The basic goals of executive compensation have changed little since the advent of large corporations in the late 19thcentury: Provide strong incentives to increase shareholder value, retain key talent, and limit shareholder cost. The literature of compensation consultants and HR executives, however, claims that the guiding policy used to achieve these objectives has indeed been revised. In the first half of the 20th century, it was fixed sharing in a measure of value added, typically, a fixed percentage of an economic profit measure. Since then, it has been “competitive pay policy,” that is, target compensation set at market levels regardless of past performance (O’Byrne, 2013).
The theory of competitive pay policy is that targeting pay at market levels (i) retains key talent as target pay does not fall below the market wage for the executive; (ii) controls shareholder costs as pay does not rise above the market wage for the executive; and (iii) achieves strong incentives as long as a company has a high percent of pay at risk through bonus and equity compensation plans.
The competitive pay method sets a target amount of total compensation – salary, bonus, and equity – within a specified range of the amount paid to an executive’s peers, typically in the same industry sector and at companies of a similar size.
In a new study, we document the wide-spread prevalence of the competitive pay policy and how it undermines CEO pay for performance. We provide evidence that this policy creates an inherent performance penalty: poor performance is rewarded with more shares, while superior performance is penalized with fewer shares. Such a penalty undermines the strength of managers’ incentives.
Our results highlight an inverse relation between the stock price performance of a firm and the change in the equivalent shares awarded to the CEO. This evidence is consistent with the hypothesis that, to keep the value of the shares granted constant, firms whose stock price declined increase the number of equivalent shares granted to the CEO and decrease that number when the stock price increases.
We also examined the components of stock price changes – idiosyncratic or systematic – associated with changes in the number of shares given to the CEO. On average, compensation committees appear to offset 40 percent of the stock price changes attributable to a specific firm and 55 percent of such changes attributable to an industry at large. Thus, compensation committees appear to partially shield CEO pay from factors outside the CEO’s control.
A natural question is the potentially transformative impact of expensing stock option awards, as permitted by Financial Accounting Standard 123R. Since 2006, when FAS 123R came into being, we find a significant increase in the practice of increasing (decreasing) the number of shares granted when the stock price decreases (increases) in order to keep the compensation of the CEO stable.
Three additional results are potentially interesting. First, we find that directors’ equity compensation appears to adhere even more strongly with the philosophy of competitive pay policies relative to CEO’s equity compensation. On average, 88 percent of the change in stock prices is offset by an opposite revision in the number of shares awarded to directors. Second, we demonstrate, through simulations, that adherence to competitive pay policy penalizes the sensitivity of CEO wealth to stock price performance. Finally, we investigate whether the objections of proxy adviser Institutional Shareholder Services (ISS) reflect the de-linking of pay and performance imposed by competitive pay policy. Remarkably, we find that the competitive pay schemes reduce the odds of a negative vote recommendation by ISS. That is, ISS is more likely to recommend a positive vote on a compensation package for senior managers in a proxy statement that reflects competitive pay policy, despite evidence that such a policy weakens the link between CEO pay and performance.
Another study (Shue and Townsend, 2017) documents the prevalence of equity grants of a fixed number of shares to CEOs. About 13 percent of all CEO grants over the years 1993-2019 are fixed share grants. We document that the policy of giving option or stock grants, covering the same number of underlying shares, is less likely to be observed in the data, especially after 2010, when their sample ends. In particular, we find that, after an initial decade of growth (1993-2003), the number of fixed-number option grants peaks in 2003 (208 grants), then progressively declines. Very few fixed-number grants are observed in the most recent years.
We believe we are among the first to document that (i) the competitive pay policy is increasingly popular, suggesting fixed value equity grants, both for CEOs and directors; (ii) the competitive pay policy weakens the link between CEO wealth and firm performance; and (iii) the recommendations of ISS on CEO pay proposals do not appear to recognize the weakening of the link between CEO wealth and firm performance on account of competitive pay policy. A remarkable feature of modern proxy disclosure is the nearly complete absence of any discussion of the performance penalty inherent in target dollar pay levels and its impact on management incentives.
This post comes to us from Mascia Ferrari at University of Modena and Reggio Emilia, Stephen F. O’Byrne at Shareholder Value Advisors, Inc., Shivaram Rajgopal at Columbia Business School, and Francesco Reggiani at RF Value Advisors. It is based on their recent article, “Competitive Target Pay Practices for CEO Compensation,” available here.