The Complexity of Executive Compensation

Many jurisdictions have moved recently to give shareholders a “say on pay,” which typically means that companies are required to hold advisory (i.e., non-binding) shareholder votes on compensation. In other words, establishing executive pay remains the responsibility of the Board of Directors, but shareholders are given an opportunity to voice their approval or disapproval.

The Wall Street Journal recently reported that when given their say, shareholders at a resounding 98.5% of American companies have said “yes.” So it seems that, thus far, shareholders are hesitant to challenge Boards in their compensation decision-making.

This is not surprising, given the complexity of the decision that Boards face in setting executive pay. Setting executive pay is a task typically delegated to a Board’s “Compensation Committee.” Now consider the task faced by a Compensation Committee in establishing the total pay-and-incentive package offered to their CEO.

The question facing a Compensation Committee is this: what combination of cash, bonuses, equity, and perks should we put on the table in order to inspire our CEO to perform optimally? In practice, this is a pretty complex question, one not admitting of cookie-cutter solutions. A Comp Committee needs to consider, just for starters:

  • pressures from shareholder (and other stakeholders),
  • pressures from proxy advisory firms and various think-tanks,
  • human psychology, including their particular CEO’s character and motivational levers,
  • the managerial experience and expertise of Committee members,
  • corporate objectives (profit, market share, sales, social responsibility, etc.),
  • their company’s ‘risk appetite’ (roughly speaking, are they trying to incentivize their CEO to be bold, or conservative?),
  • expert opinion about optimal compensation structures (which is deeply divided, to say the least).

The problem here is as much one of epistemology as it is one of ethics. Compensation Committees need to take an enormous amount of information and opinion and distill it into a decision that will work and that will be defensible in the face of enormous scrutiny.

Of course, there is no shortage of compensation consultants, ready and willing to help Compensation Committees with this task. But recent (not-yet-published) research at the Clarkson Centre suggests that many corporate directors are skeptical about the value of compensation consultants.

Given this complexity, it’s not surprising that shareholders — even sophisticated institutional shareholders — are so far pretty hesitant to do much second-guessing. Whether or not that’s a good thing is a separate issue.

2 comments so far

  1. Nicole Edge on

    I’m struggling with the premise that the reason ‘they’ have voted yes is because they are reluctant to second-guess what is presented as a robust, well-thought out compensation committee decision. While some committees may indeed spend a lot of energy, effort, and $ …on compensation consultants in some cases, from my observations (admittedly not the numbers of data points that could statistically justify a broad statement about common practice) I’m not convinced the process is as carefully crafted as one might hope. Deeper analysis of ‘who’ the shareholders are in the cases that have voted ‘yes’ would be interesting. The groups of shareholders in a company and their relationships with the various executives would be interesting to analyze. In some public companies, the executives themselves are significant shareholders… so would they really vote ‘no’? Even amongst the institutional shareholders it’s in some ways a pretty small world. As representatives move in the business community throughout their career, how many of them would be willing to stick their neck out as it were and vote ‘no’ especially when they might be the next executive.

    • Chris MacDonald on

      Nicole:

      Thanks for your comment. You’re right that there are alternative hypotheses that would be worth considering. But for most big companies, my impression is that executives own too few shares to matter much at voting time, and other owners of large blocks of shares (e.g, big institutional investors) are sufficiently independent that they aren’t afraid to stand up to management when they think it necessary. But I’m not an expert on the history of such things.

      Chris.


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