The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Thanks to Eleanor Bloxham and her “Corporate Governance Alliance Digest” for this blog by Tama Copeman, Chair of the Board of Mid Atlantic Diamond Ventures (tama@alcyone7.com):

Rising CEO compensation frustrates many board members and for good reason: setting CEO pay-above-the-50th percentile broadly leads to unbounded growth in pay. (Similar results will occur if a large portion of companies set aggressive increase targets each year.) Although advisory say-on-pay votes now available to shareholders provide a check, the votes provide a weak check on rising pay.

System dynamics is a methodology for understanding the behavior of complex systems which can be applied to understanding the dynamics of executive compensation. Originally developed by Forrester at MIT Sloan in the 1950s to provide insight into corporate and managerial problems, system dynamics is currently being used by the public and private sectors for policy design, environmental change, economic behavior, project management and supply chain analysis.

The basis of the method is the recognition of feedback, interlocking, and time-delayed relationships among components of a system. A system’s feedback structure drives the dynamics of the system. So-called causal loop diagrams provide a visual representation of the feedback loops in a system and enable the creation of mental models for qualitative analysis.

In a system dynamic of growth, loops with all positive links are self-reinforcing and produce unbounded growth. Balancing loops provide self-correction in the system. They are created when there are an odd number of negative links and are self correcting. John D. Sterman (“Business Dynamics – Systems Thinking and Modeling for a Complex World”, McGraw Hill, 2000) provides many examples of applications of causal loop diagrams.

As a CEO’s compensation is set above the 50th percentile within the peer group, the average of the peer group rises correspondingly. The causal loop model in Figure 1 illustrates self-reinforcing compensation behavior. If the majority of boards employ above 50th percentile pay positioning, the peer-group compensation increases with the rate of growth dependent on the fraction of companies using this strategy. If the majority of boards employ below 50th percentile pay positioning, the peer-group compensation decreases. The latter case is, naturally, less likely. Conversely, as CEO pay increases, say-on-pay concern also increases with a corresponding push to reduce pay. The causal loop model illustrates self-correcting say-on-pay behavior. Within a corporation, the internal “say on pay” is far stronger than the advisory shareholder vote, as senior management, human resources and budgetary factors weigh in.

Figure 1. Causal Loop Model applied to CEO compensation

The above cycles occur on a one-year basis; however other balancing factors can enter throughout the cycle. The Wall Street Journal (June 30, 2011) reported: “Companies may not have to abide by shareholder advisory say-on-pay votes mandated under the Dodd-Frank Act, but lawyers specialized in securities class action suits have already brought a half dozen suits against directors and executives for ignoring their results. A number of firms have tried to settle the claims quickly.”

Peer benchmarking has been a powerful tool in compensation. System dynamics provides a simple perspective to understand the dynamics at work. Unless there are changes to the current systems-dynamics for CEO pay, CEO compensation will continue to spiral upward.