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5 Drivers of CEO Pay

Author: Anjie Cai Anderson

CEO pay is an emotive topic, one which is often framed in a way that compares the inordinate amount a CEO receives relative to one of the employees, questioning whether their contribution can justify such compensation. According to The Economic Policy Institute (EPI), the CEO-to-worker compensation ratio in the top 350 publicly owned U.S. firms had grown significantly between the 1960’s and the turn of the century, falling back in recent years. As the income gap between CEOs and other workers widens, people are questioning what drives the pay of CEOs.

graph1

Source: The Economic Policy Institute (EPI)

 

Here we detail  some reasons for the  level of CEO compensation.

Performance-Based Compensation Plan

CEO pay is increasingly tied to a company’s performance to have CEOs’ interests aligned  with shareholders. Therefore, executives’ monetary gains reflect improvement in a firm’s value, according to specified metrics . Successful CEOs often have gained substantial amounts of money through equity stakes in their companies and by driving share-prices up and benefiting from appreciation in equity asset classes. Of course, such remuneration incentives do not always award only successful CEOs.

Graph2

Source: The Economic Policy Institute (EPI)

Graph3

Source: The Economic Policy Institute (EPI)

 

Executive equity compensation plans typically include instruments like stock options, stock appreciation rights (SAR), restricted stock and restricted stock units (RSU). In 2014, Hay Group conducted a study of Executive and Director Compensation for The Wall Street Journal. Among the 300 largest US companies that filed their final definitive proxy statement between May 1, 2013 and April 30, 2014, 65 companies (21.7%) made some form of restricted stock grant and 192 companies (64%) made some form of RSU grant. Thus, RSU awards were almost three times more popular than restricted stock grants.

Stock options grew in popularity during the 1970s and 1980s, and were the leading long-term incentive vehicle through the 1990s. However due to recent regulatory changes, along with employee tax obligations, companies reduced or even eliminated stock option programmes.  According to Hay Group, to date, performance-based stock options have not constituted a prevalent form of executive reward.

Increased Demand for Talents

It is argued that the growth in CEO pay is the efficient result of increasing demand for CEO effort or scarce managerial talent (Here). Running a successful and sustainable business is no easy task. CEOs with years of experience and an impressive track-record are extremely sought after. The law of supply and demand determines price. Offering an impressive pay package helps attract and retain top-notch talents.

The changes in technology, organisational complexity and a global market landscape over the last 30 years have increased the level of CEO effort as well as the effect of executive leadership on firms’ value. This places successful CEOs very much at the top of wish lists for other CEO vacancies. Data suggests that companies in the top quartile tend to change CEOs somewhat more frequently than average performers. (Median tenure was 4.8 years compared with median tenure of just over six years for companies in the middle quartiles.) This is probably a result of CEOs being poached for bigger roles with competitors and also more exacting performance standards demanded by investors or boards within these high performing entities.  With competition rife, the cost of acquiring leading talents can be high, with large compensation awards of cash or equity required to counter existing pay scales.

For multinational companies, executives with international experience and resources are more likely to demand higher compensation and are more successful in convincing executive boards to agree (Here). CEOs with international experience are also more likely to be hired to engage in risky, but potentially performance-improving market-oriented strategies, which can affect their job security and marketability in the case of failure.

Use of Benchmark for Comparison

In order to attract and retain top talents, benchmarking has become a common approach for large companies. This is an approach very familiar to most professional companies who attain benchmark data for their employees at all levels. The accuracy of the data can sometimes be questioned, and this can limit competitiveness, particularly in highly specialised areas where demand for skills is not reflected in the broader data, yet it remains the commonly applied approach to set compensation levels. Many companies cite their use of such benchmarking data in the compensation provided to CEOs, however, rarely is this benchmarking fully transparent.

For example, CEO pay awards for two relatively recent pharma CEOs; Teva and Shire.

Teva’s CEO compensation: “The Company also used Radford to conduct a benchmark study of peers to determine that the proposal is in line with market practice. Following their review, the Compensation Committee and the Board of Directors resolved to approve, and recommend that shareholders approve…”

Shire’s CEO compensation: “In accordance with our remuneration policy and the recruitment arrangements disclosed in last year’s DRR, this brings his base salary in line with the median for comparable roles.”

People generally look at companies or indexes considered to be peer level to compare their salaries. However, this peer-level benchmarking, like most exercises in ascertaining value can be inexact, with some executives compensated when compared with more successful companies. Also, the salary is not always the major part of the compensation mix, whereas the short or long term incentives which are commonly linked to performance-based equity are, with Relative Total Shareholder Return the most common metric of performance to link with.

It is common for CEOs to expect above average pay when negotiating compensation plan. Repeating this process can drive CEO pay up. People expect their companies to be price setters rather than price takers.

Weak Governance

The optimal contracting hypothesis (e.g., Grossman and Hart, 1983; Holmstrom, 1979) believes that boards of directors bargain at arms-length as shareholders’ loyal agents, and maximise firm value by actively monitoring the executives (Here). However, boards with weak governance do not always bargain at arms-length, especially when board members are affiliated with the executives and the board is not independent from management.

When a company has weak governance, it’s difficult to say no to a CEO’s rising pay package. Large companies hire external consultants to evaluate CEO performance and to design compensation packages, asking lawyers to review the legality. However, these people are sometimes hired by the CEO and their appointed board. In an article by Adam Hartung, a Forbes contributor, he says: ‘It is like an old fashioned king’s court’ (Here). Good governance and executive pay are  increasingly gaining attention from shareholder interest groups like ISS who have provided broad-based analytics of CEO and executive pay to inform company shareholders of  where disputable pay practices are being employed. This has enabled a far more active shareholder base to scrutinise and object to poor executive pay structures. Getting your governance right helps control pay for both internal and external appointees and to construct the right composition of incentives.

External Hiring

There has been a shift in the type of skills demanded by firms from firm‐specific to general managerial skills. Such a shift intensifies the competition for talent, improves the outside options of executives, and allows managers to ask for better compensation packages (Here).

According to Hay Group’s Irv Becker, when a CEO is promoted from within the organization, the board doesn’t have to worry as much about the negotiations around severance, employment contracts and incentives that it might with an external candidate.  When an external CEO joins the firm, the CEO’s requests might not necessarily fit in to the firm’s existing plan or culture. Boards generally have weaker negotiating positions when recruiting an external CEO as they’re competing with an open-market which is often financially opaque and where a shortage of candidate supply can reduce competitive tensions capable of strengthening contract negotiations.

Effective succession planning is one way to ensure there is better control of compensation and that businesses have sustainable value based of leadership which has been appropriately aligned to assume the CEO position. General Electric had Jack Welch at the helm for 21 years, during which time he increased the company’s value by 4,000%, earning him a $417 million severance pay upon retirement.  Jeff Immelt, Welch’s CEO successor, was a seasoned GE executive and spent nearly two decades preparing to assume the CEO position of this global behemoth.

As we have highlighted, executive pay is driven by multiple factors and therefore it is important for the board to evaluate the driving forces behind the CEO compensation they are seeing. Market-driven factors such as increased demand for talents and the practice of peer-benchmarking can be difficult to influence in any considerable way. However, the design of effective performance criteria linked to strategy and long-term goals needs careful consideration and the compensation mix needs to reflect this.  Ensuring strong corporate governance and effective, long-term executive succession plans will help the board gain more control over the matter of executive compensation.

 

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