This is the first time I’ve attended a Council of Institutional Investors (CII) semi-annual conference. As at most conferences, the biggest draw is the ability to network, making new contacts and refreshing old ones. I was delighted to reconnect with Meredith Miller, chief corporate governance officer, UAW Retiree Medical Benefits Trust. I hadn’t seen Meredith since we were both graduate students a long time ago. Continue Reading →
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Robin Ferracone hits the right buttons in her new volume (Fair Pay, Fair Play: Aligning Executive Performance and Pay) when she describes how to develop of an “alignment” report that can be used by boards and shareowners to ensure executive pay will be judged as “fair.” She also interviewed the right people to work in a reasonable degree of wisdom from the perspective of shareowners. However, she falls short in glossing over high executive pay as a potential problem, a “myth.”
That’s understandable, given that she is a pay consultant. Shouting out that most CEOs are overpaid isn’t likely to win clients, since most compensation committee members still look to CEOs and other incumbent directors, not shareowners, to hold them accountable… although that may be changing. The book is clearly aimed at compensation committees but shareowners will also find the book useful, once they get past some of the contradictions in Ferracone’s analysis as an amateur sociologist and into the tools she has developed to better align pay with performance.
Warren Buffett, who doesn’t use compensation committees or consultants at Berkshire Hathaway thinks the best way to effect irresponsible board members and overpaid CEOs is to embarrass them. Nell Minow advises that stories on overcompensated CEOs loudly name all members of the compensation committee.
In contrast, Ferracone hopes that “solid and consistent analysis, not embarrassment” using her “Alignment Model” will lead corporations to “self-monitor and adjust their executive pay practices, and that voluntary reform will obviate the need for additional government intervention and allow government to go back to helping solve other problems in our society, such as issues in education and the environment.” Yes, and if companies would just take the necessary steps voluntarily, governments won’t have to mandate measures to address global climate change. We can all imagine it; but will it happen?
As a result of the recent financial crisis, many investors have seen their 401(k) plans reduced to 200½(k) plans. Those who haven’t lost their jobs and still hold some equity in their homes count themselves lucky. Ferracone’s says, “The notion that America’s wealthy people have become wealthier by virtue of seizing the wealth from others instead of creating it is just simply misguided logic.”
The rich may not have “seized” our wealth at the point of a gun, but they did largely take control of our government through false advertising… dramatically reducing their own taxes, overturning laws and regulations designed to guard against fraud and externalizing corporate costs, filling regulatory agencies with executives who believe companies will “self-monitor.” Citizens United further entrenches CEO power, since they spend company funds to install candidates friendly to their own entrenched power.
The rich now bring home the largest proportion of income since the 1920s. One out of seven Americans lives below the poverty line, while the top 2% fight to retain Bush tax cuts amounting to $700 billion over 10 years. Upward mobility in the USA is now lower than in almost all other developed economies. The only industrialized democracy with a higher concentration of wealth in the top 10% than the United States is Switzerland. (Poverty Rises as Wall Street Billionaires Whine, Huffington Post, 9/18/10; Wealth, Income, and Power by G. William Domhoff, updated August 2010)
The American Dream was based on a growing middle class and the prospect that by working hard, you could rise from log cabin birth to business tycoon or President. While the dream is still alive, myths often take time to die.
Ferracone wants to dispel myths, but she focuses her pitch at helping boards find that zone of acceptability, where pay is aligned with value delivered. High pay can still be justified, even in a “say on pay” environment.
While Ferracone’s alignment model is a surer route to justifying pay at most companies than putting up the pirate flag of Larry Ellison or hiding behind all-virtual shareowner’s meetings, such as that held by Symantec, I can’t give Ferracone a free pass as myth buster, even though her actual discussions on how to pay for performance are on target.
According to Ferracone, the vast majority of CEOs are not overpaid. Their compensation, adjusted for company size, industry, performance and inflation, has been virtually flat over the last 15 years, only increasing 1.6 times. Productivity gains alone account for all but $400,000 of the increase.
Investors agree. “About 75% of the investors surveyed by the Center On Executive Compensation in 2008 said that they had no real concerns about the levels of executive compensation in the United States.” Who are the members of the Center? They are the chief human resource officers of 300 of the large companies. They work for the CEOs! (See their comments to the SEC requesting a narrow view on Dodd-Frank) Who were the investors surveyed? They were the top twenty-five institutional U.S. equity investors. Many, like Goldman Sachs, JP Morgan, and Morgan Stanley were the same “investors” who took the financial services sector from 20% of the economy to 40% before the crash, through bets on synthetic derivatives and other nonproductive “investments.”
Even after driving the world economy to the abyss and being bailed out, the CEOs of many of these large investment firms still got huge bonuses. Ask the beneficial owners if CEOs are overpaid; you’ll get a different response. They didn’t put “say on pay” or a requirement to report pay ratios into the Dodd-Frank bill because 75% of the biggest institutional investors surveyed had no concerns. They did so because beneficial owners and average Americans are outraged.
Unfortunately, the American Dream and the personal aspirations of too many CEOs are built around the trinity of wealth, power and fame. These superficial values have become too embedded in the American consciousness. As we strive to resolve the financial crisis, we would do well to examine the need for a constructive shift in values. (See, for example, Corruptions of the American Dream: Wealth, Power and Fame by Joseph Yumang, a graduate student at Saint Mary’s College Of California). CEOs should be looking more to their mission, rather than their pay, to measure their success. Having one’s mission of dying with the most toys and money should no longer be socially acceptable.
Ferracone contends people are angry because a small percentage of companies have distributed excessive pay packages, which she rather arbitrarily defines as companies paying at the 95th percentile or higher… coupled with low performance. Yes, it is hard to argue that outlier CEOs paid anywhere from 15 to over 250 times median performance-adjusted pay deserved what they got. Does that mean those who weren’t outliers earned their pay?
No, not even according to Ferracone. Many companies say that they align pay with performance, but most don’t know whether, in fact, they’ve achieved alignment. Only 8% of variation in Performance-Adjusted CompensationTM (i.e., compensation after performance happens) is explained by variations in performance, defined as Total Shareholder Return (TSR); on the other hand, 30% of variations in Performance-Adjusted CompensationTM (PACTM) is explained by differences in company size, 11% is explained by industry, and 51% is unexplained. With only 8% explained by performance, how can Ferracone argue the vast majority of CEOs are not overpaid?
In a study Ferracone herself conducted, she found the vast majority of board directors and executives feel as though greater government intervention will not only not solve the Alignment issue, but could make matters worse. Is this supposed to be a revelation? Of course they don’t want government intervention.
Ferracone does offer some degree of balance in her Epilogue. She notes, “executive compensation should mostly be a matter that is between shareholders and the executives they employ.” Government “needs to make sure shareholders have the rights they need to appropriately influence the companies in which they are invested.”
Unfortunately, the first right she goes on to mention is the ability to buy and sell shares in a level exchange process. While that’s important, the “Wall Street Walk” encourages poor pay alignment, since if the investors who are unsatisfied walk away the more passive investors who are left are unlikely to take action regarding pay abuses.
She adds that shareowners “need to be in a position to elect board directors and vote on key proposals that affect their equity.” Good, but I would have felt better if she had inserted the word “nominate” with regard to selecting directors. Those interviewed by Ferracone for the book overwhelmingly indicated that retention is an overblown argument for increasing executive pay. Most CEOs identify strongly with their companies and generally won’t leave companies because of pay. If true, why are so many of them paid so much? Of course, the problem isn’t just incentives for CEOs. After all, traders at AIG Financial Products practically brought the entire economy down, and none were senior executives.
Ferracone’s firm, Farient Advisors LLC, is one of a growing number of pay advisers that sprung up to meet the needs of compensation committees that don’t want to be seen as conflicted by hiring the same firm that simultaneously works for management. That’s certainly a positive step in the right direction, as is Ferracone’s discussion of how to align pay and performance. Ferracone moves beyond Corporate America’s Pay Pal (NYTimes, 10/15/10) by wanting to be the shareowner’s pay pal too. If both sides converge around her Performance-Adjusted CompensationTM that would be another good move.
Yonca Ertimur, Fabrizio Ferri and Volkan Muslu offer some further hope in their paper, Shareholder Activism and CEO Pay (download pdf). They studied a sample of 134 vote-no campaigns and 1,198 non-binding shareholder proposals related to executive pay between 1997 and 2007 and found that shareholders are sophisticated enough to identify firms with excess CEO pay, both when targeting firms and when casting their votes.
Proposals that try to micromanage level or structure of CEO pay receive little or no voting support. Instead, shareholders favor proposals related to the pay setting process (e.g., subject certain compensation items to shareholder approval). These proposals are also more likely to be implemented. In some cases, compensation-related activism has a moderating effect on CEO pay levels. Firms with excess CEO pay targeted by vote-no campaigns experience a $7.3 million reduction in total CEO pay. The reduction in CEO pay is $2.3 million in firms targeted by proposals sponsored by institutional proponents and calling for greater link between pay and performance. (Hat tip to Stephen Davis for tweeting about the study.)
Perhaps the increasing power and sophistication of shareowners, combined with somewhat more neutral firms, like Farient Advisors LLC, will make the difference. Probably even more important, is the need for a shift in cultural values so that CEOs are driven by more altruistic missions than simple greed.
See also, Executive Compensation and Corporate Governance in Financial Firms: The Case for Convertible Equity-Based Pay (pdf) by Jeffrey N. Gordon, July 2010 and What’s your CEO really worth? INSEAD’s Corporate Governance Initiative creates a model, 9/22/2010.