6 May 2016

Determining CEO remuneration

CEO remuneration is a controversial subject, prompting considerable debate over whether CEOs are paid appropriately. In recent years, this debate has become more widespread and contentious. This should serve as a warning to directors: a board might believe it has the right pay structure in place, but it needs to communicate this in a way that resonates with not only investors, but the general public as well

Caption: The challenge of justifying executive pay policies

Recent research that we conducted at Stanford Graduate School of Business demonstrates a significant gap on CEO pay between the perceptions of the general public and corporate directors. While 65% of directors believe that CEO remuneration is not a problem, a full 70% of the American public believes that it is; 62% of the public believes that CEO pay should be capped relative to that of the average worker, and 49% favour government intervention to change pay practices. By contrast, 84% of directors believe that there should be no pay limits, and 98% oppose government intervention.

Twenty years ago, median CEO remuneration among the largest US companies was about $4m per year; today it is over $10m — up 150%. But wages of the average worker have grown only 58% over this period. The growing gap in these levels has prompted a broader debate on social issues including income inequality and fairness.

While US and UK corporate board members answer primarily to their shareholders, they should not ignore societal pressures caused by their compensation decisions. The most straightforward solution is to re-evaluate and justify CEO remuneration arrangements in terms of value creation and value sharing. Simply stated: is the board satisfied with the value shareholders are receiving for the price they are paying for the CEO? This type of thinking is not often explicit in the boardroom, even though it commonly happens at the non-executive level.

For example, a decision to hire a new employee — customer service representative, sales person, finance officer, or engineer — is based on an assessment of whether additional headcount creates sufficient value at a given price point. At the CEO level, this type of analysis is harder to do, and can be done in three steps:

1. How much value does the board expect the company to create over a given period?

2. How much does the executive team and CEO personally contribute to value creation?

3. How much of this contribution should be shared with the CEO as remuneration?

While answers to these questions are not straightforward, they are crucial for determining whether CEO remuneration is “fair”. For boards, it means a move away from straight benchmarking of pay against peer institutions and toward a rigorous deep dive into value creation and value sharing.

Finally, communication is essential, not only with shareholders but with the public broadly. Critics of executive compensation have come to the conclusion that pay is not justified based on their instinctive calculations. Boards need to do a much better job explaining why pay is reasonable.

This requires sharing hard numbers, assumptions made, and pay philosophy. This type of dialogue will provide a structure and substance to the ongoing debate on executive compensation. It might also reveal common ground between boards and the public. We’ve found surprising agreement about how much corporate value creation should be “shared”. Given a hypothetical situation where a company increases in value by $100m in a given year, both directors and the public give an average answer of approximately $3m, or 3%.

If boards cannot clearly and convincingly communicate their ideas and process, government representatives — urged on by their constituents — will likely step in to “solve the problem.” We have seen this occur in recent years in both the UK and US, including requirements for a shareholder “say on pay”, restrictions to the bonus structure of banking and finance executives, and mandatory disclosure of CEO-to-worker pay ratios. It is much better for companies to be proactive in structuring the debate around hard numbers and careful explanations, leading to a market-based solution, than one that is imposed on them by politicians.

David F Larcker, professor at the Stanford Graduate School of Business, wrote this article in association with Nicholas Donatiello and Brian Tayan

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