FAQs about Executive Compensation

THE BASICS

POST-CRISIS REFORMS

DIGGING DEEPER INTO THE DETAILS

THE BASICS

Why is executive compensation an important shareholder and societal issue?

The current system of executive pay:

  • Contributes to the destabilizing effects of income inequality;
  • Makes consumers and employees wonder if they are playing in a game rigged against them;
  • Distorts incentives, leading to a short-term focus rather than sustainable growth.

Executive pay may represent, and in some cases encourage, a poor allocation of resources. Executive pay is often structured in such a way that encourages short-term focus, rewarding executives that extract profit by acting in ways that harm employees, the environment, and often the consumer. Pay packages can reward short term efficiencies – such as outsourcing production overseas to countries with lax regulatory laws – rather than promoting innovative, sustainable production. Poorly designed programs correlate with underinvestment in research and development.

One academic survey of 400 financial executives, including Chief Financial Officers, found that 80% of CFOs would reduce research and development spending, delay maintenance, and limit marketing in order to meet short-term targets, which are not explicitly connected to compensation, but often used to determine it.

CREDIT: Lee Judge, Kansas City Star
CREDIT: Lee Judge, Kansas City Star

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If the stock price is doing well, why should shareholders care?

Universal investors – those that hold stock in index funds or through pension funds – are not only concerned with the short-term stock price of an individual company, but with the conditions of the economy at large and the well-being of society and the environment. Understanding compensation amounts to a risk assessment.

Looking at pay also provides insight into how good a job directors are doing. Directors are elected by shareholders to represent their interests, but knowing what happens behind the closed doors of a boardroom is impossible. Compensation provides the clearest view shareholders have as to how engaged directors are, or are not, in serving shareholder interests.

khalil bendib corpwatch org - edited
CREDIT: Khalil Bendib, Corpwatch.org

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How does executive compensation in the US compare to that of other countries?

In the United States, CEOs are paid astronomically more than peers in other countries by any calculation. Estimates vary somewhat, but one calculation cited by Robert Reich finds that the ratio of CEO to employee average pay is 11:1 in Japan, 12:1 in Germany, and 20:1 in Canada, compared to the much higher ratio in the United States.

While executives in other countries are paid relatively less, the rates are climbing. Shareholders around the world are speaking out, many with more power than those in the United States. Shareholders in the UK, who have been able to cast advisory votes on compensation since 2006 recently succeeded in winning the right to have binding votes. The High Pay Centre, an independent think tank in the UK that focuses on issues of income distribution and pay, recently published a report calling for the Government to take bold steps to address the issue.

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How did executive compensation inflation happen?

CEOs have always been well paid, but not always excessively paid. Something changed in the 1980s and 90s. One theory suggests that under changing tax rates, executives saw a greater advantage to accumulating more wealth. Changing social mores – think “greed is good” – may also have played a part.

There’s also been a rise in the idea of a superstar CEO, an idea boards often seems attracted to. However, in general hiring someone from within the company is both less expensive and more likely to provide good results.

Some attempts at reform have had unintended consequences. An attempt to set a limit on tax deductibility of pay inadvertently contributed to sharply increasing what executives took home by encouraging stock options and bonus plans with huge upsides.

Bill Clinton campaigned on a promise to disallow tax deductions on compensation over $1 million, but some in his administration suggested there should be an exception for “performance-based” pay. According to Robert Reich, Labor Secretary under the Clinton administration:

I argued the $1 million cap should have nothing to do with corporate performance because the goal was to hold down executive pay. I was outvoted. The rest is history: Stock options exploded, as did CEO pay. Corporations are now deducting more than $5 billion a year for executive stock options. Since a tax deduction is the economic equivalent of a government handout, you and I and every other taxpayer are subsidizing widening inequality by providing corporations with at least $5 billion a year for executive stock options. Clinton’s original campaign proposal – no deduction of any executive pay in excess of $1 million– should have been implemented. It still should, even if it is more than 20 years later.

– Robert Reich, Labor Secretary under the Clinton administration

At that time, stock options were not required to be expensed, and essentially had no cost to companies. While an appropriate tool for many companies, including start-ups that wished to give innovators a stake in the company’s future, they also provided a disproportionate upside for executives when stock prices increased. Since 2005, FASB has required options to be expensed, but windfalls collected during the years of mega-grants became part of the comparisons that drove packages ever-upward. And the “pay for performance” loophole remains in the law.

Additional reading:

Forbes – Narcissistic CEOs Get Paid The Most, Says Study

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Pay for performance sounds like a good thing, not a loophole. What’s the problem?

Runaway executive compensation packages may incentivize excessive or inappropriate risk taking to the detriment of investors. In other words, the potential for a pot of gold may lead executive management to take risks they otherwise would not take.

– SEC Commissioner Luis A. Aguilar, June 27, 2014

When you hear the term “pay for performance” you might assume it means that an executive’s pay is affected by their contributions and accomplishments, but this is not always the case. A poorly designed plan allows the CEO to get credit for all of the shareholder wealth created, when actually it represents the work of many people. Too often we see CEOs awarded astonishing compensation based on larger market trends. We have seen that the price of a barrel of oil or an ounce of gold, or simply the bull market itself, has led to huge packages that are “performance-based” in name only. It has also led to considerable losses of hundreds of millions of tax dollars for the federal treasury.

Even when a plan appears to be driven by quantitative metrics and clearly disclosed, boards may decide to make exceptions that change the picture. Sometimes they blame outside factors, contending that executives shouldn’t lose pay because of things “beyond the control” of the CEO. (When outside market forces improve the company’s situation, there is rarely a similar acknowledgement.) Boards may decide to exclude some factors when calculating CEO pay metrics, and alter the numbers for that one purpose, though accounting standards require them to disclose the correct numbers in the company’s financial statements. For example, in 2013, Wal-Mart Stores made adjustments excluding the impact of 15 items that could have led to reduced pay, allowing executives to make a bonus for which they would not otherwise have been eligible.

Sometimes a board may just award additional compensation for no discernable business reason. Some companies that had issued a routine fixed number of stock options for many years issued a much larger number when the market bottomed out in 2009. Now those executives continue to reap windfalls from being in the right place at the right time.

When pay for performance is done right, everyone benefits. But it’s up to shareholders to make sure it is done right.

nick anderson houston chronicle 3 - edited
CREDIT: Nick Anderson, Houston Chronicle

POST-CRISIS REFORMS

We should be strengthening oversight and accountability… The fact is this crisis has left a huge deficit of trust between Main Street and Wall Street.

– President Barack Obama, December 6, 2011

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Do shareholders get to vote on compensation? What’s the history of say-on-pay advisory votes?

Following the financial crisis of 2008, one of the first components of reform was the requirement under Section 951 of the Dodd Frank Act requiring companies to allow shareholders to cast advisory votes on executive pay packages and golden parachutes. Adopted in January 2011, the rule followed years of shareholder activism on the issue. The United Kingdom adopted a requirement in 2002, and Australia followed in 2004. U.S. shareholders had filed many shareholder proposals on the issue, and some companies had adopted a voluntary policy of placing compensation up to a vote. But the 2011 rule requiring all companies to allow shareholders to vote means that shareholders now have a right – and a responsibility – to weigh in annually on the issue.

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What has been the outcome of the votes thus far?

Though the votes have no mandatory component, boards have taken notice. The outright failure of an advisory vote is very rare. In 2013, shareholders voted on advisory votes at 3,363 companies, and just 70 failed to receive majority support. In most cases companies do respond to such a vote with changes, though some are merely cosmetic. However, practices that were once common – for example, tax gross-ups in which the company paid any extra taxes an executive was required to pay on outsize severance packages – have been practically eliminated. While these steps are to be applauded, the general trends have remained troubling.

Say on Pay votes can have a powerful effect. After the majority of shareholders failed to support the company’s pay packages in 2012 and 2013, Abercrombie and Fitch separated the chairman and CEO positions, increased its emphasis on performance-based equity, redesigned both short-term and long-term incentive programs, and signed a new employment agreement with CEO Michael Jeffries. In 2014 shareholders approved the advisory vote on compensation.

Some companies claim that high levels of support suggest that there’s nothing wrong with pay: the average say on pay vote is supported by 91% of votes cast. However, we believe that this does not reflect investor intent, but rather voting logistics. Many funds have a default pro-management inclination, and even those who hope to do case-by-case analysis often are unable to do so. Because most companies have fiscal years that end on December 31, there’s a tsunami of proxy statements that arrive within a month of each other. Analyzing executive compensation isn’t easy, and plans crafted by teams of lawyers can be difficult for shareholders to comprehend. Many defer to proxy advisors who have a variety of rubrics, some stronger than others.

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I hear people talk about ratios between CEO and employee pay – what is that about?

In 2010, a provision known as 953b was added to the Dodd-Frank Wall Street Reform and Consumer Protection Act, proposing to require companies to disclose the ratio of CEO to median employee pay. The proposed rule was issued in October 2013, and many investors have filed letters in support of the idea. However, corporations have been resisting the rule, and final rules have not yet been issued. It is likely that this figure will not appear in proxy statements until 2016.

Comparing CEO compensation to that of workers highlights the issues of inequality. According to economist Lawrence Mishel, “The CEO-to-worker compensation ratio was 20-to-1 in 1965 and 29.9-to-1 in 1978, grew to 122.6-to-1 in 1995, peaked at 383.4-to-1 in 2000, and was 295.9-to-1 in 2013, far higher than it was in the 1960s, 1970s, 1980s, or 1990s.”

Additional reading:

AFL-CIO – FAQ on Dodd-Frank Section 953(b): CEO-to-Worker Pay Ratio Disclosure

nick anderson houston chronicle 1 - edited
CREDIT: Nick Anderson, Houston Chronicle

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What other reforms are being attempted and where do they stand now?

Dodd-Frank Section 953(a) will require companies to provide explicit information on the relationship between executive compensation actually paid and the financial performance of the company. This rule has not been crafted yet – a proposed rule is likely to be issued in October 2014. Some in the corporate community have suggested that this information be provided in place of existing information, but that would create misleading tables. Shareholder advocates will need to insist that the new information is an addition to existing data, and not a replacement.

Dodd-Frank Section 955 would require additional disclosure about whether directors and employees are permitted to hedge any decrease in market value of the company’s stock. Executives who hedge company stock insulate themselves from losing money if the stock price goes down.

Dodd-Frank Section 956 states that financial institutions, including banks, investment advisers, and brokerage firms, should structure pay in a way that doesn’t encourage excessive risk-taking. The rule proposes to ensure that incentive-based compensation does not encourage excessive risk at financial institutions with more than $1 billion in assets. The adoption of this rule has been hampered by the fact that it is a multi-agency rule being crafted by the SEC, Federal Reserve, and other regulators. The FDIC issued a version in 2011 that would require deferral of at least 50% of incentive compensation for at least three years for those financial companies with $50 billion in assets.

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What are clawbacks, and what is the new rule related to them?

The idea of clawbacks emerged after Enron and other corporate scandals where executives were able to keep bonuses even after the figures upon which they had been based were proved to be inaccurate, despite the company being forced to issue accounting restatements. A clawback provision would force executives to return compensation that was later discovered to have been calculated incorrectly. Earlier reform under the Sarbanes-Oxley Act required clawbacks for any unearned executive compensation if there was specific misconduct by the CEO/CFO.

Despite large fines paid by companies, very few executives have had to return bonuses that were earned in the run-up to the financial crisis.

However, that may change. Requirements in the Dodd-Frank Act will affect any compensation paid in the three years prior to an earnings restatement, and will not require acts of executive malfeasance. Boards may have broad discretion to create their own policies, but once the rule is adopted the SEC will not allow a company to be listed on any exchange until a policy is in place. The SEC announced that it plans to have a proposed rule on this issue by October 2014.

nick anderson houston chronicle 2 - edited
CREDIT: Nick Anderson, Houston Chronicle

DIGGING DEEPER INTO THE DETAILS

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Who decides how much a CEO is paid?

Boards of directors, and specifically the Compensation Committees, are responsible for determining pay packages.

In many cases directors have abdicated their responsibilities to compensation consultants, who accurately realize they are more likely to succeed in their profession when they support rather than challenge the status quo. Warren Buffet once aptly described a fictional compensation consultant he called, “Ratchet, Ratchet, and Bingo,” because indeed the process they use creates an upward spiral.

Directors themselves benefit from the inflationary system. Many are themselves executives, and those who are not can be extraordinarily well paid for serving on boards. Board interlocks and social connections between directors and their families also drive an implicit reciprocal mentality.

There are also systemic issues that go beyond the problematic practices at individual companies, including an over-reliance on peer groups. Consultants specialize in designing peer groups but historically have not designed them well. There are a number of academic studies that show bias in peer group selection, but the best review of the inherently flawed and inflationary methodologies can be found in “Executive Superstars, Peer Groups and Over-Compensation – Cause, Effect and Solution“, a study funded by the IRRC institute.

Another important issue is benchmarking. Executives are always paid at least the average of their peers. Some have called this the “Lake Wobegon” effect, based on Garrison Keillor’s fictional town where “all the women are strong, all the men are good looking, and all the children are above average.” When no CEO is considered worthy of below average or even average pay, the average just ratchets upward. When a particular company grants an absurdly large package – often with the rationale of rewarding a departing CEO or enticing a glamorous CEO with a large new-hire package – these outlier rewards get baked into the system, and contribute to the constant upward spiral.

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How would I go about finding out the pay for a CEO of a public company?

The SEC requires companies to disclose details on pay for the highest paid executives. (Some scholars believe that this disclosure has inadvertently created more competitive and ultimately higher pay.) Proxy statements can be found at www.sec.gov. You can look up the company you are interested in, by ticker or by company name, and look for a document called DEF14A. If you want to get right to the numbers, search for the Summary Compensation Table that breaks down categories of pay: salary, stock awards, and options, with the estimated grant date value determined by federal accounting rules. You should also check the Options Exercised and Stock Vested Table which gives you a sense of the current value of past grants, which are often much higher than the estimated value at the time of the grant.

If you have the time and interest in learning more, read the Compensation Discussion and Analysis (CD&A). This section of the proxy has been massaged and messaged by layers of lawyers, and is required to include the objectives of the compensation programs (expect to read the words “attract and retain”), what the compensation program is designed to reward, as well as additional information.

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What are stock buybacks, and what do they have to do with compensation?

A stock buyback is when the company purchases a large number of its own shares on the open market. The central concept is that when management and boards believe the company’s stock to be undervalued, purchasing it theoretically becomes the best use of company assets. Some companies have taken on debt even while engaged in buybacks. There have been more $1 trillion in buybacks since 2009, and nearly $160 billion in the first quarter of 2014. Biriyani Associates estimates that between 2006 and 2013 companies have spent $4.14 trillion in buybacks.

That money could have been used to promote more sustainable success, such as investing in research and development, implementing energy efficient production processes, enhancing employee and customer satisfaction, paying higher wages, or sourcing raw materials from suppliers who adhere to international standards that protect human rights and the environment.

A very common metric used to calculate executive incentives is earnings per share. There are some corporate observers that have noted that while there are few quick corporate actions that can change the earnings part of the equation, a significant buyback changes the denominator of the fraction.

Additional Reading:

Roosevelt Institute – Taking Stock: Why Executive Pay Results in an Unstable and Inequitable Economy

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Why are ineffective CEOs given “golden parachutes” instead of being held responsible for company performance?

We’re not talking about a rational system of rewards – just random acts of kindness, vast sums of money alighting when and where they will, generally in the outstretched hands of those who already have far too much.

– Barbara Ehrenreich, Nickled and Dimed

The original idea behind golden parachutes was that they would allow an executive to dispassionately consider a merger or takeover without needing to worry about his personal financial future. However, rather than insulate executives from worry, they became so lucrative that in many cases takeovers seemed attractive.

Many of the problems in executive compensation occur when contracts are signed. Whether the board is desperate, besotted, or just distracted, too often it appears that executives have the negotiation advantage. Once stipulations that are not in the best interests of shareholders have been agreed to, they are nearly impossible to remove. This is particularly the case when an executive comes from another company and is giving up some entitlements to do so. Most contracts offer packages for an executive who is asked to leave without cause, which seems fair enough until one considers the fact that top executives are very rarely fired. Some reasons include fear of lawsuits and the desire to prevent hard feelings.

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Where can I learn more?

For more research and other resources related to Executive Compensation, visit our Resources page.