Fixing the Executive Pay Problem, 1990-2011

Every week I receive a Giga Alert, pointing me to where I have been posted, cited, or referenced.  Some of these represent a chain going back quite far.  Today I received one citing an article published by Rutgers University in 1992 that mentions an editorial I wrote for the Sunday Los Angeles Times in 1990.  I hadn't read that piece, or even thought of it, for quite some time.  21 years later, not much has changed.  See the original here, or keep reading.

Fixing the Executive Pay Problem : Compensation: Improvements must come in incentive programs that link pay to performance, with an emphasis on long-term stock benefits instead of quick cash.

EXECUTIVE PAYCHECKS. California's Rising Sums: First in a series.

May 27, 1990|VINCE TAORMINA and FRED E. WHITTLESEY | VINCE TAORMINA is a principal and FRED E. WHITTLESEY a senior manager in compensation and benefits consulting at the accounting firm KPMG Peat Marwick in Los Angeles

What should be done, if anything, about the seemingly excessive executive pay in U.S. corporations? The answer, while technically simple, is difficult to implement.

Most economic and financial theorists agree that a senior executive's job is to maximize long-term shareholder value. If this is correct, then the executive's pay should be maximized when shareholder value is maximized.

If boards of directors are to design such programs, then the improvements must come in so-called incentive compensation programs--such as annual bonus plans and stock options--that link pay to performance. It is these programs--not salaries, benefits and perquisites--that are creating the highest compensation levels. These incentive programs deliver two forms of compensation: cash, mostly from annual programs, and stock, mostly from long-term programs.

Unfortunately, most annual cash incentive plans are based on such measures as pretax profit, return on equity and other financial measures that encourage short-term maximization and are easily manipulated by savvy executives. A large body of financial research indicates that better measures are available that ensure that shareholders' capital is earning an adequate return. Incorporating these measures into annual incentive plans will improve one element of the total executive compensation situation.

The current use of stock options and stock-related compensation programs is consistent with the goal of increasing shareholder value. If structured properly, stock-based compensation should not ruffle shareholders' feathers because their fates will be linked with that of executives. When an executive's share holdings far exceed any benefit or risk derived from cash compensation programs, shareholders' interests will be maximized.

The abuses tend to come when various "bells and whistles" are added to already potentially lucrative stock programs. And these are easily remedied:

* Eliminate stock appreciation rights. SARs allow an executive to get a cash bonus when the stock price goes up. While this objective seems noble, the cash payment allows an executive to profit from temporary rather than long-term stock price increases.

* Require executives to hold stock options for a longer period before cashing out. Most plans allow executives to begin exercising stock options as soon as one year after receiving them and continuing over a three- to five-year period. By extending these schedules, the executive has a true long-term incentive to maximize share price.

* Require the executive to continue holding shares acquired through stock option and stock award plans. This would truly align executives' interests with shareholders' interests. These holding periods can allow for some cashing out along the way, but only when stock value is maintained or increased. Without holding periods these stock plans can become just "quick cash" programs.

* Eliminate the cancellation and reissuance of options. When an executive receives an option and share price drops soon after, an option may not be "in the money" for some time. Most options usually give an executive the right to buy stock at a price close to the market price when the option is granted. So if the stock price then goes up, the option becomes more valuable, in effect allowing the executive to purchase stock at a discount. But if the price goes down instead, the option is essentially worthless.

Many companies have solved this problem by canceling the old option and reissuing it at the lower price. Unfortunately, a shareholder who bought a share at the higher price does not have the same opportunity. It is difficult to imagine a situation in which a cancel or reissue is truly warranted, particularly if companies follow rational option-granting policies.

* Grant large options at the beginning of a period and eliminate annual grants. If on the day a senior executive is hired or promoted, he or she received 10 years' worth of stock options and the options could not be exercised for 10 years, the executive's perspective would be much longer term. The practice of making annual option grants encourages a short-term cash-out mentality.

* Consider paying executives only in stock, with special arrangements to provide the necessary cash flow for living expenses. If all other compensation is in stock, then dividends, selective liquidation programs and company loans can eliminate the need over time for any base salary or bonus plan. In the transition, a well-designed annual incentive program should provide all the cash necessary for a well-funded executive lifestyle.

The obstacles to implementing these shareholder-oriented compensation programs are not technical in nature. The obstacles are timid boards of directors, relationships between consultants, and executives that prevent objectivity and objections by executives who benefit from the current programs.

With improved board scrutiny and timely redesign of compensation programs, the executive compensation controversy will end to all parties' satisfaction, with the exception of those poorly performing executives who were excessively paid under the old schemes. In absence of such action, there is the risk that the government will step in to curb the perceived excesses.