Bread Winners

Based on research by David De Angelis and Yavin Grinstein

• Executive pay tends to reflect specific firm characteristics and needs.
• But an important portion of an executive’s paycheck falls within the discretion of company boards.
• The basis of that discretionary pay is still a puzzle.

In the best of worlds, executive pay and performance should be in sync. That's not just the opinion of shareholders and boards: Former UK Prime Minister Theresa May has prioritized reforms to avoid out-of-control executive pay, and and economist Thomas Piketty has long blamed executive raises for widening income inequality.

So how should a company’s board decide if they pay their top brass too much? The question is of special interest to the Securities and Exchange Commission, which in December 2006 required more complete disclosure of the way firms tie executive pay to performance. The SEC was concerned that rules governing compensation packages had not kept pace with the marketplace, so mandated greater transparency about the guidelines used to determine CEO rewards, performance targets and the time frame during which performance is judged.

The new reporting requirements allowed Rice Business professor David De Angelis and Yaniv Grinstein of Cornell University to undertake a vast study of executive pay patterns. First they culled data on CEO compensation contracts from the proxy statements of more than 490 public U.S. firms in the S&P 500 index. Then they reviewed each statement's section on CEO compensation.

What they found reflected an array of priorities that directly affect the value of America’s most successful corporations.

Ninety percent of the firms in the study granted some type of performance-based award, payouts contingent on a company reaching a specific performance level. While the statements showed that the vast majority of the performance measures were accounting-based, some 13 percent were market-based, and 8 percent were based on non-financial measures such as diversity and customer satisfaction.

De Angelis and Grinstein analyzed CEO packages across economic sectors, finding large variations in the incentives for executives in different types of businesses. Energy-related companies, for instance, tied roughly 43 percent of their compensation to market measures. Firms in the durable and shops sectors, however, based only 7 percent and 5 percent of their compensation, respectively, on market measures.

That compensation indicators tend to be similar within given sectors of the economy suggests that executive compensation reflects firm characteristics. Managers in high-growth firms, for example, tend to focus on actions aimed at long-term growth. For these firms, stock-price performance measures and sales-growth performance measures are likely to be used. CEOs in larger, more complex enterprises tend to be judged to a greater extent on market performance.

There’s a certain complexity, to be sure, in executive compensation arrangements. Firms typically spread out their performance terms of compensation to include both accounting and market-based targets.

But overall, De Angelis and Grinstein’s findings indicate that the structure of performance-based awards doesn’t come out of the blue. Instead, it’s consistent with economic rationales.

Not all CEO compensation, though, is in the form of performance-based awards. Firms also grant discretionary awards, ones that can be paid in cash or equity. These discretionary awards, the researchers found, tended to show no significant link to past, present or future performance. Why is this? The result is somewhat puzzling, De Angelis and Grinstein say, and merits further research.

The general public, in other words, is not alone in wondering how executives’ total pay correlates to the value they bring their firms. While there are advances in understanding the design of performance-based awards, discretionary pay remains a puzzle. That even academic researchers can't yet explain it should only increase public questions about how these pay models work, as well as scholars' resolve to study them further.

David De Angelis is an assistant professor of finance at Jones Graduate School of Business at Rice University.

To learn more, please see: De Angelis, D. & Grinstein, Y. (2015). Performance terms in CEO compensation contracts. Review of Finance, 19(2), 619-651.