CEO compensation: Do performance incentives pay off?

June 27, 2013

During the past two decades chief executive officers have seen their annual pay checks skyrocket, in many cases, to more than 500 times those of an average worker. With recent stock market gains many executives will likely earn more than $50 million this year in salaries, bonuses and stock options.

Stunned stockholders, who ultimately pay the huge salaries, are increasingly calling for measures to ensure executives earn their keep and boost company profits and share prices. They are tying those giant paychecks to performance measures and dangling stock options, restricted stock and other instruments as incentives to get CEOs to hit their marks. Such incentives become valuable only if certain benchmarks, such as increased share prices, are hit.

A recent Wall Street Journal study found that the 2012 pay plans of more than half the executives surveyed included performance, or incentive pay. That compared with 35 percent in a 2009 study three years earlier.

While the trend toward performance pay is increasing dramatically, experts disagree on whether it effectively produces better results for shareholders by aligning the interests of executives and shareholders.

Research from management professor Albert Cannella, Jr., is shedding new light on the performance-pay trend, which could lead to more effective use of the incentive compensation, more profitable companies and higher share prices.

Cannella, who returned to the W.P. Carey School of Business last year after a five-year stint at Tulane University in New Orleans, explained that performance pay plans are supposed to get executives to take more strategic risks in order to boost profits.

“If you want to increase profits and take a business to a higher level, the thinking is that you have to take calculated risks,” Cannella said.

The problem is most executives are basically risk-adverse. They are afraid of making a mistake and looking foolish or losing their jobs.

Means to what end?

Cannella explained that stock options provide an incentive for executives to break out of their comfort zones by making the risk of missing out on a performance bonus through inaction greater than the risk associated with taking the action.

“It’s all about risk and how you perceive it,” he said.

While compensation experts seem to agree that stock options are a motivator, some behavioral theory points out shortcomings in the risk-taking logic. Behavioral theory predicts that stock options do provide incentives for increased risk-taking, but only when those options aren’t “in the money” – the current share price is well above the option trigger price. Perversely, “in the money” options provide incentives for risk-averse decision making, because executives fear that risk-taking will turn out poorly and they will lose the value accrued in their options.

Through deeper research and an innovative approach to the study of performance pay structures, Cannella and colleague Cynthia E. Devers, a professor at Michigan State University’s Eli Broad School of Business, were able to provide important new insight into the relationship between performance pay, the risk posture of managers and ultimately shareholder returns.

“People tend to take a simplistic view of risk and what motivates it,” Cannella said. “Actually it can be very dynamic and complex.”

“Top Management Team Incentive Heterogeneity, Strategic Investment Behavior, and Performance: A Social Psychological Theory of Incentive Alignment,” the research paper co-authored by Cannella, Devers, and Michael Holmes and Tim Holcomb – both at Florida State University, has broad implications for the practice of paying for performance and could lead to the development of compensation plans that achieve superior results for shareholders.

Cannella had worked on research projects with Devers before and jumped at the opportunity to collaborate again when she suggested the project.

“We have a great relationship and it sounded like an interesting idea,” he said noting the topic offered an opportunity to contribute something new to an important area of study.

Approach to risk

The research found that while performance pay encouraged executives to take more risks, the risks they actually selected (making large acquisitions) often did not produce the desired results for shareholders. But when the pay plans of top management teams (TMTs) were varied with different terms, incentives etc. across TMT members, the acquisitions they made were tempered and results for shareholders improved.

The theory they developed was that variance in pay plans across members of TMTs creates different perceptions of risk among team members which leads to a more robust investigation, or vetting, of acquisition prospects and as a result, more profitable transactions.

Cannella explained that executives separate their own personal risk from that accruing to the organization and stockholders and perceive both differently. The perception of risk is also relative to the executive’s situation.

“An executive’s approach to personal and organizational risk depends on where they stand,” Cannella said. “If everybody has options in the money, the team is going to be less inclined to take risks than if nobody has options in the money. And, if some have in the money options and some don’t, there will be more debate and discussion because of the divergent perspectives on risk-taking within the team.”

The research involved an exhaustive study of the companies that comprised the Standard & Poor’s 500 index from 1997 to 2002. The S&P 500 companies were selected because they include a diverse group U.S. industrial firms for which detailed financial information was readily available.

The research team scoured Thomson Financial’s Securities Data Company Platinum Mergers and Acquisitions database and came up with almost 3,000 mergers completed by the S&P 500 companies during the six-year period.

Next they studied the pay packages of the companies’ top management teams, consisting of the CEO and next four highest paid officers. Proxy statements typically give detailed compensation information about the five highest-paid executives.

The authors gleaned information about the pay structures of the top management teams from Standard & Poor’s ExecuComp database, proxy statements and other sources, to rank the firms according to the level of performance pay included in their compensation plans.

The group then looked at the structure of the executive pay packages at the companies to determine which ones had high levels of dispersion, or disparity in incentives across TMT members.

Cannella noted that much of the disparity in incentives across TMT members is unintentional, arising as a result of normal turnover among team members. “Longer-serving members of the TMT are much more likely to have ‘in the money’ options than newer members, for example” he said.

The group used shareholder return, a measure of the price of a company’s stock plus dividends over a period of time to determine how well the companies performed for stockholders over a six-year period.

Finally, they looked at how performance-based pay and the structure of the pay plans of the top management team members influenced the executives’ actions with respect to the acquisitions. And they assessed the impact the acquisitions had on the company’s profits and share price.

Structure matters

The research came to four significant conclusions.

  1. Performance pay plans that include stock options and other incentives can induce executives to take more strategic risks, such as acquiring other companies.
  2. While such acquisitions often were beneficial for CEOs, they often didn’t always similarly enrich shareholders.
  3. Teams with different, or disperse, performance pay structures among members made fewer acquisitions than those with more homogenous plans.
  4. Acquisitions made by teams with disperse pay structures turned out better for stockholders than those made by teams with less diversity in pay plans.
  5. The final finding was perhaps the most significant, according to Cannella; it showed that by structuring pay plans differently for executives comprising top management teams, shareholders could overcome at least some of the negative implications of performance pay to achieve better results.

“Hopefully it gets people in corporate governance to think more deeply about the structure of management compensation plans,” he said.

Cannella, who was a farmer before joining the ranks of academia, has now moved on to other research projects. He is studying how global companies compete with one another and how the language used by CEO’s in analyst interviews and earnings conference calls can be interpreted by competitors to make strategic business decisions.

The Bottom Line

  • CEO pay has skyrocketed over the past years to more than 500 times that of average workers.
  • Companies are increasingly tying soaring executive salaries to performance measures – ostensibly to ensure they get what they pay for.
  • Studies on the effectiveness of performance-based pay have been inconclusive.
  • The above research found that performance pay plans encouraged top management teams to take more risks by engaging in acquisitions.
  • While enriching the executives, acquisition generally do not achieve the expected returns for shareholders.
  • Teams with more disparate pay plans made fewer acquisitions.
  • Acquisitions made by teams with more homogenous pay plans were less successful than those made by teams with more heterogeneous compensation structures.