Forty years ago, Directors & Boards posited the question, “Is Any CEO Worth $1 Million?” Today, almost all CEOs are apparently worth $1 million — often $1 million a month!
As our nation struggles to come to grips with income inequality, wealth disparity and social injustice, corporate bosses are being awarded huge payouts, with the median Fortune 500 CEO taking home almost $15 million.
Chief executive compensation, adjusted for inflation, has risen 1000% since 1978, vastly more than the average American worker’s pay. At that time, the average U.S. chief executive earned 20 times as much as a typical American worker; today that ratio is 300. And the disparity is widening.
Despite recent initiatives to reform and restrain payouts, including CEO pay ratio disclosure, top executive pay has continued to inexorably spiral upwards.
What measures are used by board compensation committees to justify these payouts? In general, CEOs receive a fraction of their total pay in base salary, double that amount in an annual bonus, with the bulk (roughly three-quarters) deriving from a long-term incentive plan (LTIP). The latter is most often based exclusively on total shareholder return (TSR) relative to a peer group, such as the S&P 500. Studies have shown that realized LTI pay has closely aligned with TSR, with CEOs of top-performing companies taking home three times as much as those at low-performing ones. This finding underscores an appropriate link between pay and performance as well as a suitable alignment between top management and its shareholders.
However, executive comp plans, notably LTIPs, often fail to take in the complete picture.
First, TSR is usually evaluated on a moving three-year cycle, with a new cycle starting every year. Paying out each year, these so-called long-term plans resemble an annual bonus. Second, TSR underscores the supremacy of the shareholder. Other constituencies, such as employees, do not always benefit from this singular focus. For example, M&A activities may enrich both top management and shareholders, at the expense of workers who may suffer job losses. Third, CEOs should be rewarded for positioning the company for the long-term, not merely for providing short-term financial results. LTIPs riveted on a signal financial measure ignore the importance of strategic initiatives such as new product development, technological innovation and management succession.
Boards of directors increasingly recognize their social and environmental responsibilities. Some compensation committees are beginning to design CEO pay plans that incorporate milestones toward longer-term, non-financial goals, notably relating to social responsibility, environmental sustainability and governance best practices.
Board compensation committees need to set aggressive incentive plan goals, including ESG goals, that offer big paydays if, and only if, top management delivers truly exceptional performance. If this performance/reward relationship has too little stretch, executive compensation will seem to better serve top management than shareholders. Having chaired many compensation committees, I recognize both the responsibility and the challenge of forging the appropriate relationship so that we can slow down the runaway gravy train.