Myths and Realities of Executive Pay

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Media Room > Author Q&A

Q&A WITH IRA T. KAY, PH.D., AND STEVEN VAN PUTTEN
Authors of Myths and Realities of Executive Pay (Cambridge University Press, 2007).

1. What are the most significant findings in Myths and Realities of Executive Pay?
Kay: First, our research clearly demonstrates that despite all the statements to the contrary, there is strong alignment between pay and performance at most companies. Second, the pay-for-performance model is not only viable, but essential to the continued success of U.S. companies and the U.S. economy. If we change the model, we could exacerbate the migration of top talent away from corporate America to private equity firms and hedge funds. And, finally, optimizing the alignment between pay and performance is not easy. It requires hard work on the part of senior management, the compensation committee and its advisers to strike the appropriate balance between risk and reward. That’s the only way to truly drive desired outcomes.

2. How has the U.S. executive pay model improved corporate performance?
Kay: The current executive pay model has improved corporate performance ten-fold. The model and the executive pay practices that drive it have created investment returns for millions of shareholders and funded pension and retirement savings plans, now worth trillions of dollars. Despite the myth that executives are excessively compensated, the reality is that executives receive a very small portion of the economic value they helped create for shareholders. For example, during their careers, the top five executives at U.S. companies received, on average, 2 to 3 percent of the value generated by the corporations they manage.

Van Putten: Ultimately, the U.S. executive pay model works because of the incentive effect that underpins the pay-for-performance approach. The old adage “you get what you pay for” holds true in that if you design proper incentives for management that maximize long-term shareholder value, an executive will work hard to make that happen. And this incentive works at every level in the organization. The key is to make sure executives and employees can clearly see how their performance helps the company meet its goal of driving shareholder value.

3. How has the U.S. corporate model contributed to the U.S. economy?
Kay: Executive pay practices have played an integral part in generating the most productive economy in the world, though there certainly are other factors involved. Although U.S. executives are commonly vilified for their decisions to reduce headcount or tightly control spending for wages and benefits, in almost all cases, these decisions ultimately protect a company’s economic efficiency, competitive position and long-term success. That economic efficiency creates a dynamic and robust labor market capable of absorbing virtually all of those laid-off employees.

Van Putten: The U.S. leads the large advanced economies in job creation and low unemployment rates, which in recent years has been less than 5 percent. One characteristic of the U.S. economy and its corporations is the ability to recover quickly after a downturn. This speaks to the flexibility of U.S. companies and their efficient structure, and the willingness and ability of their executives to make rapid adjustments. All of this is supported and reinforced through pay practices aligned with performance.

4. How will executive pay practices change as a result of the new SEC disclosures?
Van Putten: For the vast majority of companies and their shareholders, the rules will simply improve what is already a successful executive compensation system. Nevertheless, based on early 2007 proxy filings, we have seen some notable and welcome improvements in executive pay practices. First, the new compensation and discussion analysis section has forced companies to improve their thought process for executive pay decisions by answering questions, such as “Why do we choose to pay the way we do?” and “What factors do we consider in establishing executive compensation levels?”. The new disclosures are contributing to an increased use of share ownership guidelines and the adoption of specific timing for stock incentive grants. We are also noticing signs of a decline in perquisites and other forms of non-performance-based pay. While it remains to be seen what effect the new disclosure rules will have on the levels of executive pay, we expect that the impact will be felt more in the way pay package are constructed rather than in the level of pay opportunity, which will continue to reflect an efficient labor market for top talent.

5. What best practices does the book offer for compensation committees?
Kay: Chapter 8 focuses on best practices for compensation committees. The key elements are that committees need to increase their own independence and demand objectivity from their key advisers. They must put more emphasis on pay at risk and pay for performance. Committees must move away from discretionary bonuses and add performance hurdles to restricted stock awards.

Van Putten: We outline three key steps for establishing best practices in designing and implementing executive pay: creating excellence in corporate governance, setting the CEO’s pay as rigorously as possible and building a pay-for-performance environment.

Good governance produces pay that is commensurate with performance, provides significant stock ownership for management and the board, and protects against excessive dilution. Setting executive compensation as rigorously as possible means collecting data from the right peer group, reviewing the pay and performance history of the company and the CEO, determining the risk and cost of losing the CEO, and examining the strategic needs of the company. The compensation committee must also align executive pay with the broader employee compensation and create superior proxy disclosure to preserve the company’s reputation and meet the SEC‘s new requirements.

6. What factors determine pay at the top levels?
Kay: Various factors -- the executive’s pay and performance history, whether the executive was promoted from within or recruited from outside, and even net worth (it may take more pay to attract an ideal candidate who happens to be wealthy).

Executives, like other employees, generally are paid commensurately with their skills. Their pay levels reflect marketplace supply and demand and are also in line with compensation levels for top people in other sectors – investment, entertainment, athletics – who reach rarified levels of achievement.

The relative scarcity of top talent is apparent to any board that has had to replace a CEO. In most pay negotiations, these vital assets use their legitimate, market-driven bargaining power to obtain pay commensurate with their skills. Recruiting packages often reflect the executives’ success and large amounts of forfeited unvested restricted stock and stock options for which they need to be compensated. In addition, companies often need to offer executives upside opportunities in the new company. Boards are willing to risk millions of dollars for the right talent because properly designed pay opportunities drive superior corporate performance.

7. Which long-term incentives are best at motivating CEOs toward business success?
Kay: In this new era of stock-option expensing, the goal is to maximize value delivery – perceived and actual – for a given level of expense. The transformation from an option-centric long-term incentive strategy to a portfolio approach is under way. The portfolio approach supports varied objectives. At a high level, a balanced program might include restricted stock to promote retention in a cost- and share efficient manner, stock options to ensure shareholder alignment and leveraged incentive opportunities for exceptional stock price performance. A long-term performance plan can focus attention and rewards on key underlying drivers of shareholder value. Additionally, unlike stock options, the expense associated with a long-term performance plan can be reversed if performance goals are not attained.

Van Putten: Although stock option expensing and concerns over dilution are leading more companies to move to full-value share programs, we expect that stock options will remain a core long-term incentive for senior executives. Stock options are a strong pay-for-performance vehicle in that recipients only benefit to the extent that shareholders also benefit. Stock options also communicate to investors and analysts that the company is a “growth” company. Performance shares and vehicles that promote stock ownership such as management stock purchase plans will continue to increase in prevalence, as will share holding requirements. We also may see some companies increasing their use of cash-based long-term incentive plans because aggressive actions by institutional investor and their advisers are making it more difficult for companies to get share plans approved by shareholders.

8. How can stock-based incentives be used to make managers think like owners?
Kay: Companies use a number of techniques, such as stock options with net share retention requirements and stock purchase plans, to encourage executives to act like owners. High share ownership motivates executives to make better decisions about acquisitions, divestitures, layoffs, stock buybacks, research and development, pricing, product development and other critical business issues. A basic assumption of executive compensation – that more stock ownership is better than less – is as solid as the theory that supports it. The theory is that companies flourish if their executives act like owners rather than hired hands. If the executives own only a small amount of stock in the company, their self-interest may be paramount and not completely aligned with the interests of the shareholders.

Van Putten: There is a reason that private equity firms hire results-oriented CEOs with proven track records in corporate America and then load them up with significant equity stakes. As the new owners of the under-performing business, private equity firms know that the most effective way to enhance the value of their ownership position is to provide senior executives – the managers of the business – a significant equity position in the company. By aligning managers’ interests with their own interests, private equity owners have increased the probability of enhancing value creation for all parties involved.

9. What is the biggest challenge facing those companies moving away from stock options to alternative vehicles?
Kay: Companies are not moving entirely away from stock options, but many are reducing the number and value of options awarded and are complementing options with an increased use of performance shares. The primary challenge with introducing performance shares relates to metric determination and goal setting. Ultimately, the objective is to motivate and reward long-term value creation. Certain performance metrics are more correlated with value creation than others, and those metrics tend to vary by industry. By employing statistical techniques, companies can identify which metrics correlate with value creation, and over what period of time, Setting performance goals is more art than science, but by employing analytics, companies can improve the likelihood of setting appropriately challenging goals. Such analytics include probability analyses based on company and peers’ historical results, researching and evaluating analyst expectations and conducting pay and performance analyses of prior years’ outcomes.

Van Putten: Another challenge companies are now confronted with is the loss of vertical alignment that occurs when companies abandon broad-based stock option or employee stock purchase plans, which has occurred in the face of stock option expensing. Without those tools at their disposal, how do companies create exciting and motivating compensation programs that drive performance at all levels in the organization? We discuss this issue and provide solutions in Chapter 8, but the key is finding effective ways to do more with less. Rather than spreading options like peanut butter across the organization, consider using restricted stock to selectively reward employees that exhibit actions and behaviors that drive business success.

This Q&A can be reprinted in whole or in part if attributed to: Myths and Realities of Executive Pay, Ira T. Kay, Ph.D., and Steven Van Putten (Cambridge University Press, 2007).