Many CEO compensation packages include fixed dollar values of total stock and option awards. Freezing the dollar value of these stock packages perversely guarantees more shares for the CEO when stock prices fall – and vice versa. What exactly is this pay-for-performance?
I bet you have never heard of the term “competitive compensation policy”. The competitive compensation method sets a target amount of total compensation—salary, bonus, and stock award—within a specified range of the amount paid to an executive’s peers, typically in the same industry sector and at companies of similar size. It turns out that most American companies implicitly or explicitly follow such a competitive salary policy to compensate their CEOs. I understand if this sounds innocuous, or perhaps too wonky, to read on. But please stay with me. The implications of this policy are bizarre, creating perverse incentives that guarantee massive payouts.
Competitive remuneration policy explained
Here’s how the competitive compensation policy works in practice. A compensation consultant comes in and assesses that, to be “competitive” with the job market for CEOs, the going rate for a CEO for a company of a particular size (say $60 billion in revenue) is 20 million dollars per year. About 40% of this salary is usually paid in the form of salary, bonuses and benefits. The larger chunk, 60%, is usually paid as capital, and this capital can be provided in two ways: a total number of stock units or stock options with a strike price which is usually fixed at the stock price on the date of the grant. You might ask, “so what?”
Well, let’s say we pay this CEO about $12 million (60% of the $20 million compensation) in stock every year over three years. As long as the company’s stock price is reasonably stable over those three years, the CEO gets more or less the same number of shares or options in the company. Therefore, a policy of effectively anchoring CEO compensation to a “fixed value” of equity will not differ materially from a policy of distributing a “fixed number” of shares.
Distortions occur when the company’s stock price has risen or fallen over the three-year period. If a company’s stock price drops for some reason, “fixed value” stock awards, defined by the idea of a competitive compensation policy, would reward that CEO with increasing amounts of money. shares or options in such a company. Why exactly are we rewarding weak stock price growth with more stocks? The opposite chilling effect occurs with rising stock prices, as we would reward stock price growth with fewer options or restricted stock. Hence my assertion that a competitive pay policy is the opposite of performance pay.
Chevron as a case study
Consider Chevron as a concrete example of this distortion. I realize that the oil companies will likely make the problem I mention worse because we would potentially be rewarding a CEO for oil price increases that are largely beyond the oil CEO’s control. This is precisely why this case study illustrates the strange thinking behind the competitive compensation policy.
Over the three calendar years, 2019, 2020 and 2021, MK Wirth, CEO and Chairman of Chevron, received equity awards of $11.6 million, $11.2 million and $12.2 million respectively (from Proxy Statement 2022). The gap between the highest reward ($12.2 million) and the lowest in this sample ($12.2 million) is barely a million. Similarly, consider the dollar value of stock options granted: $3.75 million in 2019 and $3.875 million in 2020 and 2021. The change in the dollar amount of option awards is even greater. lower than that of stock grants. In contrast, Chevron’s stock prices have fluctuated significantly between 2019 and 2021.
Restricting our attention to the option component of equity only, the exercise price of options granted by Chevron’s board of directors to its CEO during this period (usually the stock price on the last business day of January of the year) was $113 in 2019, $110 in 2020 and $88 in 2021. These exercise prices reflect share prices at the date of grant. Note that the strike price of $113 in 2019 is 28% higher than the strike price of $88 in 2021.
As expected, the CEO got more options in 2021 than in 2019. To be exact, the CEO got 236,900 options in 2019, 298,100 options in 2020 and 317,000 options in 2021 according to the Chevron’s 2022, 2021 and 2020 proxy statements. Thus, the number of options granted in 2021 is 34% higher than the number granted in 2019. In essence, the change in the number of stock options granted (+34%) is almost similar but opposite to the change in the Chevron stock (and strike price) (-28%). That is, the “competitive compensation policy” offers more options, the lower the stock/strike price!
Chevron was trading at $163 on October 19, 2022, the day I wrote this article. Therefore, the unrealized gain on the 2021 CEO Grant, as of 10/19/22, is $23.7 million. [($(163-$88)*317,000 options]. The unrealized gain on the 2020 grant is $15.8 million [$(163-110)*298,100 options] and $11.8 million from the 2019 grant [$(163-113)*236,900 options], totaling $51.3 million across the three grants. If Chevron had instead followed a “fixed number” option policy and had, for example, granted 236,900 options each year, the cumulative gains would have been only $35.5 million.
Does the Chevron case generalize?
You might ask yourself, “OK, that’s a nice story. To what extent is this competitive compensation policy generalizable beyond Chevron? ” It’s here that the research paper that I wrote with my co-authors (Steve O’Byrne, Mascia Ferrari and Francesco Reggiani) comes into play. We show that a large majority of American companies follow this so-called “competitive remuneration policy”. We also demonstrate, via detailed data simulations, that a competitive salary policy philosophy penalizes CEO wealth sensitivity to stock price performance.
Shouldn’t the board fix that?
You might ask, “What does the board do? Shouldn’t he understand and correct this distortion? It turns out that equity compensation for directors seems to adhere even more strongly to the philosophy of competitive salary policies than equity compensation for the CEO. Therefore, admins seem to either ignore this problem or not want to fix it. I bring this up in every class I’ve taught boards and administrators. I can say with certainty that less than 10% of our participants were aware of the incentive distortions caused by the competitive compensation policy.
Shouldn’t the proxy adviser recognize the distortion?
What about proxy advisors? They study pay-for-living policies. Shouldn’t they be aware of these issues? I can’t say for sure, but the data suggests that counterintuitive competitive compensation plans reduce, not increase, the likelihood of a negative vote recommendation by Institutional Support Services (ISS), the most prominent proxy advisor, despite evidence that such a policy weakens the link between CEO wealth and performance.
In summary, I believe that the distorting effects of such a competitive compensation policy are neither well known nor widely discussed. I hope investors, especially large ETF providers and public pension funds, will take a hard look at this policy and ask tougher questions of proxy advisors and management.