CEO pay system needs revamp
For 40 years, boards of directors have tried to link executive pay to corporate performance, and they still can’t get it right.
The highest compensated chief executives tend to underperform, while companies tend to underpay CEOs who generate the best results, according to MCSI, an investment research firm. Whether it is stock performance, earnings per share or some other metric, 60 percent of companies failed to pay chief executives a salary commensurate with results, a study of 423 public corporations found.
“Among the most poorly aligned companies, 23 underpaid their CEOs for superior stock performance and 18 overpaid for below-average stock returns, relative to their sector peers,” researchers found.
This latest study looked at the pay that CEOs realized over time, not just the amount awarded at their departure from the company. That’s an important distinction, since 60 percent to 70 percent of a CEO’s compensation may be in stock options that can only be exercised years after he or she leaves the company.
The delayed payment is intended to encourage CEOs to think about the long-term health of the company and not take shortcuts to boost shortterm stock performance that may harm it in the long
run. MSCI researchers found that rarely works.
“If anything, realized pay was even more out of whack than awarded pay” report author Ric Marshall concluded. “Long term, these findings suggest that the 40-year-old approach of using equity compensation to align the interests of CEOs with shareholders may be broken.”
Do you think? Did it ever work?
Perhaps the biggest con ever pulled on a board of directors was the executive who demanded performance pay. After all, the implication is that a million-dollar salary is just not enough to make him or her work hard, only a share of the profits will inspire maximum effort.
Years of study, though, show little or no connection between CEO pay and corporate performance, perhaps because the CEO simply has too little control over a company’s success when compared to other factors, such as the economy or disruptive technology.
Writing for the Harvard Business Journal, business professors Dan Cable and Freek Vermeulen argue that top executives should be paid a flat salary because performance pay simply does not fit with their job descriptions.
Contingent pay is best used to incentivize people performing routine tasks to maximize performance; it does not encourage creativity in solving big problems, the professors argue. Contingent pay also encourages people to game the system rather than improve it, thereby distorting performance measures.
And most importantly, no one has found a system that works.
“For a complex job such as senior management, it is simply not possible to precisely measure someone’s ‘actual’ performance, given that it consists of many different stakeholders’ interests, tangible and tacit resources, and short- and long-term effects,” Cable and Vermeulen write.
Houstonians need look no further than the oil patch. In the early days of the shale drilling boom, boards paid executives bonuses on how much oil they found and pumped, a traditional measure of an oil company’s success.
That encouraged CEOs to take out huge loans and sell enormous amounts of equity to buy overpriced acreage and hire expensive drilling crews to drill as many wells as possible. That worked well until oil prices dropped, cash flow dried up and debts came due.
One would think that the CEOs would have slowed drilling, but they didn’t because their compensation was tied to proven oil reserves, not the financial health of the companies. A perfectly logical compensation system led to dozens of bankruptcies.
“The problem is that once you link someone’s financial rewards to a particular measure or set of measures, it is going to affect that person’s behavior — in terms of what they do, and don’t do,” the professors concluded.
Performance-based pay has become so entrenched, though, it is hard to imagine corporate boards no longer offering it. And since many board members are executives who have been paid for performance, there is cultural bias against accepting the huge amounts of evidence that prove it does not work.
However, reports like MCSI’s should at least start a conversation about how much executive pay should be contingent on corporate performance. A gradual easing in the proportion of salary versus stock options might be a good way to begin phasing it out.
Other studies, as well as Cable and Vermeulen’s research, are pretty clear that personal motivation makes the real difference. Lower-paid, first-time CEOs looking to prove themselves tend to generate better returns than experienced executives looking for expensive and elaborate pay packages.
People who believe in doing a good job for its own sake also tend to perform better than those demanding a piece of the action.
As strange as it may seem, when it comes to senior executives, you don’t always get what you pay for.