The Way We Pay Now

The last decade has seen a dramatic shift away from stock options and in favor of performance-based equity or “performance shares” in senior executive packages at large US public companies. Once accounting for over 60% of ex ante executive pay in aggregate at S&P 500 firms, conventional options have recently fallen to about 17% of total compensation, with no floor in sight. At around a 30% share of aggregate senior executive pay, performance shares now make up the single largest component of these pay packages, and their use continues to grow.

In my recently posted paper, The Way We Pay Now: Understanding and Evaluating Performance-Based Executive Pay,[1] I investigate this transformation, unpacking these new pay instruments for a non-technical audience and exploring the corporate governance implications of the shift.

Performance shares are essentially time-vested and performance-vested restricted stock grants. However, unlike conventional restricted stock and stock options, there is tremendous heterogeneity in performance share design. Targets can be based on share price or on accounting measures of performance, such as earnings per share, and performance can be measured on an absolute basis or relative to peer group or broader market performance. Many plans include multiple performance metrics.

In the typical case, however, a participant in a performance share plan will receive a variable number of shares after, say, three years depending on firm performance along one or more dimensions. Under these plans, stronger firm performance generally results in more shares being issued and in those shares being more valuable, producing a multiplier effect that resembles the economics of a stock option. Indeed, one of the key takeaways of the paper is that to the extent that performance measures and share price are correlated, performance share plans like these create incentives (measured by delta and vega) that are similar to options; not just the incentive to meet targets or increase share prices but to take on risky projects. So while options may be on the way out, optionality remains robust.

Conventional compensatory stock options are uniformly granted “at the money,” that is, with an exercise price set equal to the market price of the stock at the time of the grant, and that exercise price is fixed for the term of the option. As a result, in a bull market, stock options can pay off for executives of even average or under-performing companies, as long as they retain their positions, resulting, in the words of one wag, in “pay for pulse.” These design features are at least partially dictated by a tax rule – IRC sec. 409A – that essentially precludes firms from issuing in-the-money options or options with an exercise price that adjusts for market movements. [2] Importantly, performance share plan design is not constrained by sec. 409A. Performance share plans can be designed to replicate in, at, or out-of-the-money options, and we observe the full spectrum. Moreover, the use of relative performance metrics, such as in popular relative total shareholder return plans, essentially replicates indexed stock options, tying pay much more closely to firm-specific performance and providing a solution to the problem of “pay for pulse.”

These are very attractive features, but performance share plans also raise corporate governance concerns. These instruments are more difficult to value ex ante than conventional stock options, undermining any market-based discipline created by executive pay disclosures, and they create opportunities for gaming the choice of metric and peer group composition (for relative metrics). Making matters worse, two different accounting regimes apply to performance share plans (depending on the type of metric utilized), which leads to accounting-driven design choices. And while they differ importantly in detail, both accounting regimes facilitate under-reporting of executive pay and firm-wide compensation expense.

I conclude the paper with some tentative suggestions for mitigating these problems, while attempting to retain the benefits of performance shares, including a proposal to shift to mark-to-market accounting for all forms of long-term compensation. I hope my analysis and initial reflections will prompt more thought and debate on appropriate regulatory responses to this evolving executive pay landscape.



[2] Although the enactment of IRC sec. 409A in 2004 essentially precluded the issuance of in-the-money or indexed conventional options, these instruments were very rarely observed prior to 2004. Apparently there were or are other constraints on issuing in-the-money or indexed options that do not apply to the performance share analogs.

The preceding post comes to us from David I. Walker, Professor of Law and Maurice Poch Faculty Research Scholar at the Boston University School of Law.  The post is based on his article, which is entitled “The Way We Pay Now: Understanding and Evaluating Performance-Based Executive Pay” and available here.