and ask, “who were they competing against to provide that award?” Was another company ready to offer $10 million for him to stay? Was someone calling in with an offer of $10.5 million or $11 million if he didn’t leave?
It is likely that his severance was, in fact, established by contract or policy at the time he agreed to commit to the CEO job. Severance is a reasonable component of an executive compensation package, especially to the extent that it consists largely of unvested stock or options in the context of a change in control. If an executive builds a company to the point where the shareholders can cash out in a sale or merger, they want their executives to work hard to make that situation as valuable as possible, without worrying that they are cutting themselves out of the payday through forfeiture of their now valuable, but still unvested equity. So, in a sense, the competition happened at the time the executive was hired, and the board is simply following through on a deal.
However, the average person doesn’t get millions of dollars for being fired. So when the average person doesn’t know about the deal, which is ancient history, and when fulfillment of the deal is simply referred to as “competitive,” the average person can easily be left with the feeling that the game is rigged. Then the average person ends up supporting Dodd-Frank and similar monstrosities.