I propose a simpler alternative. Check the buy and hold return of an average Joe shareholder who bought stock on the grant date of CEO’s stock/option grant and sells such equity on the vesting date. Compare that return with reasonable benchmarks such as the S&P 500 or the firm’s cost of equity capital. If the average Joe loses money with reference to these benchmarks, does the CEO deserve to be paid “performance based” compensation?
CEO pay for performance?
The SEC just issued a set of final rules in its continuing effort to bring greater transparency to “pay for performance” for CEOs. In its latest instalment, the SEC requires companies to publish, among other things, fair value changes during the year for previously issued equity awards. This is a good first step but does not really get to the heart of the debate.
On top of that, there is whole scale confusion about how to think of pay for performance in the existing academic literature. Researchers run regressions of annual pay on either contemporaneous or lagged stock returns and/or earnings and assume that higher explanatory power (R-squared in the jargon) suggests more pay for performance. Some of this thinking is also reflected in the SEC’s rule.
Here is what I would have proposed instead, if I were the SEC. If CEO pay actually reflects shareholder performance, the CEO needs to internalize the pain felt by the shareholder. Hence, I would run the following thought experiment. Assume an average Joe shareholder bought say IBM’s stock on the same day as the day on which the CEO was granted stock/options by the compensation committee. Further, assume that the average Joe shareholder sells IBM’s stock on the day the option/stock vests as a part of the CEO’s package. Compute the return, inclusive of dividends paid during this period, that the average Joe earned.
Compare the return that average Joe earned with some reasonable benchmark: (i) a reasonable estimate of cost of equity capital; or (ii) how the overall market index such as S&P 500 or the sector index that the firm is closely affiliated with. If the average Joe did not earn a reasonable return relative to some agreed upon benchmark, then institutional investors need to ask if the CEO deserved a vesting of the option/equity grant.
Let me explain using the concrete example of IBM. The 2022 IBM proxy statement states on page 54 that Arvind Krishna, CEO of IBM, vested 151,030 shares valued at $20.2 million. I could trace exact grant dates, nature of the grant (RSUs or restricted stock units or PSUs or performance stock units or RRSU or retention restricted stock units or RPSU or retention performance share units) for 145,312 of these shares valued at $18.6 million. Tracing these details takes a fair amount of detective work as I had to compare the unvested shares as reported in the 2022 IBM proxy (covering year ended 12/31/21) with that of the 2021 IBM proxy (covering year ended 12/31/20). Consider the following table that summarizes the work.
IBM: Pay for Performance?
To understand the calculations, let us consider the first RSU grant in the table given out on 6/8/2017. It was not immediately obvious to me when that RSU grant actually vested in the calendar year 2021. So, I have assumed all vesting dates in 2021 are set to 12/31/21.
If our average Joe had bought IBM stock on 6/8/2017 and had sold that stock on 12/31/21, he would have made 13.7%, inclusive of dividends. Had average Joe instead invested the same money in the S&P 500 index, he would have made 95.83%. Instead, had he placed these funds in the S&P IT index, he would earned a whopping 210.29%. If you assume a modest 7% cost of equity capital for IBM, the stock must have returned at least 24.5% over the three and half period under consideration for the 6/8/2017 grant. Despite such massive underperformance, IBM’s CEO vested that grant of 2,250 shares valued at $301,500 and pretty much all of $18.6 million package.
That is because the exact same intuition is repeated in grant after grant, as seen from column (6) which computes buy and hold dividend adjusted return for many more average Joe experiments for every grant that vested in 2021. Column (6) shows the yawning gap between what average Joe made relative to the alternatives such as the S&P 500 and the S&P IT index. It is hopefully clear that the entire package of $18.6 million I looked at is far from pay from performance.
The private equity folks that I have spoken to love my methodology. Directors and CEOs of public companies, as expected, are not fans of this metric. They often say things like, “oh, we need to pay the guy, otherwise he will simply quit.” That’s fine. Call the $18.5 million payment a retention bonus and avoid referring to pay for performance in the proxy statement.
Why is my method better than the one the SEC proposes? The SEC’s table only considers the fair value change of the stock or option awards for the year. Most option and stock awards vest between two and five years. Unless the buy and hold return of that entire vesting period, spanning the grant date to the actual vesting date, is considered and laid out in the manner I outline, it is hard to perform the average Joe calculations I propose.
The open question, of course, is whether institutional investors, or at least state pension funds, will press management harder on CEO compensation based on my average Joe calculations. We may then really move to a world where pay tracks performance in corporate America.
