REVIEW ON HOW COMPENSATION COMMITTEES MAKE THINGS WORSE
Why Executive Pay Is Failing
by Stephen F.
O’Byrne and S. David Young
Most compensation packages do a poor job of linking pay to
performance. Our research of pay packages at 702 publicly traded U.S.
companies between 1995 and 2004 reveals that on average a 1% increase in
company value generated a 0.43% increase in the estimated wealth of senior
executives. That might not seem unreasonable, but there were huge variations
across the sample, with executive wealth at some firms being highly sensitive
to company value, while at others there was no sensitivity at all. More
significant, nearly all of the incentives came from current stock and option
holdings. (See the chart “Sensitivity of Executive Wealth.”) The present
value of future compensation, which constitutes 75% of executive wealth,
shows very little sensitivity to company value.
So what did the incentive programs at these companies reward? We found that
in nearly two-fifths of our sample firms, incentives for sales growth
exceeded those for shareholder wealth, resulting in the obvious risk that
managers at those companies pursued growth to the detriment of shareholder
Most of the blame for this sorry state of affairs, we believe, rests with the
companies’ reliance on competitive pay policies. When the primary focus of
compensation is to ensure that managers are paid more or less in line with
their peers at other companies, then pay becomes decoupled from performance.
If the share price drops, the number of option grant shares issued will be
increased to ensure expected pay is maintained at competitive levels.
Similarly, if the share price increases, fewer shares will be granted. In
effect, the number of shares awarded (and potentially other elements of
incentive pay) rises or falls inversely with the company’s share price. The
strong sales growth incentive arises because pay levels are closely tied to
company size—the larger the company’s revenues, the larger the average pay
The justification for maintaining pay competitiveness is that it reduces the
risk of losing good managers, who could be costly to replace. Corporate
boards could also argue that it minimizes the risk of seriously overpaying
managers as a consequence of large, windfall gains from surging share prices.
In short, the claim is that competitive pay policies not only help lower
retention risk but also impose limits on shareholder cost. This is false
logic. By causing companies to overpay underperforming managers and underpay
star performers, a competitive pay policy will actually increase retention
risk. The poor performers stay on and the good ones go. What’s more, it
ignores the potential wealth-creating effects of strong financial incentives.
Despite their commitment to competitive pay policies, compensation committees
sometimes do act to strengthen incentives by increasing option grant shares
after a year of strong stock-price performance or decreasing them after a bad
year. On the surface, this appears to be good news. But such moves have
little overall impact because directors tend to reverse their actions in the
following year. In other words, an option grant that rewards good performance
or penalizes poor performance is followed, almost half the time, by a grant
that penalizes good performance or rewards poor performance. On balance,
therefore, ad hoc adjustments by boards contribute almost nothing to wealth
If companies are serious about rewarding performance and retaining star
performers, they will first have to wean themselves off competitive pay. They
should give managers fixed-share interests in stock appreciation and economic
profit improvement, thereby increasing the impact of future pay on executive
wealth. Perhaps most important, they need to review vesting and holding
requirements to prevent managers from unilaterally cashing out share-based
pay, which also reduces the sensitivity of their wealth to company value.