What CEOs Really Get Paid under Long-term Incentive Plans

U.S. public firms increasingly use long-term performance-based plans to compensate CEOs. Under these plans, CEOs are expected to receive different levels of pay based on how the firm performs relative to various performance goals over multi-year periods. For example, Tesla gave Elon Musk a controversial pay package in 2018 with an initial estimated value of $2.6 billion and a potential payout of over $50 billion. However, to realize the payout, Musk needs to meet 12 market capitalization milestones and 16 revenue- or earnings-based milestones in the coming 10 years. What Musk will actually receive at the end of the performance period can be drastically different from the $2.6 billion estimated value.

The gap between executives’ reported compensation and actual take-home pay is growing. Under the current SEC rules, the estimated value of performance-based plans is featured prominently and tabulated as part of total executive compensation in proxy statements. Information on actual plan payouts, however, is buried in footnotes or managerial discussions in proxy statements filed years later at the end of the performance period, making it difficult for outsiders to track.

We believe there are at least three benefits to examining the actual payouts of performance plans. First, researchers have relied on estimated plan values to assess the amount of an executive’s pay and the pay-for-performance relation, which could result in biased conclusions as the estimated plan values can differ significantly from the actual payouts. Actual plan payouts thus provide accurate information on the CEO pay size and whether such pay is a result of performance. Second, given growing anecdotal evidence that some firms tinker with the performance plans to enrich the CEOs, information on the realized payouts could help investors monitor the implementation of performance-based plans. Third, a board of directors can incorporate internal, private performance expectations into managerial incentive contracts. Thus, the actual payouts that a CEO earns from performance-based plans may signal whether she meets the board’s internal expectation and convey incremental information about her quality.

Recognizing the importance of actual payouts, practitioners and the SEC are pushing for enhanced disclosure on executive compensation that is actually paid. The existing literature, however, does not provide much evidence on actual payouts that can be used to assess such disclosure decisions. In a recent working paper, we fill the gap in the literature by evaluating how investors could benefit from the information in realized payouts. We use hand-collected data on actual plan payouts from 2,262 long-term accounting-based performance plans (LTAPs) granted to the CEO by S&P 500 firms from 1996 to 2011. These LTAPs are significant in size and increasingly popular within U.S. public firms. LTAPs use complex accounting performance measures to evaluate CEOs. The limited disclosure of these plans and the length of time between plan grant dates and actual payout dates make it very challenging for investors to assess and keep track of plan payouts.

We first evaluate the relation between actual plan payouts and firm performance. We find that a firm’s accounting performance during the evaluation period strongly predicts the probability that the CEO will receive a payout, the probability that the payout is at the target level or higher, and the actual payout amount after controlling for firm characteristics, other aspects of CEO pay, CEO power, and corporate governance. We find no evidence that the strong payout-for-performance relation is driven by earnings management. There is also no strong evidence that firms design contacts to award CEOs regardless of performance.

In contrast to the significant relation between the actual plan payout and performance, the disclosed target plan payout, which is often used as a proxy for the estimated fair value of performance plans, is not correlated with firm performance in the evaluation period. The finding suggests that the current practice of extrapolating executives’ payout-for-performance relation from the reported expected values could be misleading.

We also find that the actual plan payout contains information about CEO quality. Achieving the target payment level or higher may signal that the CEO is of good quality as she can meet or beat the internal performance expectations set by the board. Confirming that investors infer CEO quality from actual plan payouts, we find that, when the LTAP payout is at or above the target payment level, the stock market reacts positively, shareholders are less likely to vote against executive compensation in subsequent say-on-pay (SOP) voting, and the CEO is less likely to leave the firm over the next two years.

A small subset of our sample LTAPs (8.6 percent of those with actual payouts) has abnormally high payouts that generally exceed the plan’s maximum payment level. These firms do not have better accounting or stock performance over the performance evaluation period than firms with normal payouts and experience significantly lower performance over the next three years. The CEOs who receive abnormal payouts tend to be powerful and work for firms with weak governance, and they are more likely to sell their shares after receiving abnormal payments. After reading the proxy statements, we find that firms granting abnormal LTAP payouts on average provide less detailed disclosure, adopt complex plans with soft payout targets, and allow adjustments to the amount ultimately paid.

Our paper provides new evidence on the informational role of actual payouts from performance-based compensation plans. We show that the actual payout is crucial to evaluate whether executives’ take-home pay is truly tied to firm performance. We further show that shareholders infer information on CEO quality from the actual plan payout. We also uncover a subset of firms with opaque disclosure that make abnormally high payouts to CEOs that are not tied to performance. All the information is unique to actual plan payouts and cannot be inferred from traditional pay measures that are based on the estimated plan values.

The SEC recently voted to adopt “Pay Versus Performance Disclosure Rules” for fiscal years ending after Dec. 16, 2022. It remains to be seen whether the rule will result in greater transparency around actual payouts from individual performance-based incentive plans. Our findings highlight the importance of such disclosure to help investors better monitor incentive compensation design and execution.

This post comes to us from professors Zhi Li at Chapman University’s George L. Argyros School of Business & Economics, Qiyuan Peng at the University of Dayton’s School of Business Administration, and Lingling Wang at the University of Connecticut. It is based on their recent paper, “Information in CEO Take-home Pay: Evidence from Long-term Incentive Plans,” available here.

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