Fair Pay, Fair Play

Aligning Executive Performance and Pay

Robin A. Ferracone

• Publisher: Jossey-Bass
• Year: 2010
• Print ISBN: 9780470571057
• eBook ISBN: 9780470612859
• Edition: 1
• Topic: Business
• Subtopic: Leadership
• Index: Business

A timely look at how to evaluate and determine executive pay

Recognized as the leading expert on executive compensation, Robin Ferracone combines her own 20 years of experience with interviews with executives and compensation committees to provide a clear examination of and guidance on determining pay packages, actions, and designs. and Over the past 25 years, the author has created a database of executive pay across 44, 000 companies, broken down by company performance, company revenue and industry. Using this data, the author provides boards and individuals evaluating executive pay with the ability to analytically determine an appropriate compensation package.

• Provides real-life stories, perspectives, and insights from thought leaders on executive compensation
• Contains interview with compensation committee members, executives, academicians, government leaders, and shareholder activists
• Research based on 44, 000 companies broken down by performance, revenue and industry

Offers a timely resource on a hot button topic.

Part One

FAIR PAY

1

SAME PROBLEMS, DIFFERENT CONTEXT

A Case in Point

When I walked into the boardroom, I saw four compensation committee members staring at me, eager to hear my presentation on how to retain the CEO of this publicly traded, high-flying company. The CEO had enjoyed meteoric performance, but he was threatening to quit if he didn’t receive a generous helping of restricted stock¹ as part of his new employment agreement.

Weeks earlier, I had been called by the chairman of the compensation committee to provide advice to the committee regarding this matter. And while the members of the committee said they wanted my opinion concerning what they should do, my hunch was that they really wanted me to bless the CEO’s requested grant.

Like most board and compensation committees, this one wanted to be supportive. It would be easier to say “yes” than “no.” Further, the compensation committee thought that the CEO was doing a splendid job. The stock price had risen more than 50% since the CEO had taken charge three years prior. They figured that the company would be at considerable risk if they lost their “rock star” leader. After all, there was no successor in sight. On the other hand, the committee realized that what the CEO wanted was “over the top, ” and that they could be subject to undue criticism if they approved the requested package, particularly without an outside, objective opinion.

My report was not a surprise. I had telegraphed my preliminary findings well in advance of the meeting. My analysis showed that the requested grant would put the CEO ’s compensation well above the market, even considering the company’s high performance. As a result, I recommended a more modest grant, contingent on performance. I delivered my report to the compensation committee in the executive session, with the CEO absent from the meeting. The compensation committee heard my report and asked a few questions, and then the committee chairman excused me from the room.

A few days later, I called the chairman to see what had happened. He said, “The compensation committee was extremely pleased with your work, but decided to give the CEO what he wanted.” In fact, the board had penned a lucrative new employment agreement, complete with generous severance, change-in-control, tax gross-ups, and other bells and whistles. Of course, the news media had a heyday when the agreement was disclosed, and shortly thereafter, one member of the compensation committee even resigned from the board, although I suspect that it wasn’t only about CEO pay.

Fast forward to a year later, when the demand bubble for the company’s services burst and the financial performance collapsed. The CEO was asked to resign in return for the large severance deal that had been provided by his employment agreement. As the consultant who had given the compensation committee advice to pare back the sought-after restricted stock grant and apply performance hurdles, I felt vindicated that my advice had been sound, but not satisfied that it had been dismissed.

Is this a story out of today’s news? It sounds like it is, but it’s not. It actually took place a decade ago. But in a fundamental way it doesn’t really matter. Getting the pay-for-performance equation right is a long -running issue that remains an issue today. But why should we care? Does pay for performance really matter? Do incentives really motivate good performance?

The Role of Compensation

Among academics there is a great deal of debate regarding the motivational power of incentives. Some, such as Dan Ariely, James B. Duke Professor of Behavioral Economics, Duke University, think incentives are not good motivators. “In experiments, we’ve seen that in some cases, people’s performance actually was lower the larger the bonus they got,” Ariely said. As a result, stock bonuses, stock grants, and other incentives are “probably better for creating loyalty than performance,” he said. Among other academics, some agree with Ariely; some disagree.

My own view from working on matters of compensation over the years is that good people, and top executives in general, are intrinsically motivated, but incentives provide a powerful messaging and focusing device. In addition, the market for executive labor is generally willing to pay more for an executive who produces great performance versus one who does not. For these reasons, incentives matter.

As for the question “Why should we care?” investors have said that they care. In a study conducted by the Center on Executive Compensation in 2008, twenty of the top twenty-five institutional U.S. equity investors were interviewed regarding their views on executive compensation. Investors resoundingly reported that the most important issue of concern was the alignment between executive performance and pay. Correspondingly, their second most important concern was having a compensation committee that they could trust and rely on to represent their interests. For this reason, we should care.

Nearly every board in America states that its philosophy for executive compensation is to align pay with performance (or words to this effect). This is not without reason. Not only is paying more for better performance intuitively appealing, it also has motivational value to executives and seems fair to investors. And although I have not proven causality, companies whose pay is more sensitive to performance also have better performance (as I’ ll discuss later in this book). Further, corporate leaders are not living up to their pact with investors and employees if they don’t put real meaning behind the mantra “our objective is to align our executive pay with performance.”

Finally, pay for performance has become a biting social issue. The populist view is that executive compensation is the root of all evil. In fact, some blame the largest financial collapse since the Great Depression on egregious executive pay. While I have not met anyone sophisticated in business and finance who agrees with this view, the fact of the matter is that it has built up a head of steam and is implicitly shaping public policy. According to a study conducted by Farient Advisors, the executive compensation and performance advisory firm I founded, the vast majority of board directors and executives feel as though greater government intervention will not only not solve the pay-for-performance issue, but could make matters worse.

Except for requiring clearer disclosure, there are almost always unintended and negative consequences to government intervention in matters of executive pay, the most famous of which was the decision made to cap the deductibility of non-performance-based pay at $1 million for certain executives in public companies. As a result of this governmental decision made in 1993, early in the first Clinton Administration, CEOs began receiving less in the way of cash, but more in the way of stock options² and restricted stock. Ultimately, rather than pushing down CEO compensation, the result of this action was to raise CEO pay levels.

But if we come back to our question, “Should we care about linking pay to performance?” the answer is a resounding “yes.” Short of inviting the government to do our work for us, it is incumbent upon boards, their advisors, and management to crack this code. Charles M. Elson, director at the John L. Weinberg Center for Corporate Governance at the University of Delaware, sums it up nicely: “Government will only make it worse. If you didn’t like what they did in 1993, then you ’re really not going to like what they’ re doing now.” It is something that we all need to get right.

Old and Persistent Problems

For nearly thirty years I have worked on solving vexing issues around performance and pay. I certainly am not the first or only one to tackle these issues. Many have gone before me and acknowledged the difficulty. As far back as the 1980s, Robert A. G. Monks, founder of Institutional Shareholder Services, Inc. and cofounder of The Corporate Library, was practically inventing the shareholder rights movement when he took on Sears, Roebuck for the way it generously compensated its top team, made poor investments, and developed an ill -fated strategy. From Monks’s point of view, the compensation system is far too arcane. In fact, he calls it “complex, difficult, remote, and virtually inaccessible to anyone without a lot of experience.”

At about the same time, Graef “Bud” S. Crystal left the world of compensation consulting to become the b ête noire of American CEOs by widely publishing articles with extended tables showing how CEOs compared to each other with regard to pay and performance. Crystal’s analysis led to a great deal of finger pointing. What he did was to tally CEO salaries, bonuses, stock options, restricted stock, and other types of compensation. He then compared what CEOs received relative to the performance of their companies and created tables comparing who got what, when, and what for. Crystal’s 1992 book In Search of Excess: The Overcompensation of American Executives became a best-seller and for many people a reason for outrage, since so much of the information Crystal uncovered was hidden in proxy statements that were difficult to decipher. Crystal is still at it and publishes a weekly newsletter not surprisingly called The Crystal Report, but let’s pick up where Crystal’s book left off.

What Exactly Are the Problems?

What exactly are the problems? Is it that executive compensation is simply too high? Or are there executive pay outliers that attract undue attention and create a media feeding frenzy? Is the problem that there are too many instances when executive pay is high but performance is low (including cases in which executives take lucrative stock option gains off the table right before the bottom falls out of company performance)? The short answer is “all of the above,” although my view is that the most significant issues are outliers, which I am defining as companies paying at the 95th percentile or higher, and high pay coupled with low performance.

Median executive compensation is not really the issue. On the surface, performance-adjusted CEO pay (to be defined later in this book) increased threefold since 1995. This seems like a lot. But if we take into account (1) inflation (as measured by the Consumer Price Index) and (2) the increase in median company size (larger size begets higher CEO pay) over this same time period, then real size- and performance-adjusted CEO pay has increased approximately 1.6 times the 1995 level. This implies a compound annual increase in real performance -adjusted CEO pay of 3.6%. Because Gross Domestic Product rose by 2.6%, productivity gains account for all but $400,000 of the total compensation increase. As a result, I conclude that the absolute level of executive compensation is not the issue on which to focus. The real issues are about outliers and performance and pay alignment. Investors agree with me. 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.

How Investors View Pay

According to Patrick S. McGurn, vice president and special counsel to RiskMetrics Group, Inc.

“There are some investors and obviously other interested parties for whom the numbers are very important, and I think there are some people who simply would like to see pay go down. However, I can’t remember having too many conversations with our clients with that as the ultimate goal. The conversation is generally not about how much you pay them but how you pay them. How much you pay them does come into play, particularly when boards do an absolutely terrible job of calibrating those pay programs and get these huge outsized payouts that I think, even from a board perspective, were never intended when they designed the programs. They simply didn’t take adequate care in either setting maximums or multiples or whatever it is they’re going to use to stop those payouts from going into uncharted waters.”

Outliers

Let’s consider outliers. They shock the senses. They’re the stuff that headlines are made of, and for good reason. As shown in Exhibit 1.1 (page 20), there are always a few outliers—companies that generate performance-adjusted compensation that looks “off the charts,” regardless of how hig...

Table of contents

• Praise
• Title Page
• Copyright Page
• Preface
• Part One - FAIR PAY
• Part Two - FAIR PLAY
• EPILOGUE
• APPENDIX A
• APPENDIX B - GICS SECTORS
• APPENDIX C - LIST OF INTERVIEWEES
• Notes
• Acknowledgments
• The Author
• Index