Current issues in CEO compensation

There is no question that CEO compensation has become a highly contentious issue in the business world, attracting significant (and mostly negative) attention from the popular press, regulators, investors, company employees, and other corporate stakeholders. Several factors appear to be behind this image problem, but uppermost is the dramatic increases in CEO pay in recent decades, particularly as a multiple of an average employee's wage. Another bone of contention is that CEO pay is often not commensurate with actual firm performance. The recent global financial crisis (GFC) has brought the executive pay debate into much sharper relief than ever before. Among other issues, the spate of GFC related corporate collapses, distressed mergers, and government bailouts resulted in widespread employee lay-offs and devastating losses for investors. Rightly or wrongly, the public perception is that CEOs have continued to enjoy financial rewards and/or termination benefits (such as ‘failure parachutes’) grossly disproportionate to firms' actual performance, many of which were failing or entering Chapter 11. The widespread public perception that CEO pay is excessive and a ‘runaway train’ has led to a raft of new regulations. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) introduced additional pay-and-performance disclosures (which more clearly link CEO compensation and firm performance), pay ratios (the ratio of the median employee pay to CEO pay), clawback provisions, and disclosures relating to the independence of compensation advisors and committees. The Act also introduced new say-on-pay rules, such as the requirement for advisory votes of shareholders about executive compensation and ‘golden parachutes’. Similar requirements have been introduced into Australia and other countries.

This special issue features an article by Yaowen Shan and Terry Walter (hereafter S&W) titled ‘Towards a Set of Design Principles for Executive Compensation Contracts’. The paper reviews the extant CEO compensation literature and proposes a number of principles for guiding the development and framing of more effective executive compensation contracts. The special issue also contains 13 commentaries drawn from a wide range of academic experts and commentators in this field. The commentaries are structured as a single article entitled ‘Comments on Shan and Walter: ‘Towards a Set of Design Principles for Executive Compensation Contracts'. This commentary article adopts a simple structure where each section represents each author/s individual commentary on the S&W article. The commentary article does not suggest that every commentator necessarily agrees with, or endorses, the views of other commentators. Many of the commentators, in fact, take quite different views on the S&W paper, and several of the commentators have very different views from each other. S&W were also invited to provide a short rejoinder to these commentaries, which appears after the commentary article.

As a motivation for their study, S&W pick up on the popular perception that CEO pay is excessive and that corporate boards are largely ineffective in curtailing powerful CEOs in compensation negotiations. S&W identify three elements to these debates: (a) CEOs are over-paid and their pay continually rises; (b) CEO pay is not linked to firm performance; and (c) corporate boards are not effective in monitoring executive compensation. As noted by S&W, the US regulatory response to the Enron and WorldCom collapses (among many other high profile failures) was to introduce far-reaching corporate governance reforms in the form of the Sarbanes-Oxley legislation of 2002, while the Dodd-Frank legislation was introduced soon after the GFC.

The S&W paper essentially takes the view that much of the CEO pay controversy arises from executives being rewarded on the basis of performance contracts that have inherent design flaws. They argue that: ‘few stakeholders in firms would object to generous compensation for managers whose performance results in abnormally high long-term shareholder wealth creation’ (p. 620). Based on their review of extant theoretical, regulatory, and empirical literature, the authors suggest a number of design principles that could form the ‘fundamental building blocks for designing executive remuneration systems in public firms, especially where ownership and control are separated’ (p. 620).

In arriving at these design principles, S&W contrast two schools of thought on executive compensation. One camp is the efficient-contracting or agency theory literature, where CEO compensation is set in a ‘competitive equilibrium with appropriate incentive structures to motivate managers to maximize shareholder wealth’ (p. 621). The other camp is the managerial-power literature, which posits that CEO compensation is determined through CEOs exercising power over ineffective or ‘captive’ boards. Drawing extensively on the work of Murphy (2013), S&W acknowledge that the efficient-contracting and managerial-power concepts are not mutually exclusive, indeed treating them this way tends to ignore other important factors that impact on CEO compensation (such as political, tax, and accounting influences). As Murphy (2013) argues, while efficient-contracting theory provides useful insights explaining rising levels of CEO compensation, it fails to explain why, for instance, there has been a shift from stock options to restricted stock as the preferred form of equity compensation after 2001. While efficient-contracting theory may have limited explanatory power in this context, S&W also observe that the managerial-power concept is even less effective in explaining the increase in CEO pay over the decades.

The 13 commentaries on the S&W study take quite varied positions on the issue of CEO pay. As pointed out in the S&W rejoinder: ‘We are fortunate to have received 13 excellent commentaries on our paper. Each commentary is quite unique, perhaps reflecting how controversial is the topic of trying to set down fundamental design principles for managerial reward systems’ (p. 772).

Beaumont et al. point out that regardless of the economic model (efficient contracting or managerial power) there is a widely held perception that CEO pay is too high—hence the main issue with designing principles for CEO contracts is to develop multiple measures of performance to avoid over-compensating CEOs. However, Beaumont et al. take the position that greater regulation, such as in the form of executive design principles, is not likely to improve the situation. They provide an interesting context for their discussion by comparing CEO pay with the remuneration of professional athletes. The conclusion from their empirical analysis is that in the US ‘the shape and nature of the distribution of CEO pay appears quite similar to that of professional athletes’ (p. 690) and that most CEOs receive relatively low pay by comparison, although different conclusions appear to be drawn from the Australian and UK samples. While the comparison between the remuneration of CEOs and athletes may not be strictly valid in all cases, Beaumont et al. are not convinced about the desirability of compensation principles. They observe that critics of CEO pay usually cite the responsibility of CEOs to shareholders as justification for increased regulation of CEO pay, but they maintain an alternative view that shareholders can ‘vote with their feet and invest in firms with relatively lower or perceived “better” CEO compensation’ (p. 693). Beaumont et al. conclude that a set of external principles designed by academics may even distort the market for executive talent.

Boyle's commentary introduces an alternative perspective to the efficient-contracting and management-power theories. He draws this third view from the work of Dorff (2014) who rejects both paradigms in favour of a behavioural approach in which ‘psychological factors cause well-meaning but befuddled directors to excessively remunerate CEOs’. 1 In particular, Boyle focuses on real-world frictions that can limit the general applicability of the efficient-contracting model. One friction is the role of compensation consultants. Boyle argues that much of the information needed to implement the S&W principles is commonly provided by consultants. If a board of directors decides to engage a compensation consultant to provide information and/or a recommendation on CEO pay, the consulting firm may have strong incentive to describe the CEO's current pay as below average (particularly if the CEO hires the consulting firm). The likely result is that the board ‘then decides to increase the CEO's pay to a level that respects CEO above-average status’ (p. 696). Boyle suggests the use of independent labour economists to assess compensation data. However, in order to avoid such conflicts, this could also be good reason to use abnormal returns as the main firm performance measure as suggested by S&W. Boyle is circumspect about the use of abnormal returns as a performance measure because it can be distorted by unusual events (not related to the CEO's skill or effort). S&W appear to have taken this contingency into consideration in their tenth principle, which would give compensation committees discretion to assess such events. Overall, Boyle is pessimistic about the likelihood of successfully designing a set of CEO compensation principles. He believes that any such rules will simply result in new problems (as firms will exploit them), or be inefficiently constrained by others.

Brown and Szimayer broadly agree with the principles set down in S&W. They observe that executive stock options (ESOs) grew in popularity in the US between 1992 and 2001 but since then have fallen out of favour for a number of reasons, such as the ‘value gap’ (or difference between what they ‘cost’ the company and what they are worth to the executive). They discuss three issues not covered in detail by S&W: (1) the ‘value gap’, including difficulties in determining the fair value of an ESO; (2) the composition (form) of executive compensation; and (3) where and how to adjust for dividends. Overall, Brown and Szimayer believe S&W make a useful contribution by refocusing discussion on the design of efficient compensation contracts. They seem to find sufficient support for most of their principles, for example, vesting that depends on performance, dividend protection in remuneration contracts, and carefully chosen performance targets that are specified in advance. As to the future, Brown and Szimayer see opportunities both to develop contracts with theoretically more sensible pay–performance characteristics/sensitivities and to test them empirically.

Da Silva Rosa makes three essential points: (a) there is a plausible case that the controversy over CEO pay is a sideshow with minor impact on the market for CEOs; (b) the confidence with which commentators on both sides of the CEO pay debate offer ‘best practice’ prescriptions is not matched by a correspondingly robust understanding of the drivers of CEO pay and diffidence in advocating solutions is appropriate; and (c) we risk asking too much of the market in tying CEO pay to abnormal equity returns. Da Silva Rosa argues that CEO services come at a price but it is not clear that the market itself is the best mechanism for determining that price (although some of Da Silva Rosa's concerns are addressed in S&W's tenth principle). Da Silva Rosa believes a clear connection of CEO performance and compensation that is also politically acceptable could be too difficult to achieve. His comparison with superannuation fees and expenses is revealing as it implies that the whole CEO pay debate is disproportionate to the economic and social effects of excessive CEO compensation (which is not so significant in economic terms). He argues that superannuation fees and expenses are not as controversial as CEO compensation, and yet their economic and social consequences are certainly more far reaching. Nor does Da Silva Rosa accept that CEO pay is inherently flawed or broken, requiring immediate fixing (if so it would suggest the market has grossly mispriced CEO services). He concludes that the process is more important than measuring specific performance outcomes: ‘The transparent demonstrable link between a firm's equity value and CEO pay that S&W aspire to achieve via their nine principles is most likely unattainable. Principles that focus on process rather than outcomes are more advisable’ (p. 714).

Hillier et al. argue that the general design principles for executive compensation contracts outlined in S&W are a step in the right direction. However, they make a number of additional recommendations to supplement and operationalize the S&W principles in order to optimize their impact. They also identify distinct issues and time periods in the CEO life cycle and apply the pay principles of S&W to these circumstances.

Howieson questions the agency theory foundation of the S&W principles. His commentary attempts to raise awareness that the executive compensation debate should engage concepts beyond the confines of economics, including law, ethics, and sociology. He argues that economic principles on their own are never sufficient grounds to convince the majority of people that specific cases of executive compensation are fair, reasonable, or appropriate. The literature and research described in his commentary suggest that one of the reasons for this is the human frailty of ‘envy’; people will naturally compare their situations to those of others and often will be unhappy with what they perceive. All this suggests that size of CEO remuneration matters. However, arguments that simply assert that CEO pay is ‘too high’ (and therefore unfair) are difficult to justify in the absence of some agreed benchmark as to what CEO pay should be. Howieson implies that it is up to the CEO to reject excessive pay but S&W's rejoinder points to practical problems with this assertion. While Howieson does not comment specifically on any of S&W's nine principles, he does suggest that their principles should be supplemented with a further principle to: ‘promote and demonstrate the transparency of executive appointment, remuneration, and evaluation and that require executives to have undertaken appropriate training in practical skills in value clarification and ethically informed decision making and policy setting’ (p. 729).

Matolcsy and Spiropoulos ‘unashamedly’ contend that on average executive compensation is efficient, and the literature supports the contention that executive compensation is determined by the managerial labour market and economic characteristics of the firm. Matolcsy and Spiropoulos provide further discussion and analysis of areas not covered in the S&W paper, such as the CEO pay slice (the ratio of the CEO pay to the pay of the five highest paid executives), the say-on-pay regulations in the US and Australia, gender diversity in compensation committees, and the use of economic value added (EVA) or residual income (RI) as a firm performance indicator. Matolcsy and Spiropoulos conclude that despite regulatory efforts to reduce the levels of executive compensation and align managers' interests with those of shareholders', the topic of executive compensation will likely continue to be a contentious issue in the public and academic arenas.

Roberts rejects the agency theory underpinnings of the efficient-contracting literature. He argues that ‘simplistic’ assumptions about agents and principals, and our ‘clumsy’ attempts to align these interests through CEO pay, has established a strong culture of self-interested opportunism that has become a powerful norm amongst executives. Ultimately this culture has undermined the interests of the shareholder in the long-run wealth creation process. Roberts concludes that instead of ‘tinker[ing] with the calculus of self-interest’, we should challenge the assumption that CEO pay can be effectively tied to individual performance. He sees wealth creation as a social process that will be damaged by self-interested opportunism. Finding better ways to align CEO self-interest to the interests of shareholders will likely only exacerbate the problem.

Smith and Zhou agree in principle with most of S&W's principles and seek to provide some specific, practical design implication directions. Their overall recommendation is to keep CEO pay simple, keep it fair, make sure outstanding performance is recognized, and acknowledge and tie performance pay to a market benchmark based on long-term performance. They point out how these aims will benefit not only the CEO and shareholders but also employees, customers, suppliers, society, and possibly even humanity.

Swan concludes that S&W's nine principles provide good general guidance. However, Swan argues that these principles are relatively silent in the advice they provide on the critical pay mix—incentives versus cash—and shed very little light on compensation for pay risk, managerial effort, and managerial talent. Swan's commentary highlights where further revision is needed, particularly in relation to the cash component of compensation, the inability to observe managerial talent ex ante, the mechanisms that need to be in place to ensure appropriate levels of risk-taking (where it is proposed that options with downside protection might be considered) and issues that might arise in cases where the CEO is dismissed for poor performance or illegal conduct.

Taylor argues that S&W's principles fail to fully consider the role of financial reporting in shaping executive compensation practices, including the role played by accounting regulations in shaping the design of any ‘optimal’ compensation contract. S&W's efficient-contracting perspective suggests that abnormal stock returns are a better reflection of shareholders' interests (either in the short or long run) than other measures. However, the introduction of S&W's tenth pay principle is potentially an avenue for compensation committees to more fully incorporate accounting measures in their discretionary judgements about bonus pools. Taylor also points out that the S&W principles are identified in the absence of any substantive ‘positive’ theory of executive compensation. Taylor argues that ideally such a theory should be able to produce testable implications regarding the structure of compensation contracts as well as the motivations facing a variety of stakeholders, including (but not restricted to) managers, directors, shareholders, and regulators.

Wright concludes that S&W is a valid research paper in the traditions of normative research and evaluation research. However, she notes that there is little discussion of other approaches and consideration should be given to alternative models that are not observed in practice. Wright concludes that whether the S&W design principles are optimal or likely to be adopted is worthy of further debate by academics in the literature. The really important question is how these principles will be received by executives, directors, chairs of boards, regulators, and shareholders.

Yermack argues that the S&W principles do not follow directly from the analysis in the paper, and ‘if applied rigorously, they would straitjacket companies into offering only certain contracts in a market that includes a diverse array of CEOs’ (p. 757). Yermack also believes the design principles are too closely linked to current practices rather than the guidance of economic models. Overall, Yermak rejects S&W principles, and instead provides six points of his own for reforming executive compensation (although not all would be appropriate for Australia and some are not inconsistent with the S&W principles). These include: (a) do away with share-based compensation, and go back to stock options; (b) end employment contracts; (c) get rid of perquisite compensation; (d) recognize the important role of inside debt compensation, which many companies already use, and broaden it to all firms that issue external debt; (e) narrow the list of suitable performance benchmarks, so that accounting data and peer-based compensation are removed; and (f) make the process more transparent, so that aspects such as retroactive and tournament-based compensation are more obvious to the firm's owners.

What is less contestable is Yermack's observation that companies have generally not done a good job in explaining unusual or irregular compensation practices to their shareholders, and he argues there is plenty of room for ‘more honesty, thorough disclosure, and improved transparency’ (p. 760). For example, he finds that even on say-on-pay voting, most firms tend to use ‘incomprehensible, legalistic prose when discussing executive compensation, and they miss an opportunity to engage shareholders more thoughtfully on an issue that is very important to all concerned’ (p. 761).

The many and varied views espoused in this special issue underscore the complexity and contentiousness of the CEO compensation debate. It is hoped that this volume will contribute to more on-going research and debate on this important issue.