Executive pay; how is it justified? By Jordan Otten and Ed Carberry

Ed Carberry and Jordan Otten,have been studying the structure and levels of executive compensation not only through the present crisis, but also through previous boom-and-bust cycles. So what has been driving executive pay, in their view? And are there ways of linking pay more tangibly and visibly to performance?

In the US, explains Carberry, the main elements of executive compensation are salary and stock-based mechanisms. Executive can also receive additional bonuses, based on hitting specified performance targets at individual or corporate level. The total package will also include a range of other benefits. From the late 1980s, stock options became increasingly popular – giving executives the right to buy a designated number of shares at a fixed price for a fixed time period.“Stock options really drove the increase in executive compensation in the States during the 1990s,” says Carberry. “Companies started rewarding with bigger and bigger packages, and as stock values shot up during the high-tech bubble, options became an extremely lucrative form of compensation.” Stock options became so popular partly because they were not included in the US government’s cap on salary, introduced in 1992, he adds. “The cap was intended to constrain compensation but actually had the opposite effect. Options were also supposed to link the long-term interests of executives to those of shareholders.”

Calls for reform post-Enron brought a shift to ‘restricted stock’ (granting stock directly but placing limitations on when executives can sell), together with new pay disclosure rules and tighter corporate governance. But, says Carberry, those reforms didn’t fundamentally change how US executive compensation is structured, nor how decisions are made at board level. Shareholders can actively vote on the proposed remuneration, but that vote is still largely symbolic.

“There are some constraints, but basically CEOs in the States have a great deal of power to influence their compensation packages. That’s the biggest thing we have to look at. That involves changing fundamentally how corporate governance is done – and that’s going to be a very difficult road to go down, especially given the strength of the corporate lobby,” says Carberry.

Otten’s research has also included Europe, where a slightly different picture emerges. Cross-national comparisons reveal large variations across and within countries, and even within industries, in both pay levels and forms of pay – the so called ‘pay-mix’. Pay for European executives seldom matches those of their US counterparts, and pay differentials are also lower. Whereas a US CEO earns about 400 times the salary of the average American worker, in Germany it’s around a 100 times, and in the Netherlands around 50 times. And there are currently no caps on salary, though such measures are currently being debated in various countries.

In Europe boards of directors also have considerable power in determining compensation, Otten explains: “They benchmark their remuneration, typically by using consultants to determine what their competitors are paying, but essentially they have the power to set their own norms and tailor their package to suit the executive they want to hire or retain.” Eager not to appear less generous than their competitors, companies pay slightly above the benchmark, which perhaps explains why compensation levels have been ratcheted up. Measures such as salary caps will only have a limited impact, argue Carberry and Otten. Whichever part of the compensation comes under attack, companies will simply shift to other forms of remuneration, exploiting any loopholes in legislation. The total compensation will remain broadly the same, or at least not decrease.

Would greater transparency help? Only up to a point, say both. Interpreting the disclosure of individual companies is highly complex, and wide variations in rules between different countries are likely to persist. But the key point, argues Otten, is that, “even with disclosure, it just shows the outcome of a complex process, but says little about the process itself. The way a firm is governed really determines how, and how much, an executive is paid. Reforms should be aimed at changing the processes themselves. What’s needed is some responsibility on the part of boards of directors, and a real hard look at what measures are used to determine pay levels and pay mix.”

Getting the right combination of performance measures is, Otten admits, a tricky business, given the plethora of potential instruments. “What really matters is finding out what drives overall corporate performance. You need a carefully balanced mix of different types of compensation and different means of linking pay to performance. Part of the pay might be linked to stock price, part to profits, part to some type of productivity measure, and part to employee safety, or whatever else may be important. It will depend, too, on what industry you are in, and on the firm’s strategy. “Settling the debate on paying for ‘bad’ performance can only be done by disclosing what performance measures the firm is using for its executives,” he adds. “That would give everyone a clear view of how they measure performance and to what extent parts of the pay mix relate to a given type of performance measure.”

The incentives to date, like stock options, have favoured short-term perspectives over longer-term vision, argues Carberry. And the research to date on executive pay and corporate performance has proved somewhat ambiguous: “Even if you find research which shows there is a strong link between executive pay and corporate performance,” points out Carberry, “then the question is, is that type of performance measure really the long-term goal and does that provide maximum benefit for different stakeholders of the corporation?

“If we really want to take executive compensation seriously in terms of how we can structure these plans to have long-term benefits for the stakeholders – whether that be just shareholders or a broader group of stakeholders within the corporation – that needs to be fundamentally debated and examined.” Reforming executive compensation, Carberry concludes, will certainly be difficult but not impossible. What is needed are better ways of linking compensation practices to robust measures of corporate performance, and for governments to develop more serious regulation – however unpopular this may be with the world’s corporate and financial leaders.

Text Catherine Walker (RSM Outlook summer 2009)

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