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A common criticism of executive pay is that CEOs make an extremely high 1. According to the AFL-CIO, the number stands at 354 times average worker pay. The statistic is at least a little misleading since it uses realizable pay instead of realized pay, but the point is that CEOs make a *lot* of money. .multiple of the average worker’s earnings. 1

One thing that is largely ignored here, however, is the fact that a large percentage of the average (large cap company) CEO’s pay is at risk.

Image Credit: <http://www.execcomp.org

Image Credit: <www.execcomp.org>

Part of the reason for this large percentage of pay at risk is Section 162(m) of the U.S. tax code. The section came into law in 1993, and it caps tax deductions for compensation at 1 million U.S. dollars. For any additional compensation to be tax deductible on a company’s balance sheet it must be performance based, which basically means that it can only be paid out 2. Increasing shareholder value could constitute a number of things, including (but not limited to) increasing TSR, revenues, market share, profit margins, expanding into a new market, or completion of a major business project/strategy/goal. The key here is that performance based pay is paid out contingent on the CEO doing something that adds value to the enterprise in some way as defined by the board / compensation committee.contingent on achievement of (shareholder value adding 2) goals.

Image Credit: <www.farient.com

Image Credit: <www.farient.com

With that said, while the tax component certainly plays a role for some (perhaps most) companies in determining the percentage of executive pay that is at risk, a larger factor here is that it is in shareholders best interests for executive pay to be driven by performance.

One can argue about the level of performance that should be required for 3. Topic for another day.payouts, and one can also argue about the merits 3 of performance based pay.

If we accept as a starting point, however, that executive pay should mostly be at risk (or at the very least that pay at risk is not going away anytime soon 4), then it makes sense that executive pay opportunities need to be 4. Proxy advisory firms (which have been empowered by the Dodd–Frank Wall Street Reform and Consumer Protection Act) are looking for a strong link between pay and performance as a requirement for recommending shareholders vote “yes” on Say on Pay votes (see Goldman Sachs for a recent example of what happens when a company fails a proxy advisory firm’s performance tests.sufficiently high to compensate for the fact that their earnings are extremely volatile compared to the average worker.

Ultimately, compensation committees are tasked with finding a way to compensate executives fairly (relative to the market as a whole) while at the same time countering social unrest around high pay packages and aligning pay with performance. It’s not an easy task.

Are compensation committees failing here? Does the fact that such a significant percentage of pay is at risk mitigate the high multiple of average worker pay (or does the multiple even matter)?

As always, please share your thoughts in the comments section 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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