The Advisors' Blog

– Broc Romanek

In this presentation, Stephen O’Byrne makes an effort to explain the weaknesses of current pay practices in a way that directors can understand. Here’s a summary:

1. Summarizes the three basic objectives of executive compensation: strong incentives to increase shareholder value, retain key talent & limit shareholder cost.

2. Re-caps the evolution of executive pay design from value sharing plans in the first half of the 20th century to competitive pay concepts in more recent times. Value sharing plans make it hard to retain key talent, while competitive pay concepts make it hard to create strong incentives.

3. Shows that competitive pay concepts (e.g., targeting 50th percentile pay) create systematic performance penalties that undermine the alignment, or correlation, of cumulative pay & cumulative performance. Poor performance leads to more shares, superior performance to fewer shares. Since incentive strength is alignment x relative pay risk, low alignment undermines incentive strength. Gives a simple example showing a 139% pay difference for the same cumulative performance due to differences in the number of grant shares needed to provide competitive pay each year.

4. Shows that there is a compact and highly informative analysis that measures a company’s success in achieving the 3 basic objectives. The analysis plots relative pay against relative performance to measure incentive strength, retention risk and shareholder cost. The analysis can be used for management, directors, asset managers and the average employee.

5. Uses this analysis to show that the alignment of relative pay and relative performance is very weak measured across companies and quite weak measured within companies. This is true for CEO pay and director pay. Alignment (r-sq) across companies for the last ten years is 11% for CEOs and 14% for directors. Alignment (r-sq) within companies for the last ten years is < 50% in 60%+ of S&P 1500 companies for both CEOs and directors.

6. Shows that companies and proxy advisors don’t have meaningful measures of the 3 basic objectives. Percent of pay at risk – as well as the ISS measures – do not a provide a meaningful measure of incentive strength.

7. Shows that better measurement of the 3 basic objectives is important because it leads to better pay design:

– There are three “perfect” pay plans that achieve the 3 basic objectives: the perfect investment manager fee contract developed by Don Raymond of Canada Pension Plan, the “Dynamic CEO Compensation” plan developed by finance professors Alex Edmans and Xavier Gabaix and the perfect performance share plan developed by O’Byrne.

– All three take account of competitive pay but find a way to avoid the performance penalty and mis-alignment created by translating target dollar pay into shares. These plans solve the retention vs incentive problem companies have been struggling with for 100+ years.

– Gives a simple example of the Edmans-Gabaix plan showing that a 50% decline in stock price requires a 30% reduction in the PV of future salary (with the savings going to purchase additional stock).

8. Argues that companies should:

– Test their pay designs using the relative pay vs relative performance analysis,

– Benchmark pay alignment and performance adjusted cost, not just gross pay levels, for management, directors and the average employee and use long horizons, e.g., ten years, to measure alignment, and

– Consider benchmarking and pay design using an operating measure of relative performance.

9. Argues that investors and proxy advisors should use the relative pay vs relative performance analysis to measure the 3 basic objectives for management, directors, and asset managers and focus their engagement on companies with pay for performance problems and a well matched peer with much better pay practices.