Pay now, pay later: The CEO compensation conundrum
Assessing the fairness of CEO pay is fraught with complexities. But, if left unchecked by shareholders, reward may further decouple from performance.
This is an extract from Morningstar senior equity analyst Brian Han's column Brianstorm. Morningstar Premium subscribers can view the full version and previous columns here.
In this edition of Brianstorm, I have decided to open a can of worms. Some cans are worth opening, if only to fertilise the mind and foster debate. And that can of worms is CEO compensation, and its immense disparity to the average person.
As can be seen below, in 2019, the average pay packet of a large company CEO in the US was 200 to 300 times that of a typical employee in the relevant industry, depending on whether we measure the incentive components on a “realised” or a “granted” basis.
Astronomical CEO-to-average worker compensation ratio in US*
* Average annual compensation for CEOs at the top 350 U.S. firms ranked by sales
** “Granted” includes the value of stock options and stock awards when granted, “realised” captures the value of stock-related components that accrues after grant.
Source: Economic Policy Institute
The disparity is not as stark in Australia, with the ratio to be 40 to 60 times, depending on the size of the company.
Average CEO realised pay-to-average worker pay not as egregious in Australia but still significant
Source: Australian Council of Superannuation Investors and Ownership Matters
At this point, if the reader’s reaction is of relief that Australian CEO pay disparity is not as egregious as in the US, therein lies the entrenched apathy on the whole issue. When did we start gauging the fairness of a CEO’s pay in Australia by reference to the US’ outlandish high-water mark? When did shareholders come to accept that 40 to 60 times an average worker’s pay is reasonable for a CEO?
We all appreciate the immense responsibilities and challenges facing CEOs. They have numerous stakeholders to answer to, and are often on call 24/7, dealing with a multitude of problems and issues. And they are often easy targets of criticism, especially from those of us who can barely run a sausage sizzle at a school sporting event. But is a CEO of a publicly-listed company really worth 40 to 60 times an average employee, or an eye-popping 200 to 300 times in the US?
Ask that question to any CEO, and he (and it is invariably he, in most cases) will often sheepishly refer you to the chairperson. That chairperson will typically direct you to the collective board of directors or the remuneration committee. And that board and/or remuneration committee will in many instances justify the CEO pay by reference to some nebulous concepts such as “war for talent”, “global mobility of exceptional leaders” and the need to pay “market rates” to attract such executives.
Somewhere in that loop one will find a breed of professionals called remuneration consultants. They are in charge of benchmarking CEO compensations globally, and making sure the pay comparison yardstick is as high as possible because they know which side of their bread is buttered. A recent US research by MyLogIQ showed that nearly 90 per cent of companies listed on the Russell 3000 Index in the US use these remuneration or compensation consultants. The chart below shows the most prominent firms in this space, and we would hazard a guess such firms are also commonly engaged by listed companies in Australia.
Top compensation consultant market shares among Russell 3000 companies in the US*
* For the 2020 Annual General Meeting year
We concede much of a CEO’s pay comprises incentives and bonuses linked to the company’s performance and/or its stock price. This is evident both in the US and in Australia.
Bulk of CEO pay tied to bonuses and incentives (% of realised pay that is not fixed salary)
Source: Economic Policy Institute for US, Australian Council of Superannuation Investors and Ownership Matters for Australia
But sometimes we have a nagging suspicion that some of these bonuses and incentives are not really such, but are paid to a CEO just for turning up and keeping the ice cold. For instance, we urge any reader to pick up an annual report and read what actually triggers a bonus or an incentive grant. One will often find reasons such as meeting customer, people, strategic, shareholder, employee and community trust and reputation targets.
Wait, come again?
Are those not what a CEO should be doing as part of his job, and for which he is compensated for via his generous annual fixed salary? When I give my kids pocket money to put the garbage out on Monday nights, they don’t get any extra dough for making sure the bags are all tied properly, put into the bin with the lid securely closed and placed on the curb correctly to the satisfaction of the council garbage truck drivers!
Worse still, in many cases, the minimum thresholds to trigger CEO bonuses are pretty subjective, or are not very stretched targets when compared to the ebullient promises made to analysts and fund managers in public briefings.
With ESG becoming a more critical part of a company’s charter, what is the chance that a CEO’s pay will also increasingly incorporate ESG-oriented targets, thereby, adding extra ways for him to get paid?
We, of course, recognise the important role that incentives play in shaping behaviour, especially for the long-term betterment of a company, the environment, and in areas of social and governance matters. But how is this for a novel incentive? How about CEOs pay more attention to ESG matters simply as part of his job because it is the right thing to do and because, over the long term, it is likely to benefit the company, its shareholders and, therefore, his pay packet? And if a CEO threatens to leave because he can get paid extra for hitting ESG targets elsewhere, that in itself may a valuable datapoint for the board in assessing his suitability as the company leader.
Perhaps we are being too idealistic. Perhaps we should pay greater heed to the fundamental notion that, if a CEO’s remuneration is tied to the company’s performance and/or stock price, then shareholders should be content.
Unfortunately, as our US colleagues Joshua Aguilar et al pointed out in “Heads I Win, Tails You Lose: CEOs Share in Investors’ Gains, but Not Their Pains”, there is a notable disconnect between CEO compensation and shareholder value creation in numerous instances. As the title suggests, the equation is often asymmetrical because a CEO participates on the upside, but nowhere near as much on the downside when the proverbial hits the fan. The report also found almost no evidence of any relationship between shareholder returns and CEO compensation. Is it possible that the war for CEO talent is waged on metrics that shareholders are oblivious to?
Virtually no correlation between total shareholder returns, CEO compensation in US*
* 2013–17 total CEO compensation and three-year total shareholder return
Such is the lop-sided equation often found in incentive-laden CEO remuneration packages that our colleagues make the following recommendations in the abovementioned report:
- Make CEOs suffer when shareholders do;
- Focus incentives on long-term value creation so CEOs stop focusing on today’s share price;
- Give “Say-on-Pay” votes teeth; and
- Reduce the cosy relationship between management and “independent” boards.
We urge investors to keep these recommendations in mind when perusing the fiscal 2021 annual reports rolling in from August, and when attending the subsequent Annual General Meetings from late October.
At the one annual event where your voice can be heard, ask the board why it takes 10 dense pages or more in the annual report to explain how the CEO’s remuneration and especially the bonuses are determined? Ask where do his basic management responsibilities to justify the base fixed salary end, and where do his “above and beyond” duties begin to justify the “bonuses” and “incentives”? Ask what mechanisms there are for the CEO to share the pain or for the bonuses to be clawed back, if the company underperforms. And please, please ask them to explain all this in layman’s terms, stripped of technical jargons and remuneration consultant-speak that befuddle most of us.
This is not some populist sentiment we are propagating. We acknowledge the difficult issues involved in setting CEO remuneration, the pros and cons of various incentive systems to align the executive and the shareholders’ interests, and the challenge in separating skill and luck in outcomes that influence the executive pay.
But there must be continued vigilance on accountability in this area. Shareholders accept the behaviours they silently acquiesce to. Before long, you end up with a situation where a CEO is paid 200 to 300 times his average employee and no one bats an eyelid. Worse still, shareholders remain disinterested until things go awry, the stock price is in the dumps and then they suddenly huff and puff, and wonder why the CEO is still being rewarded with a bonanza. Keep the boards and the CEOs accountable. After all, it is ultimately your money they are paying to the CEO.