Can CEO Pay Be Measured?

Anything can be measured. The question is whether it can be measured well. As for CEO pay, it seems it can’t be measured well, or at least in a way experts agree upon. There is nearly as much disagreement among compensation experts about how to measure CEO pay as about whether CEOs are paid too much.

 

You may have read that the Dodd-Frank Act of 2010 included “say on pay” rules, whereby shareholders have a vote on executive compensation. But what pay? There is often a big difference between expected pay (bonus targets and value of options at the time granted) and realized pay (bonuses actually received and realized value of options).

Eli Lilly announced the pay of its CEO John Lechleiter as $15.9 million, up 10% from the year before. However, independent experts calculated his pay as $20.9 million, a 45% increase over the prior year. Occidental Petroleum CEO Ray Irani’s expected pay was $58.3 million. His realized pay was $222.6 million.

 

Says one expert, even if the pay for two CEOs is reported to be the same, “you can pretty much bet they are not the same.”

 

Why is it so difficult to get an accurate read on CEO pay? A big part of the answer is that, for some time, a CEO’s pay has been tied to the company’s financial performance, and an organization’s finances are quite complex. CEO pay might be based on any number of important financial indicators: stock appreciation, profitability, market share, earnings per share, and equity per share. Many CEOs are granted stocks at a current price, providing an incentive to make the stock price grow. The main principal at play here is to align the CEO’s interests with the company’s interests, so the CEO’s motivation is in line with the company’s best interests.

 

Another complicating factor is time: The value of CEO incentives often depends on measures, like stock price, that are time-sensitive. The worth of a stock option thus depends on when that option is exercised. Timing is everything. When Apple granted CEO Steve Jobs 7.5 million stock options, someone falsified records so the stock was priced low, as if at an earlier time than when the options were actually granted. This “backdating” allowed Jobs to sell his options at a greater profit when he cashed them in.

Because this type of compensation is complicated, so are the motivational dynamics involved. CEOs have an incentive to “manage to the metric”—such as by making decisions that maximize short-term stock price (and thus increase the value of stock options) at the expense of the long-term interests of the company. Not all CEOs do this, of course, but the incentive is often there.

 

As one expert concluded, “Assessing CEO compensation is a bit of a black art.”

 

Source: S.Thurm, “For CEO Pay, a Single Number Never Tells the Whole Story,” Wall Street Journal (March 6, 2010), p. A2; B. McClure, “A Guide To CEO Compensation,” San Francisco Chronicle (May 2, 2011), downloaded May 25, 2011 from http://www.investopedia.com/; R. Gopalan, T. Milbourn, F. Song, and A. V. Thakor, “The Optimal Duration of Executive Compensation: Theory and Evidence,” Working paper, April 15, 2011, Washington University in St. Louis

Photo by Fabio Aro