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“Executive compensation may be the lightning rod for shareholders in the wake of the financial crisis, but the truth about how pay should be structured is clouded by a lot of popular myths,” according to David Larcker, professor at the Stanford Graduate School of Business and co-author of the new book Corporate Governance Matters.
“Boards have been put on the defensive when it comes to comp, but the problems that critics are offering solutions to aren’t that cut and dried,” explained Larcker’s co-author, Stanford researcher Brian Tayan.
Larcker and Tayan’s research explored what they term seven common myths around compensation:
Myth #1:The ratio of CEO pay to that of the average worker is a useful statistic.
The Dodd-Frank Act requires that companies disclose the ratio of CEO pay to that of the average worker,” said Larcker. “But in certain companies, high pay packages may be necessary, and in certain industries—such as retail—the ratio may be much higher than in other industries, such as investment banking. Boards have to consider that how much they pay will have an impact on the types of people who want to take the CEO position. You don’t want to drive talented CEOs out of public companies so that they can avoid scrutiny over how much they are paid,” Larcker said.
Myth #2:Compensation consultants cause pay to be too high.
“The perception is that compensation consultants are beholden to management,” said Tayan. “But research shows that it is not the compensation consultant or whether the comp consultant is conflicted that drives excessive pay levels. Instead, it is the governance of the firm. Pay becomes too high if the board members are personal friends of the CEO, appointed by the CEO, or highly busy (in terms of total number of board appointments), etc.”
Myth #3:We can easily identify compensation plans that cause excessive risk-taking.
“It is commonly accepted that the structure of executive compensation contracts encouraged the excessive risk-taking leading to the financial crisis,” said Larcker. “As a result, Dodd-Frank now requires companies to discuss the relation between compensation and risk. The reasoning may be valid, but we simply do not yet know how to measure the relationship between compensation and excessive risk-taking in any precise way. How many boards can go through their plans and say, ‘This feature causes risk-taking, but this one does not.’ ”?
Myth #4:The performance targets in the compensation plan tie directly to the strategy.
“Many companies have adopted complicated bonus plans whose target values depend on achieving a variety of financial and nonfinancial targets,” said Tayan. “The assumption is that these targets map directly to the corporate strategy. But evidence suggests that not all companies do a good job of making this connection. It is a very difficult assessment, and requires testing the relationship between performance drivers and actual operating results—something that is not common in boardrooms today. Companies also tend to overemphasize the financial metrics and underemphasize nonfinancial metrics that might be the real indicators of future performance.”
Myth #5:Eliminating discretionary bonuses is a good idea.
“Sometimes when a company misses its performance targets, the board may decide to give what is called a ‘discretionary’ bonus to the CEO anyway,” explained Larcker. “The perception is that these bonuses are always bad because they reflect pay that was ‘unmerited.’ The truth is that there are times when external factors, such as an economic downturn or change in industry conditions, reduce company performance. What the board needs to assess is whether the company still performed above expectations, even though these unexpected factors occurred. If it did, the board should reward that individual.”
Myth #6:Proxy advisory firms know how to evaluate compensation contracts.
“Following Dodd-Frank, companies are now required to allow shareholders to cast an advisory vote on whether they approve of the executive pay packages—this is known as ‘say on pay,’” said Tayan. “Proxy advisory firms are heavily influential in this vote, but it is not at all clear that their rigid guidelines are in the best interests of shareholders. For example, they automatically vote against a company if they allow things such as option exchanges that are not approved by shareholders, very large severance agreements, or tax gross ups on certain benefits or payments. These restrictions might be arbitrary and might not be appropriate for a specific company.”
Myth #7:The numbers reported in the financial statement for stock option expenses are a good approximation of their cost.
“Companies award stock options because they want to give executives an incentive to create long-term value, and the cost of these grants are required to be included in financial statements and the annual proxy,”Larcker said. “The truth is that we do not know the true cost of executive stock options. The current models do not take into account human behavior, such as the propensity of executives to exercise their options early when they are 100 percent in the money. The board would clearly benefit from more precise valuation models that more closely measure the cost to firm and the value to the executive.”
“In the rush to assign blame for the financial crisis, it’s easy to point to all the big numbers in top executive compensation plans,” said Larcker. “But the truth is a lot more complicated.”
Evaluating CEO Pay
Linda Henman, a consultant for Fortune 500 CEOs and author of the new book Landing in the Executive Chair: How to Excel in the Hot Seat, said she isn’t as concerned about CEOs getting paid large salaries as much as she is about them being worth it.
CEOs in the U.S. earned an average annual paycheck of $11 million in 2010, with pay soaring by an average of 23 percent that year, according to research released by the AFL-CIO in April 2011. As the economy’s sluggish recovery has analysts worried, Henman believes that company top dogs who actually earn their money are easy to spot.
“Those at the top have three major responsibilities: Develop the business, grow talent and make decisions that drive innovation,” said Henman.
“There is much shuffling at the top," Henman explained. "Too often boards don’t make wise decisions about CEOs and CFOs, and these executives, in turn, don’t make wise hiring decisions throughout the enterprise. But if leaders do a better job, companies can do a better job, which means individuals can do a better job. These leaders create companies where customers want to do business and people can do their best work; that all leads to financial health on the micro level, which translates to better financial health for the country. That’s why I think it’s important for people to understand if their CEO evidences the ability to soar above the competition because, in the end, only the strong will survive.”
Henman’s top qualities of a good CEO include:
Strategy. Strong strategic thinking defines the effective CEO. These leaders understand how to match a strong strategy with the tactics and talent to see it through. CEOs who constantly react to events, instead of planning for the future, remain followers and not leaders.Decisions. When CEOs consistently make good decisions, little else matters; when they make bad decisions, nothing else matters. Even though decisiveness distinguishes leaders from everyone else, effective decision-making stands at the center of executive leadership. A decisive CEO who can’t hit the target is the same as an indecisive CEO who doesn’t even know where to find it. The results are the same. Hiring. Successful CEOs know how to tie talent to their strategies so they ensure the company hires the best and the brightest and compensates them fairly. Moreover, they give these people a chance to thrive.Excellence. Leaders who attract and retain top talent stress excellence. They focus on good execution of plans and strategies, and they don’t skew the mission by placing value on tertiary issues that have little to do with execution of strategic goals. Results orientation. Too many executives talk about how to motivate the troops. Those who excel in the hot seat do better. They hire people who are self-motivated, define clear objectives, hold people accountable, and then they get out of the way. Couple these practices with challenging, rewarding work, and the organization ends up with both better results and motivated employees.
“It all comes down to leadership, as opposed to management,” Henman added. “Managers come in all different flavors: good, bad, neutral, ineffective, overbearing, innocuous and more. But true leaders, by definition, move people to perform at levels that allow them to beat the competition. Moreover, leadership doesn’t necessarily come with a title or a status. Responsibility and accountability come with that title, but leading requires the ability to take people to places they wouldn’t have gone if you hadn’t been in the picture. Leaders who possess this ability offer golden opportunities for their organizations and the people who work in them; those who don’t simply hope for a good golden parachute.”
Dodd-Frank Act Has Far-Ranging Impact, SHRM Online Legal Issues, March 2011
Directors Looking Beyond Dodd-Frank Act to Fix CEO Pay, SHRM Online Compensation Discipline, November 2010
Reporting CEO-Employee Pay Ratios: Navigating the Minefield, SHRM Online Compensation Discipline, November 2010
Bonus Cuts, Pay Raises, Then Layoffs, New York Times, June 2011
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