Total shareholder return (TSR), is the most frequent metric used to pay CEOs for performance. The authors of this excellent study from IRRCi believe CEO pay should, instead, be linked to the cost and future value of capital.
CEO Pay for ‘Performance”
In 1993, Congress amended the tax code to tie executive pay to “performance” metrics. To be a deductible business expense, pay had to be linked to performance. Stock price was an easy proxy for performance and the link was acceptable to the IRS. Before the amendment, in 1991, average CEO pay at large public firms was 140 times that of average employees. By 2003, it was approximately 500 times. Whereas equity-based compensation at such firms was zero percent in 1984, it climbed to 66% by 2001. The percentage of CEO pay from stock option grants rose from 35% in 1994, to 85% by 2001.
As the authors point out, “total shareholder return is, by far, the most dominant performance metric in long-term incentive plans.” Yet, increased TSR often has little to do with actually growing a business for the long-term. The rise of fall in stock price generally has little to do with CEO effort. When there is effort involved, rewards come quicker through cost-cutting (firing employees, reducing R&D), stock buybacks or financial engineering than by developing new products, training staff or increasing sales.
New Research on CEO Pay
- Read Wall Street Journal coverage of this new study, What’s a CEO Really Worth? Too Many Companies Simply Don’t Know.
- Watch the webinar replay here.
- Download the PowerPoint presentation here.
- Read the press release here.
- Follow @IRRCResearch.
For the vast majority of S&P 1500 companies, there is a major disconnect between corporate operating performance, shareholder value and incentive plans for executives.
The study details an over-reliance on accounting metrics that do not measure capital efficiency, and how total shareholder return obscures a line of sight to the underlying drivers of economic performance. Moreover, economic performance explains only 12% of variance in chief executive officer (CEO) compensation.
The report finds that:
- Economic performance explains only 12% of variance in CEO pay. More than 60% is explained by company size, industry, and existing company pay policy. None of those are performance driven.
- Some 75% of companies have no balance sheet or capital efficiency metrics in their disclosed performance measurement and long-term incentive plan design.
- Only 17% of companies specifically disclose return on invested capital or economic profit as a long-term performance measure for long-term executive compensation.
- Some 47% of S&P 1500 companies over the last five years (2008 – 2012) did not generate a positive cumulative economic profit or return on invested capital greater than their cost of capital.
- More than 85% of the S&P 1500 have no disclosed line of sight process metrics aligned to future value such as innovation and growth drivers.
- Only 10% of all long-term incentives have a disclosed longest performance period for named officers of greater than three years.
- Nearly 25% of companies have no long-term performance based awards at all, relying instead stock options and time-based restricted stock in their long-term compensation plans.
- Total shareholder return (TSR) is the most dominant performance metric in long-term incentive plans, present in more than 50% of all plans despite the fact that executives do not have line of sight accountability for key drivers that impact TSR outcomes.
- Nearly 60% of companies changed performance metrics for CEO compensation in 2013, and one-third of companies changed at least 25% of the peer group used for performance benchmarking. That lack of stability of performance metrics can suggest a short-term focus despite the fact that the incentive plans are supposed to be long-term focused.
The study suggests that the majority of companies could enhance long-term value creation and long-term incentive plan design by:
- Applying value-based performance metrics such as return on invested capital (ROIC) and/or economic profit in performance measurement design while migrating away from the dominant use of total shareholder return or earnings per share;
- Adding future value improvement drivers (i.e. innovation, customer loyalty) to the performance metrics mix and long-term incentive plan design;
- Extending the longest accountable performance-period for named executive officers to a period longer than three years;
- Stabilizing the performance metrics and peer groups used in long-term incentive design to the extent possible; and
- Creating coherent and coordinated reporting on business performance, executive rewards, and disclosures for investors based on this framework.
A sustainable and viable business model must eventually provide consistent positive economic profit and a return on invested capital greater than its cost of capital. Without a reasonable expectation of positive economic profit then no amount of sales or earnings growth will create sustainable shareholder value
Investors Must Link CEO Pay to Creating Long-term Economic Value from Invested Capital
The CFA Institute recently issued a report on proxy access that is now being cited in almost all proxy access proposals submitted by shareowners. For example, here’s what I put in a proposal to EBAY: CFA Institute’s Proxy Access in the United States: Revisiting the Proposed SEC Rule found proxy access:
- Has the potential to enhance board performance and raise overall US market capitalization by up to $140.3 billion
- Would “benefit both the markets and corporate boardrooms, with little cost or disruption.”
I would love to see this report from IRRCi used similarly when shareowners propose additional metrics be added incentivize long-term value creation by corporate executives. Expect push-back. For example, here’s a no-action request from Apple ($APPL) on pay methods. Apple wants the SEC to throw it out as interfering with “ordinary business.” While Marco Consulting and As You Sow don’t raise the same issues as raised in the IRRCi research, expect companies to use many of the same arguments in keeping such proposals off the proxy. Let’s hope ISS, Glass Lewis, Equilar, GMI and others start offering more of the type of research exemplified by the IRRCi study to their clients.
Take Action on CEO Pay
According to the report, only 17% of companies specifically disclose return on invested capital or economic profit as a long-term performance measure for long-term executive compensation. Logically, if we want to ensure our investments are put to good use, the rest of the pay plans should be voted down. How do we identify such companies if our advisors don’t provide the analysis? The first step is to ask them to analyze how well CEO pay is incentivized in terms of creating economic value and efficiencies.
CEO Pay Authors
Congratulations to Jon Lukomnik, Executive Director, Investor Responsibility Research Center Institute (IRRCi @) and to report authors: