CEO pay quantum has been a topic of conversation for many years. When the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) regulations were implemented, many thought this would finally be the time that CEO pay began to level off. However, that was not the case and CEO pay has shown significant gains in the past 10 to 15 years. While Dodd-Frank did not slow down CEO pay growth, there were several other important developments that contributed to CEO pay growth.
Enacted in 2010, Dodd-Frank was a reaction to the 2007 financial crisis. It intended to harden perceived weaknesses in the financial system. However, tucked away in the legislation was the fulfillment of an investor wish list. Most importantly, the requirement that companies provide a nonbinding advisory vote to shareholders on executive compensation at the annual meeting. The shareholder say-on-pay, as it is now commonly called, was the most significant development in corporate governance and executive compensation in 15 years. It not only changed the way corporations incentivize and retain executives, but it allowed proxy advisors to have an outsized role in board decision-making.
Public corporations were wary before the say-on-pay rules went into wide effect in January 2011. CEO pay declined between 2011 and 2012 as boardrooms fretted over possible lawsuits and shareholders interjecting themselves into committee conversations. While the former concern did not broadly materialize, the latter did. Shareholders now had a chance to communicate, albeit indirectly, with the compensation committee through the say-on-pay vote.
Shareholders' newfound voice in the boardroom was aided by powerful allies, most notably Institutional Shareholder Services and Glass Lewis. It turned out that proxy advisors could steer enough shareholders in the same direction to have meaningful impact on vote outcomes. This provided proxy advisors with substantial power in the marketplace and the ability to modify incentive programs over time. While the say-on-pay vote is largely symbolic, shareholder opposition and proxy advisor attention were something to be avoided. This fact had a consequential effect on executive compensation.
Some governance observers have argued that executive compensation programs had more variability in design before the implementation of say-on-pay. Equity programs, in particular, were more varied in mix and performance orientation. Others have disputed this by suggesting that corporations often gave a raft of stock options and current incentive programs are more creative than ever given the mix of performance metrics, measurement/vesting periods and supplemental awards. Regardless, say-on-pay and proxy advisors moved compensation programs inevitably toward a common framework — a short-term cash incentive program and equity awards equally split between time- and performance-based equity vesting over a three-year period. There are certainly varying design choices in this framework, but, ever since 2011, the programs have looked increasingly alike due to the pressures from shareholders and proxy advisors. This movement toward performance-based full-value awards may have greased the wheels toward increases in CEO pay. Stock options, the favored long-term incentive (LTI) vehicle throughout the 1990s and early 2000s, began to dissipate once say-on-pay was introduced — because proxy advisors generally do not consider this vehicle to be performance-based (many shareholders would disagree). After 2014, performance-based equity awards consistently made up at least half of total LTI, reaching an all-time high of 60% in 2022 (see Figure 1).
Performance awards are also being utilized within 92% of the LTI programs among the largest 300 publicly traded companies, up from 74% in 2008. The most prevalent LTI combination today consisting of restricted stock and performance awards (43%) was only employed by less than 10% of the largest publicly traded companies 15 years ago. Stock options were being considered by 73% of the largest public companies in 2008 while that prevalence has shrunk to 42% today. A similar number of companies in 2008 and 2022 continue to use all three LTI vehicles. While a stock-options-only approach was very limited in 2008, it has become nonexistent in 2022 (see Figure 2).
Heavier reliance on performance-contingent equity introduced significantly more risk for executives. Unlike stock options or other time-vested awards, performance-based equity could be forfeited if financial goals were not met. For many executives, the risk of forfeiture necessitated the possibility for greater reward. In effect, the focus on performance-vested equity drove up grant values to not only insulate executives from smaller pay days but also build toward a notion of pay for performance. After all, greater risk leads to greater reward.
While say-on-pay may have played a role, CEO pay has rarely hit more than a speed bump in CEO pay increases. In 2008, the median CEO total direct compensation within the largest 300 U.S. publicly traded companies was $7.5 million. That number more than doubled, growing to $15.6 million in 2022 (see Figure 3). CEO base salaries exhibited a modest 2.3% compound annual growth rate (CAGR) while LTIs exhibited a more meaningful 5.0% CAGR during this period.
While CEO pay has had setbacks due to market events, the subsequent rebounds have pushed executive pay even higher. CEO pay retreated during the financial crisis of 2007 but jumped nearly 50% and 11% in 2010 and 2011, respectively. Similarly, while boards approached pay decisions with caution during 2012 as say-on-pay was being rolled out, CEO pay experienced yet another double-digit percentage (~14%) rise in 2013.
Between 2014 and 2019, CEO pay steadily climbed until the pandemic arrived in 2020 — executives voluntarily took fixed pay cuts resulting in a modest CEO pay decline from the year prior. However, during a period of continued uncertainty in 2021, boards were quick to recognize retention concerns and pay spiked again through a combination of pay tactics that involved the use of special awards, a shift toward time-based equity, emphasis on strategic objectives that were worth paying for within the annual incentive program and the application of discretion.
Economic and regulatory uncertainty seems to push compensation levels ever higher. This is perhaps a knee-jerk reaction on the part of compensation committees leading to hikes in pay, all in an effort to shore up executive retention and goal attainment. How do we properly address pay in challenging times — and normal ones — and make prudent decisions for the organization and shareholders?
Boards and compensation committees need to think about new ways to benchmark and evaluate CEO pay. When determining executive pay, committees should come at CEO pay considering a number of analytical and contextual factors. Let's call this new approach CEO pay quantum review. Compensation committees all too often default to standard benchmarking during the annual compensation review process. This traditional benchmarking should only be a small part of the whole. Additional analyses that should be performed in order to achieve a more holistic view of CEO pay involves:
⢠Absolute and relative realized and realizable pay
⢠Pay ratios (vs. direct reports)
⢠Pay relative to absolute and relative financial performance (total shareholder return, profitability, return metrics, etc.)
⢠Pay within the context of job size and complexity (vs. direct reports)
⢠Pay within the context of tenure
Applying each of these lenses to assessing CEO pay will uncover various insights allowing compensation committees to calibrate pay with more nuance than simply through traditional pay benchmarking methods (i.e., comparing to peer CEOs). CEO pay has and always will be a hot topic, so extra care is required when making CEO pay decisions.
Note: All data is sourced from Korn Ferry's (and Hay Group's, prior to 2016) Annual CEO Compensation Studies.