A recent article in the Harvard Business Review, “Decoding CEO Pay,” by Robert C. Pozen and S.P. Kothari, calls into question whether the current practices of executive compensation at US companies are in fact producing results that align CEO compensation with investor interests.

In recent years, investors in the United States have been engaging more with companies on the topic of executive compensation. The reason is related in part to the say on pay vote, which allows investors to express their views on executive pay through a nonbinding vote on a public company’s compensation report.

Best practices around pay disclosure have also developed. These treat the Compensation Discussion and Analysis (CD&A) portion of a company’s proxy statement as a communications document meant to inform shareholders and not as a compliance documents meant to satisfy regulators. Many of these best practices are reflected in the CD&A template published by CFA Institute.

More Improvements Needed

Although there have been improvements in transparency and clarity around CEO pay, Pozen and Kothari believe not enough has been done. They conclude that board compensation committees need to do a better job of explaining the basis of their decisions to investors, and that investors need to develop standards and best practices for compensation design and reporting.

The authors of the article are particularly critical of the propensity of compensation committees to use non-GAAP (generally accepted accounting principles) earnings per share to determine CEO incentive pay. Often the difference between GAAP and non-GAAP earnings per share is large. For example, the non-GAAP earnings of 36 of the S&P 500 Index companies were more than twice their GAAP income.

As Pozen and Kothari show, the non-GAAP earnings of many tech companies exclude the GAAP expenses for grants of restricted shares and stock options. They argue that it is inappropriate for compensation committees to use such non-GAAP numbers in setting compensation for top executives because these numbers exclude expenses for shares and options granted to these same executives.

Pozen and Kothari are also very critical of the composition of the peer groups used by compensation committees to compare the total shareholder returns of their company with those of other companies. Too often, the peer groups used to benchmark performance include companies with much larger revenues and market capitalizations. These larger companies are selected to boost compensation because larger companies tend to have higher executive pay.

So, What Is the Solution?

The authors argue that most institutional investors do not have the resources to adequately evaluate the complex compensation arrangements of the thousands of public companies in the market. In their view, an association with the sole mandate of evaluating compensation packages could better handle the growing complexity of today’s compensation plans than proxy advisers.

The authors recommend that, through such an association, investors ask compensation committees to comply with the following guidelines or explain any deviations:

• Committees should generally use GAAP measures of financial performance in determining both long-term and short-term compensation.
• Departures from GAAP may be permitted to exclude the consequences of events beyond the control of management, provided the exclusion applies to both positive and negative changes.
• Committees may also exclude GAAP expenses for onetime events, such as restructuring charges, provided such charges do not recur each year.
• Committees should not exclude expenses for stock-related awards to executives.
• All exclusions of GAAP expenses should be justified and quantified in the compensation committees report.

Would such an association work? Would investors pay for it? If dissatisfaction with the alignment of pay and performance continues, I would expect the answer to both questions to be yes.

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