Businessman holding dollars/putting dollars in a pocket, closeup shot
Many CEO pay packages include fixed dollar values of total stock and option grants. Freezing the dollar value of these stock packages perversely ensures a greater number of shares to the CEO when stock prices fall – and vice versa. How exactly is this pay for performance?
I bet you have never heard of the term, “competitive pay policy.” The competitive pay method sets a target amount of total compensation – salary, bonus, and grants of stock – within a specified range of the amount paid to an executive’s peers, typically in the same industry sector and at companies of a similar size. It turns out that most U.S. companies implicitly or explicitly follow such a competitive pay policy to compensate their CEOs. I understand if this sounds innocuous, or perhaps too wonky, to carry on reading. But please stay with me. The implications of this policy are bizarre, creating perverse incentives that ensure massive payouts.
Competitive pay policy explained
Here is how competitive pay policy works in practice. A compensation consultant comes in and assesses that, to be “competitive” with the labor market for CEOs, the going rate for a CEO for a company of a particular size (say $60 billion in revenues) is $20 million a year. Roughly 40% of that pay is usually given out in terms of salary, bonus, and benefits. The bigger chunk, 60% is usually paid as some form of equity, and that equity can be provided in two ways: a total number of stock units, or stock options with an exercise price that is usually set at the stock price on the date of the grant. You might ask, “so what?”
Well, let’s say we pay this CEO roughly $12 million (60% of $20 million pay) in equity stock every year over three years. As long as the price of the company’s stock is reasonably flat over those three years, the CEO gets more or less the same number of shares or options in the business. Hence, a policy of effectively anchoring CEO pay on a “fixed value” of equity will not materially differ from a policy of giving out a “fixed number” of shares.
Distortions kick in when the stock price of the company has been going up or doing down over the three-year period. If the stock price of a business has been falling for whatever reason, “fixed value” equity grants, set using the so-called competitive pay policy idea, would reward this CEO with more and more shares or options in such a company. Why exactly are we rewarding poor stock price growth with greater numbers of shares? The opposite disincentive kicks in with rising share prices as we would reward share price growth with fewer options or restricted shares. Hence, my claim that competitive pay policy is the opposite of pay for performance.
Chevron as a case study
Consider Chevron as a real-world example of this distortion. I realize oil companies will likely compound the problem I mention because we would potentially reward a CEO for increases in oil prices which are by and large outside the control of the oil CEO. That is precisely why this case study illustrates the strange thinking behind the competitive pay policy.
Over the three calendar years, 2019, 2020 and 2021, M.K. Wirth, the CEO and Chairman of Chevron, was given equity awards of $11.6 million, $11.2 million and $12.2 million respectively (from the 2022 proxy statement). The variation 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 given: $3.75 million in 2019 and $3.875 million in 2020 and 2021. The variation in the dollar amount of option awards is even smaller than that for stock awards. In contrast, Chevron’s stock prices have varied considerably between 2019 and 2021.
Restricting our attention to just the option component of equity, the strike price of options granted by Chevron’s board to its CEO during this period (usually the stock price of the last working day in January of the year) was $113 in 2019, $110 in 2020 and $88 in 2021. These strike prices, reflect grant date stock prices. Note that 2019’s strike price of $113 is 28% more than 2021’s strike price of $88.
Predictably 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 as per Chevron’s 2022, 2021 and 2020 proxy statements. Thus, the number of options given in 2021 is 34% more than the number given in 2019. In essence, the variation in the number of stock options given (+34%) is almost similar but opposite to the variation in Chevron’s stock (and strike) prices (-28%). That is, the “competitive pay policy” gives out more options, the lower the stock/strike price!
Chevron was trading at $163 on October 19, 2022, the day I wrote this piece. Hence, the unrealized gains on the CEO’s 2021 grant, as of 10/19/22, are $23.7 million [($(163-$88)*317,000 options]. Unrealized gains on the 2020 grant are $15.8 million [$(163-110)*298,100 options] and $11.8 million on the 2019 grant [$(163-113)*236,900 options], cumulating to $51.3 million over the three grants. Had Chevron followed a “fixed number” of options policy instead and had say given out 236,900 options every year, the cumulative gains would have only been $35.5 million.
Does the Chevron case generalize?
You might wonder, “OK, this is a cute story. How generalizable is this competitive pay policy beyond Chevron?” This is where the research paper that I wrote with my co-authors (Steve O’ Byrne, Mascia Ferrari, and Francesco Reggiani) comes in. We show that a vast majority of U.S. companies follow this so-called “competitive pay policy.” We also demonstrate, via detailed data simulations, that a competitive pay policy philosophy penalizes the sensitivity of CEO wealth to stock price performance.
Shouldn’t the board correct this?
You could ask: “What’s the board doing? Should it not understand and fix this distortion?” It turns out that directors’ equity compensation appears to adhere even more strongly with the philosophy of competitive pay policies relative to CEO’s equity compensation. Hence, directors appear to be unaware of this problem or unwilling to fix it. I raise this in every class I have taught to boards and directors. I can safely say that less than 10% of our participants were aware of the incentive distortions caused by the competitive pay policy.
Shouldn’t the proxy advisor recognize the distortion?
What about proxy advisors? They study compensation policies for a living. Shouldn’t they be aware of these problems? I cannot tell for sure but the data suggests that competitive pay schemes counter-intuitively reduce, not increase, the odds 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 sum, I believe the distortionary effects of such a competitive pay policy are neither well known nor discussed widely. I hope investors, especially the large ETF providers and state pension funds, review this policy carefully and ask tougher questions of proxy advisory firms and management.
