The Advisors' Blog

– Ira Kay and Steve Seelig, Watson Wyatt Worldwide

Sometimes the answer to a complicated question becomes clearer when different perspectives are considered. Such is the case in the debate about whether there has been pay-for-performance through the recent market meltdown. Recently, Paul Hodgson revealed the findings from a The Corporate Library study that found a weak link between CEO pay and firm performance in 2008, as evidenced by a decline in CEO total annual compensation of only 0.08% and a decrease in total realized compensation of 6.28% in 2008 for the more than 2,700 public companies surveyed, compared to a 37% decline in the S&P 500 index.

Our “2009/2010 Report on Executive Pay” reaches a far different conclusion – that CEO pay is still strongly aligned with company performance. We find that the pay-for-performance model underpinning U.S. executive compensation design still works as intended — in good years and bad:

– There is substantial downside risk for CEO wealth: the 967 CEOs in our study lost an aggregate $53 billion in 2008, compared to $3.2 trillion for company shareholders. In fact, we found that the percent decrease for the typical CEO is actually larger than that for shareholders (-42 percent for the CEO versus -34 percent for shareholders).

– CEO pay decreased significantly in 2008: when measured as realizable pay, three-year cumulative realizable LTI values decreased with shareholder returns — down to $1.4 million for 2006-2008 compared with $2.9 million for 2005-2007 and $3.3 million in 2004-2006.

– CEOs at higher performing earn more than their low-performing counterparts: the typical CEO at a high-performing company has a three-year aggregate realizable LTI value that is 150 percent larger than at a low TRS company ($2.3 million versus $0.9 million).

So, how is it two firms well-respected for the important research they do in the area of executive pay can come to such widely disparate conclusions?

One thing both firms have in common is that each goes beyond the Summary Compensation Numbers, which depict only the equity pay opportunity granted, in determining what executives actually earn in measuring pay. Unlike the The Corporate Library study that focuses on realized pay, we look at “realizable” pay as a far more accurate measure of the pay earned by executives. The difference between the two may appear subtle – but will vastly influence the results:

– Realized pay = the W-2 wages reported for the year, including restricted stock vested + performance shares and RSUs vested and paid + options exercised + deferred shares paid
– “Realizable” pay = restricted stock value earned or lost + performance share and RSU value earned or lost + option in-the-money value earned or lost + deferred share value earned or lost

Our concept avoids a focus on when equity is actually paid or monetized, which might often be a volitional act by the executive or the company that fails to consider the equity value earned or lost until the date that happens. We believe strongly that realizable pay is the number that executives think about when they consider the compensation they’ve earned or lost for a year. A proper understanding of how corporate executives think about their compensation drives far better decision making by the compensation committees and, perhaps more importantly, better illustrates the connection between pay and performance. We continue to urge the SEC to consider requiring companies to use it in their proxy disclosure.

Other key findings from our report include:

– Companies with an executive compensation architecture that creates a strong link between CEO wealth and risk had lower realizable total direct compensation (TDC) and superior total returns to shareholders (TRS) than companies with a weaker link to risk reduction.
– The value of broad-based employee option grants declined by 17 percent in 2008.
– Realized gains from employee stock option exercises declined by 55 percent last year — from an average $54 million per firm to $24 million.
– The estimated in-the-money value of options outstanding declined by approximately $100 billion for the firms in our sample in 2008.