Writing in the Harvard Business Review, Roger Martin from U. of Toronto explains that CEOs are rewarded for share price volatility not performance. (The Nasty Truth about CEO Pay, 6/3/2011) The financial crisis worked out great for them. Martin explains with great tables comparing the returns for a CEO, whose company performed with the averages, vs one that was able to steer through the storm.
Who is the more valuable CEO? Whose compensation should be higher? Should it be Thrill-a-Minute Tom, who saw massive volatility and a net loss of 6% over the period? Or should it be Steady Eddie, who avoided ups and down, protected investors’ capital and ended up 6% higher than Tom? Based on our current models of stock-based compensation, it’s clear who will come out ahead. Tom leaves Eddie in the dust.
According to the WSJ numbers, CEO compensation for a large company is about $10 million and, since 2000, about half of that compensation is stock-based. So let’s award both CEOs stock-based compensation worth $5 million every January 1 from 2007 through 2011. And we will model both stock options (using the Black-Scholes formula to calculate the number of options that must be granted each year to amount to a value of $5 million on issue date) and restricted stock units ($5 million divided by the stock price on issue date).
If the incentive compensation was given in stock options, Thrill-a-Minute Tom would end up with options he could exercise for a profit of $11 million as of May 2011 versus zero for Steady Eddie. If they had both been given restricted stock units instead, Tom would be $3 million ahead of Eddie.
As far as CEO compensation goes, under the current stock-based compensation model, it is unambiguously better to have your stock plummet and then partly recover than to have the stock stay steady over the same period.
How we pay CEOs is indeed a problem. As I’ve mentioned, I’m working with a group through the United States Proxy Exchange that is fed up with the increasing proportion of corporate profit going to top executives. Several of us work with large institutional investors that try to tie pay to performance, encouraging just the problem Martin points out. We are also concerned with the “Lake Woebegone” effect in that every board thinks their CEO is above average. Since all CEOs are above average every year, the average keeps rising.
We would very much appreciate your feedback on draft guidelines we have posted at the USPX. See comments from people at NACD, Harvard, Yale, etc.
Basically, we are trying to develop guidelines that help average investors decide quickly how to vote with regard to “say-on-pay” and compensation committee members. The guidelines have a degree of flexibility built-in. My own interpretation has been to vote against almost all pay packages where any of the named officers got paid more than the median CEO last year, adjusted for company size. The guidelines can easily be used in conjunction with those of ISS, CII or others that attempt to align pay with performance. Apply the USPX guidelines first and about half of your work will drop off because you’ll quickly decide that at least half are overpaid.
Nobody needs $9.3 million a year. The only reason we pay them that much is because we want to pay them more than the competition. They would all work just as hard if the median was $2 million a year. If we vote down pay above the median, eventually the median will ratchet down. We’re open to your suggestions. We’re meeting on 10 June in Boston to try begin to finalize our advice. If you post your comments in the “Leave a Reply” box we will consider them next week. Thanks.