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Is corporate America slighting pay-for-performance in CEO compensation? Not likely, a new study suggests

April 1, 2010

For more information, contact: Benjamin Haimowitz,

When this month's media surveys of CEO pay revealed that salaries and bonuses rose last year even as chiefs' total compensation fell, the Obama administration's pay czar, Kenneth Feinberg, was quick to warn against companies' shifting their pay emphasis from stock to cash."To the extent there is more emphasis on cash than stock, that's unfortunate," Mr. Feinberg told a major business magazine.
But how unfortunate is it? Is corporate America in danger of slighting pay-for-performance in compensating its CEOs, as Mr. Feinberg's comment implies? A new study strongly suggests not. Research in the current issue of Academy of Management Perspectives finds that, among CEOs of the S&P 500, financial incentives geared to firm performance have galloped far ahead of pay increases since the early 1990s.
The authors, John E. Core and Wayne K. Guay of the University of Pennsylvania's Wharton School, express perplexity over Treasury Department rules aimed at increasing CEO equity incentives in TARP firms and at providing a model for other companies. "US executives typically have much stronger performance-based incentives than executives in any other country," they write. When it comes to CEO pay, "problems associated with too much incentives seem just as plausible as problems associated with too little incentives."
Thus, in 1993, the study reveals,  the CEOs of the S&P 500 received median annual pay of $2.0 million in salary, bonuses, and grants, and would have realized an additional $1.7 million in paper gains via their holdings of stocks and options if their company's share price rose 15%. In 2008, CEOs received a median of $7.6 million in salary, bonuses, and grants, and would have realized an additional $9.9 million in paper gains if the company's stock rose 15%.
Unfortunately for those 2008 CEOS, though, the market didn't cooperate, as the S&P index dropped close to 40% over the course of the year. That unwelcome development exposed the CEOs to median paper losses of  more than $25 million, about three and a half times the $7.6 million they received that year in salary, bonuses, and grants.
"CEOs have enormously more to gain or lose from their companies' performance than they once did," comments Prof. Guay. "People will look at a CEO's annual bonus and salary, which generally don't closely track company performance, and express outrage at the CEO's earning millions if the firm hasn't done well. But what they are missing in their outrage is that the CEO probably has tens of millions of dollars' worth of company stock and options. If the firm's stock price drops by 20% or 30% or more, that's where the CEO takes a huge financial hit."
But do CEOs, in fact, hold on to the stocks and options that have become such a major factor in their  contracts? Indeed they do, as Core and Guay discovered by dividing their study sample (CEOs of the S&P 500 from 1993 through 2008) by tenure. They found a steady rise with increasing tenure in what they call "beginning-of-year incentives," which are estimates of how much a CEO has to gain or lose over the course of the year if there is a 100% change in stock price.
CEOs with two to three years of tenure, they found, had incentives worth about $25 million, meaning they would stand to gain $5 million in paper value if the company's stock rose 20% and would lose the same amount if the stock fell 20%. CEOs with five to six years' tenure had a median of $43.6 million in incentives, while CEOs with more than 10 years' tenure had a median of $93.9 million in incentives, potentially exposing them to one-year paper gains or losses of about $19 million if the stock moved 20% in either direction.
Taking note of "the claim by critics is too easy for [executives] to 'unwind' their incentives by selling equity," Core and Guay respond: "The data show that the typical CEO sells only about 1.9% of his equity incentives each year...While there are, no doubt, some CEOs selling large amounts of stock, there does not appear to be support for critics' claims that there is widespread unwinding of incentives by CEOs following good performance."
Meanwhile, largely overlooked in the continuing controversy over CEO pay, the professors point out, is the "important determinant" of CEO personal wealth. As Core and Guay put it, "A requirement that all executives hold $10 million in firm stock will result in very different incentives for an executive with $100 million in outside wealth as compared to an executive with only $10 million in outside wealth. There is a popular saying that an executive should have 'skin in the game.' But what constitutes significant 'skin' for one executive might be relatively trivial for another executive."
While conceding that "public disclosure of such data (e.g., through proxy statements) is tricky due to issues of privacy," Core and Guay urge "private disclosure of this information to boards, with more generic disclosures assuring investors that boards have considered this information." Such a reform, they argue, is likely to be "more fruitful than a one-dimensional doctrine that more executive incentives and less executive pay are 'better' than less incentives and more pay...If the CEO's contract imposes too much incentives and offers too little pay, the CEO will either quit and work elsewhere or ...shy away from taking the risks necessary to effectively manage the firm."
The study, "Is pay too high, and are incentives too low? A wealth-based contracting framework," is in the spring issue (Feb.-April) of Academy of Management Perspectives. This peer-reviewed publication is published quarterly by the academy, which, with about 18,000 members in 103 countries, is the largest organization in the world devoted to management research and teaching. The academy's other publications are the The Academy of Management Journal, The Academy of Management Review, and Academy of Management Learning and Education


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