Executives at high-performing U.S. companies are being paid better than those at underperforming companies, suggesting that pay for performance is working, according to a new study by global consulting firm Watson Wyatt Worldwide.
Separately, the study, Debunking Executive Compensation Myths–2007/2008 Report on Executive Pay, found that a growing number of workers are forfeiting "in the money" stock options to take jobs at other companies, and that employers are continuing to pull back on granting broad-based stock options as compensation.
Watson Wyatt’s annual report on executive compensation found that CEOs at high-performing companies earned significantly more “realizable” pay from 2004 to 2006, especially from long-term incentive (LTI) awards.
Realizable pay calculates the current value of outstanding LTI awards, which include so-called in-the-money stock options, restricted stock and performance share payouts, granted over a specific time frame using the ending stock price. This method contrasts with pay opportunity, a more traditional analysis that calculates the value of the new LTIs as of the grant date, using the Black-Scholes value of stock options.
Between 2004 and 2006, the median realizable LTI for CEOs at high-performing companies was $5.2 million, compared with just $1.7 million for CEOs at low-performing companies. The study, based on public data from 1,072 companies, found similar results for realizable total direct compensation (TDC), which includes realizable pay from stock incentives as well as cash compensation and annual bonuses, which tend to be less sensitive to shareholder returns, according to Watson Wyatt.
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Realizable Pay for CEOs Aligns with Financial Performance:
Total Return to Shareholders (TRS) |
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Number of companies |
Cumulative TRS (2004-2006) |
Cumulative realizable LTI value (MM$) |
Cumulative realizable TDC (MM$) |
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High TRS |
536 |
99% |
$5.2 |
$10.5 |
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Low TRS |
536 |
17% |
$1.7 |
$6.0 |
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All Companies |
1,072 |
49% |
$3.3 |
$7.9 |
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Source: Watson Wyatt Worldwide. All numbers and percentages are medians except for number of companies. |
“The evidence from this year’s study clearly indicates that most boards of directors are linking executive pay to financial performance, when pay is measured by its realizable value,” said Ira Kay, global director of compensation consulting at Watson Wyatt and one of the nation’s leading authorities on executive pay, in a prepared statement. “Executives who deliver above-average performance are earning significantly more than those who don’t deliver. And many executives are losing great amounts of wealth when their companies perform poorly. Both are shareholder-friendly outcomes,” observed Kay.
Pay Opportunities
A critical element in this design is setting the range of potential compensation opportunity. The Watson Wyatt study found that some companies might be setting their pay opportunities too high from a shareholder perspective. Companies that offer executives above-market LTI pay opportunities but have only average stock price performance might still deliver above-market pay.
In addition, the study found a large reduction in the value of stock-based compensation programs, as the estimated grant value per employee declined by roughly one-third from 2004 to 2006. Moreover, the rate by which workers forfeited stock options increased nearly 20 percent in the past year, from 4.7 percent to 5.6 percent.
“While some options are forfeited because they expire with no value, an increase in forfeitures in a rising stock market suggests many employees are forgoing large amounts of intrinsic option value to take jobs at other organizations,” said Kay.
However, employers should be wary of reducing option-based compensation too far. “Shutting out employees from stock options has the potential to create morale and productivity issues, particularly as executives continue to have higher realizable pay,” Kay warned.
“Greater share ownership helps motivate executives and employees while aligning executive pay with performance and shareholders’ interests. Companies can make that happen by offering programs that encourage executives to increase their company stock ownership and including a broad-based group of employees in their stock option incentive programs,” Kay concluded.