CEOs and Directors Disagree on Performance Metrics

There’s a boardroom divide over how to measure executives’ contributions to corporate sucess

By Stephen Miller, CEBS Apr 12, 2016
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updated 4/18/2016

CEOs and corporate directors don't always see eye to eye on how to measure executive performance, even as directors give CEOs considerable credit for corporate outcomes, as reported in CEOs and Directors on Pay: 2016 Survey on CEO Compensation.

According to the survey of CEOs and directors of Fortune 500 companies by Stanford University’s Rock Center for Corporate Governance and Chicago-based executive search firm Heidrick & Struggles, corporate leaders do not believe that CEOs are overpaid—an opinion that a large majority of Americans disagree with, based on a companion report from Stanford’s Rock Center, as SHRM Online recently reported (see “CEOs Vastly Overpaid, Most Americans Say”).

CEOs drive success, board members say. Directors serving on the boards of Fortune 500 companies believe that 40 percent of a company’s overall results, on average, are directly attributed to the CEO’s efforts.

These findings help to explain why CEO pay levels are as high as they are among the biggest U.S. companies. “If you believe CEOs are largely responsible for their company’s success, it is understandable that you would want to offer a lot of money to encourage them to be successful,” said David F. Larcker, a professor of accounting at Stanford’s Graduate School of Business.

Metrics and Discretionary Bonuses

CEOs and directors believe that 75 percent of a CEO’s compensation package should be performance-based (rather than fixed or guaranteed). This figure is largely in line with shareholder preferences and existing pay practices, the report states.

But less consensus exists about measuring and rewarding corporate performance. Directors are twice as likely as CEOs to say stock price performance (total shareholder return) is the single best measure of company performance (51 percent vs. 26 percent). By contrast, CEOs are more likely to believe that profitability measures—operating income and free cash flow—are the best indicators (49 percent of CEOs vs. 20 percent of directors).

Furthermore, while 58 percent of corporate leaders (directors and CEOs) agree or strongly agree that companies select “very challenging” performance goals for compensation plans, 14 percent disagree or strongly disagree. Directors (21 percent) are much more likely than CEOs (5 percent) to think that performance targets are not very challenging.

Similarly, CEOs and directors are mixed on whether it is appropriate to pay discretionary bonuses when targets are missed. Forty-six percent of the combined populations agree or strongly agree that it is appropriate to pay a discretionary cash bonus to the CEO if the company misses performance targets because of factors that the board believes are outside the CEO’s control; 31 percent disagree or strongly disagree. CEOs (53 percent) are more likely to agree than directors (43 percent) with paying discretionary bonuses in this situation, but even they are mixed with 25 percent of CEOs disagreeing that discretionary bonuses are appropriate.

“These issues are contentious among shareholders, activists and other governance experts,” said John Thompson, vice chairman of Heidrick & Struggles. “It should come as little surprise, therefore, that the divide plays out in the boardroom as well.”

Equity and ‘Excessive’ Risk

The vast majority of CEOs and directors (90 percent) believe that stock awards should have performance features. A smaller portion (58 percent) believe that stock options should have performance-based vesting features. Directors (63 percent) are more likely than CEOs (49 percent) to favor performance-based stock options.

CEOs and directors (83 percent) generally do not believe that stock options lead to excessive risk taking. However, a significant minority of CEOs (24 percent) believe that they do.

“Executives are notably risk-averse when it comes to compensation arrangements. It is understandable that CEOs would not want additional performance-based features in their stock option plans if they believe that stock prices, by definition, make options ‘performance-based,’ ” said Larcker. “Whether stock options cause ‘excessive’ risk taking is much more difficult to determine. Researchers have long noted that options encourage executives to take on more corporate risk. Whether or not these risks are ‘excessive’ is unclear. Most CEOs and directors believe they are not, but even among these individuals there is no consensus.”

Wary of Government Action

Over one-third of directors (34 percent) believe that CEO compensation is a problem, while only 12 percent of CEOs believe it to be so. These figures represent attitudes that are more generous toward CEO pay than public opinion, where over two-thirds (70 percent) of Americans believe that CEO compensation is a problem.

But CEOs and directors almost uniformly agree that the government should not do anything to change CEO pay practices: 97 percent oppose intervention. The American public is more mixed on this issue, with 49 percent favoring government intervention and 35 percent opposing it.

“The gaps in perception between what directors think and what the public thinks are substantial,” said Nick Donatiello, lecturer in corporate governance at Stanford Graduate School of Business. “Clearly, directors are in a better position to judge what compensation is required to attract, retain and motivate qualified CEO talent in a competitive labor market. But with income inequality being such a hot-button issue today, directors need to be careful that they are not inviting the very government intervention that they say they don’t want. It should be a wake-up call to boards that they need to put more efforts into justifying CEO pay.”

CEO Pay Increasingly Tied to Performance

Total compensation for chief executive officers (CEOs) at the nation’s largest corporations increased modestly last year, driven largely by weaker corporate and stock market performance, an April 2016 proxy analysis report by consultancy Wills Towers Watson found.

Long-term incentives (LTIs), the largest component of total CEO pay in major companies, increased 6 percent at the median in 2015, down from an increase of 8 percent in 2014.

Large-cap companies used performance awards more than small-cap companies: About half (56 percent) of the value of LTIs in large-cap companies is delivered via performance awards, while over a third (41 percent) of LTI value in small-cap companies is made up of performance awards.

Other findings from the Wills Towers Watson proxy analysis include:

  • Long-term performance metrics. Among the 78 percent of U.S. companies with long-term performance plans, total shareholder return (TSR) is the most common performance metric, used by about half (51 percent). Three in 10 (29 percent) used earnings per share, while a quarter (25 percent) used operating income as the performance metric. Most companies that use TSR also use at least one other metric in their LTI programs, with earnings per share the most common.
  • Strong say-on-pay shareholder support. Among the 149 Russell 3000 companies that disclosed their shareholder voting results by April 12, shareholder support for say-on-pay resolutions averaged 90 percent. This is roughly the same level of support as in each of the first five years of mandatory say-on-pay shareholder voting.

Stephen Miller, CEBS, is an online editor/manager for SHRM. Follow me on Twitter.

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