In recent years, compensation packages for CEOs and other senior corporate executives have been criticized for both their high level and their growth, often despite poor company performance. Are patterns such as this likely to continue in the aftermath of the recent financial meltdown?
You might think the answer would be obvious. For one thing, the precipitous drop in the stock market reduces the value of stock options, typically the largest component of executive compensation. Even companies that have a history of granting a fixed value of stock options may be unable to continue the practice.
“It may simply be too dilutive to grant the number of options required to maintain fixed value,” says Irv Becker, managing director of the compensation consulting firm The Hay Group, in New York. Second, current economic conditions are likely to depress corporate earnings, which are commonly used to determine incentive-based bonuses. Third, executive compensation packages are designed to attract and retain the best managerial talent, so an executive being recruited by company A is likely to be “made whole” for any compensation that he or she might lose if they leave company B, including unvested stock options. Since the current market is likely to leave many previously granted options “under water,” the cost of attracting and retaining employees is likely to decline.
In other words, when we “pay for performance,” if performance is down, shouldn’t pay go down with it? In theory yes. But many of my academic colleagues and I have observed a very robust pattern in executive compensation over the years that we like to call “pay for pulse.” The pattern is as follows: Suppose we split all companies into two groups: Group one, in which shareholders saw some positive returns to their investment for the year, and group two, in which returns were negative. As you might expect, the executives in group one receive compensation that is greater, with better returns corresponding to larger increases in compensation. So in group one we observe “pay for performance.”
In contrast, executives in group two typically also receive more in compensation, despite their poor performance. Historically this increase has been more than double the rate of inflation in most years. What’s even more troubling is that there is typically no difference between pay for executives in firms with marginally poor performance compared to those in firms with worse performance. Hence the term “pay for pulse.”
What’s driving this?
When performance is poor, the company’s board of directors and its compensation committee face the difficult task of separating the role of the economy from the contribution of management. So when the economy is bad, boards may be tempted to conclude that their management team did a great job given the circumstances. Typically boards rely on two mechanisms to reach such a conclusion.
First, compensation committees typically benchmark their company’s compensation and performance with that of a peer group. Correspondingly we see better compensation in firms where the board concludes that the company has outperformed its competition. Second, executive compensation typically allows the inclusion of subjective assessments of factors such as leadership, which are difficult to measure objectively.
Are there reasons to believe that “pay for pulse” will go away?
I think so. The revised compensation disclosure requirements enacted by the Securities and Exchange Commission (SEC) in 2006, combined with the observed growth in shareholder activism in recent years, is likely to reign in the board’s use of peer groups and subjectivity in awarding compensation. With broader disclosure, shareholders have substantially more information from which to form opinions of the fairness of their company’s executive compensation. For example, companies must disclose the peer group that they used in the compensation process, so shareholders can form their own opinion on whether a reasonable peer group was used or whether the board “cherry-picked” the peer group to justify higher compensation.
Even before the economic meltdown reached its peak, we began seeing examples of the effectiveness of the SEC’s regulations and the actions of shareholders. Specifically, a survey of executive compensation in 2007 by The Hay Group showed — for the first time in recent history — decreases in compensation when firms had decreases in stock price. In prior years, we typically observed small increases in compensation for firms when stock price decreased, and larger increases in compensation as stock price increased.
In addition, we recently began to see firms take steps to curtail “golden parachute” severance packages. Finally, in 2007 we saw the growing use of “claw backs,” which permit firms to take back the portion of compensation that was awarded to executives using misstated accounting numbers.
Overall, the executive compensation process is shaped by many forces, but in our current environment scrutiny from both regulators and investors is particularly high. The rescue of Fannie Mae and Freddie Mac, and the $700 billion federal financial rescue package, impose executive compensation restrictions including the elimination of golden parachutes and provisions for claw backs.
But as you might expect, there are efforts underway to negotiate exceptions to these compensation restrictions. Will our current economic meltdown, combined with regulatory scrutiny, shareholder activism and increased disclosures, eliminate “pay for pulse” going forward? Let’s hope so.
This column also appeared on Forbes.com.