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:
1) The typical large company CEO is worth about $10 million to $20 million per year. You may not like or agree with this sum, but try to buy one for less.
2) Nobody expects a CEO’s pay package to be totally fixed or totally variable. They expect a fixed component, e.g., salary, and variable component, e.g., bonus.
If you accept these two items, then you can probably accept a CEO pay structure of, say, $5 million in salary, and $10 million in target variable compensation. However, this poses two problems. The first is that tax law makes a $5 million salary unnecessarily expensive because of the envy tax on every dollar of “non-performance based” compensation over $1 million. The envy tax is placed entirely on the shareholders, in the form on non-deductibility of that pay from corporate expenses. A good board would not want their shareholders to suffer from the envy tax, so they award $4 million of that salary in a slightly more acceptable form, e.g., as restricted stock. Stock awards avoid the envy tax.
So, if the board’s sense that $5 million of a CEO’s pay is to be fixed is implemented as a combination of cash and time-vested stock, then one can see how it is possible that a CEO in a bad year can still earn $5 million, and it not be a failure of alignment. In fact, if a CEO falls short on his performance goals, and gets a $2 million bonus instead of his target bonus award of $10 million, then it might still not be a failure of alignment, although you might read, “can you believe this guy’s company did poorly, and he still got $7 million, including a $2 million bonus?” When his company does very well, and the CEO earns his full $10 million bonus twice over, then we see what appears to be better alignment, and we have to begin attributing that better alignment to some cause, like newly empowered shareholders.
All this is not to say that shareholders are not empowered, or that this empowerment has had no effect. In fact, Say on Pay is definitely empowering shareholders, and it is having a significant effect on pay structures. But this effect is not necessarily salutary. In order for Say on Pay to work to the benefit of investors, two conditions must be met: (1) the shareholders should be able to distinguish good compensation plans from bad plans, and (2) shareholder votes should be based on that distinction.
The truth is that shareholders’ can, at best, distinguish truly awful plans, the kinds of plans that have been gradually disappearing from view since long before Say on Pay. The other truth is that many of the shareholders that vote against company pay plans do so for reasons that might be only a tangentially related to pay. A union pension plan may not like that the CEO was paid a bonus in a year that the company laid off a bunch of people, even if those layoffs cut millions out of the company’s cost structure in a value-added way. While more companies are having dialogues with their shareholders, and such dialogues are probably a good thing for reasons that go beyond pay, there is no evidence that companies are getting useful suggestions about pay from their investors. That is not a knock on the investors or the companies–they have different jobs.
I understand that if you’re going to write a story about pay, you have to have something beyond “Pay went up with performance” and “Investors have an indeterminate effect on pay.” At least, the WSJ story was not reporting, “Performance and pay are way up. Some of these numbers are obscene.“