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The Future of Executive Compensation
It's not how much, but how, you pay
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The interests of CEOs, Presidents, and other business managers are not always aligned with those of their employees and shareholders. While changes to corporate voting schemes may help in this regard, until compensation structures are optimized, those incentives will remain out of alignment. Businesses of the future need to rethink how they pay their leaders to help them deliver their best work.
One may wonder why does this matter? Aren’t executives paid enough? That question is beyond the scope of this essay. I am limiting this discussion to the incentives executives have to perform to their fullest capacity for the benefit of stakeholders, which may include, shareholders, pensions, 401ks, employees…etc. Effective leadership benefits stakeholders. Executives who perform well for stakeholders should be rewarded, and those who deliver mediocre results, should not. There is a separate discussion to be had about wealth inequality, but this is better addressed via other mechanisms, such as an LVT (discussed here) or taxing distributed profits.
In recent decades, stock options have emerged as the premier method of compensating business executives. In a piece by Alfred Rappaport, published in the Harvard Business Review, he notes that options account for over half of CEO and roughly 30 percent of senior managers’ compensation. Options and stock grants also constitute almost half of directors’ compensation as well.
This is a trend that began in the 1990s. Prior to that decade, executive pay was generally a function of salary plus bonuses. The bonuses would be awarded only if the company achieved certain financial targets. It was thought that paying executives more via salary and bonuses would incentivize them to work longer hours and push them to innovate on behalf of the company.
But the data suggested otherwise. In a seminal work published in 1990 by Michael C. Jensen and Kevin J. Murphy entitled, “CEO Incentives—It’s Not How Much You Pay, But How” the authors illustrated that there was virtually no link between how large of bonuses CEOs were paid and how well their companies performed for shareholders.
With this revelation, corporate boards began to rethink traditional compensation approaches. Instead of simply paying more, they thought that they could better align CEO incentives with the shareholders by tying executive compensation directly to the stock price through options. It was thought this would both reward shareholders and lead to medium/long-term corporate success, as the stock price is often seen as a leading indicator of a company’s health.
The data are now in, however. Such stock options have turned out to be a poor incentive as well. The reason for this is that a stock option’s exercise price is generally set on the date that they are granted and remains fixed for a period, often ten years. Should the share price of the option rise above the exercise price, the option holder can cash in at a profit.The problem is that the stock market can be influenced by variables, such as interest rates and other market conditions, that are outside executives’ control.
When the stock market is rising (and it generally is) it rewards both good performance and subpar performance. Thus, in a rising market, cashing in options is likely to yield a windfall, even for companies that actually underperformed. By the same token, if the market happens to be in a significant downturn, the options could be worthless, even for a company that is performing well and is financially sound.
An Alternative: Indexing
The solution, Rappaport suggests, is to look beyond fixed price options and tie them instead to performance relative to other market players. This can be done by tying the exercise price of the option to an index, say the S&P 500 or an index comprised of a company’s key competitors. A payout would be contingent on outperforming the average player on the chosen index. Whatever index is chosen, indexed options do not reward underperforming managers merely because the market is rising as a whole. By the same token, they do not penalize superior performers simply because the market is falling. Only executives who outperform the index are rewarded.
Compensating in this manner is likely to encounter significant resistance from executives given that “success” is much harder to achieve. Thus, to make future compensation packages sufficiently enticing, Rappaport suggests two additional tweaks. First, increase the total options granted. More options, obviously, create a greater upside to solid performance. Second, offer a small discount on the exercise price, perhaps 1 percent per year, off the growth rate of the index.
Remember, only 50 percent of executives can perform better than average, therefore options for the other 50 percent are worthless. There is a hidden danger that some executives, fearing that beating the index might be unattainable, will “give up” entirely during their tenure. Discounted options ensure that executives who perform just below average still are incentivized to show up to work.
What about Managers?
Stock options, as currently structured, are an even worse incentive for non-CEO managers. This is because the stock measures the overall confidence level in a company, which is an amalgamation of the sum performance of all of the business units. Some business units might do quite well, but if their performance is overshadowed by failures in others, those underperforming units will drag down the stock price and penalize managers and directors for factors that are outside their control.
So how can we properly incentivize the managers who oversee their respective business units inside the larger corporation? The solution, Rappaport says, is to treat each business unit as its own standalone corporation by determining their respective SVA or Shareholder Value Added. Shareholder Value Added attempts to place a value on changes in the future cash flows of a particular business unit.
It’s calculated through standard discounting techniques to operating cash flow forecasts of a specific period. Then, by subtracting the incremental future investments expected in that same period. This can isolate the performance of a specific business unit relative to the broader organization. To ensure that managers do not focus only on short-term quarterly or annual performance, it may be wise to extend the specified period to a rolling three years.
Utilizing an “expectation approach,” managers whose business units outperform expectations will be rewarded. Conversely, those whose business units underperform, will not. Here again, it may make sense to build in a discount mechanism where mild underperformance still qualifies for some rewards.
Corporate performance matters for stakeholders, which includes many of us. For this reason, we ought to ensure that executives work on behalf of those stakeholders and not only for themselves. New compensation methods, combined with improved corporate voting schemes (discussed here), ensure faster growth, more innovation, and a fairer and brighter future for all.
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