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As promised in an earlier post, today I want to expound a bit on executive pay.

There has been a lot of discussion about this topic in the news media lately. Companies are being sued by shareholders, and while many of the suits are being thrown out some companies have also settled. The legal 1. Shareholders/plaintiffs have made several arguments in suits over the years, from inflammatory claims that boards cognizantly granted stock options and RSUs in violation of company incentive plans, to the citation of obscure sections of the IRC like section 162(m) – the argument here being that directors violated their fiduciary duties by giving executives compensation exceeding 1 million (the maximum tax deductible amount by law).arguments plaintiffs have made in filing suit are many 1, ranging from frivolous to plausible enough that some companies have settled rather than fight them in court… but the legal suits shareholders are bringing against companies is not the primary subject of today’s post.

Instead, I want to address a more simple question – are executives paid fairly?

How much is too much? What is "fair"?

How much is too much? What is “fair”?

Let’s set aside the questions of legality and compliance for a moment – 2. If you dislike Wikipedia you can read more here and here.the Dodd–Frank Wall Street Reform and Consumer Protection Act 2 will have companies and scholars grappling with those questions for some time to come.

Let’s look instead at the question of if executives are overpaid for what they do. If tomorrow hypothetical big cap Company X decided it was going to pay 10% or 20% or even 50+% less for its senior executives could it retain that talent?

…Or if the company couldn’t retain said talent could they get someone just as good for cheaper?

To answer this question the best place to look is probably at how executive pay is determined in the market. The Washington Post has a great piece on3. Here are some other great books where you can learn more: i. Charles M. Elson, Journal of Business & Technology Law, No. 2, 2007 ii. Elson and Ferrere, 2012 this topic 3 that I’ve cited before, but here is my summary/interpretation of (the quantitative metrics behind) how executives are compensated:

A. The majority of companies use a “peer bench-marking” process to help determine executive pay – they look at comparator companies in 4. The ISS prefers to select peer groups by GICS code. Conversely, most companies prefer to use their own methodology for selecting peer groups (which may or may not match up closely with GICS codes). It’s a really hot topic in the world of executive compensation right now. the same industry and of similar size 4, market pricing the total direct compensation (TDC) of executives in the comparator companies against their own executives’ TDC.

B. Pretty much every company targets median or higher pay for their executives, with the logic being that any executive that isn’t at least middle of the pack isn’t worth retaining, and that if an executive is at least middle of the pack they should be paid accordingly.

C. This means that in a good market executive pay mostly goes up for the majority of execs on an annual basis (regardless of performance). Since every company targets median or better pay for their executives (even those performing below average), compensation continues to rise as a product of every company chasing the average or better (even though every executive by definition cannot be average or better)

D. All of the above will usually happen, but market forces (specifically the stock market) drives average CEO pay down since most executive pay packages are highly equity driven and tied to Total Shareholder Return (TSR). As such, if executive stock options are collectively underwater because of poor market performance then the average realizable pay goes down.

Executive Pay

This brings us to the heart of it. We have two underlying themes that tell us different things about the “fairness” of executive pay.

1. Executive pay packages are (on average) more or less tied to Total Shareholder Return. The majority component of most executive pay packages – equity – is only worth something if the stock price goes up at some point during the vesting period (i.e. post grant date). This seems fundamentally fair, since executives pay is tied directly to company performance.

2. On the other hand, executive pay in a bull market will generally continue to 5. This term originated (as far as I know) in Executive Pay At a Turning Point” by Ira T. Kay.rise for even below average executives as a product of the “ratchet effect” 5 aka the “Lake Wobegon effect“.

An example of the illusory superiority some executives suffer from.

An example of the illusory superiority some executives suffer from.

I personally lean on the side of calling executive pay “fair”. Boards are generally trying to pay executives fairly (and competitively), and the existing pay model in most publicly traded companies is heavily pay for performance.

With that said, there are some really good arguments for internal based pay models (based mostly around the idea that executives are so locked into their respective companies by un-vested equity that it’s almost impossible for a rival company to poach them) that we didn’t touch on today.

Further, there are some pretty decent populist arguments citing the rising ratio of executive pay against the average American worker that suggest something is wrong with the system… and there are of course just as many strong arguments advocating the other side (starting with the fact that executives are in an entirely different labor market than average Joes).

We also haven’t tackled the various soft/subjective metrics many companies use in determining executive pay (you can read more about these in a company’s Compensation Discussion & Analysis aka the CD&A).

This article is getting a bit long now, however, so I’m going to wrap it up here. I’ll continue to touch on executive pay in the future (including some topics I just scratched the surface of today).

In the interim, please share your thoughts below.

Best,

Rory

If you have questions about something you’ve read here (or simply want to connect) you can reach me at any of the following addresses: 

SomethingDifferentHR@gmail.com OR rorytrotter86@gmail.com

@RoryCTrotterJr

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