I suggest a simpler alternative. Check the purchase and retention yield of the common Joe shareholder who bought the shares on the date of the stock grant / CEO option grant and sold these shares on the vesting date. Compare that return to a reasonable benchmark such as the S&P 500 or the company’s cost of equity capital. If the average Joe loses money in reference to these criteria, does the CEO deserve to be paid “performance-based” compensation?
The Securities and Exchange Commission just released a set of final rules in its ongoing effort to bring greater transparency to โpay for performanceโ executives. The Securities and Exchange Commission in the last batch requires companies to publish, among other things, fair value changes during the year for previously issued stock awards. This is a good first step, but it doesn’t really get to the heart of the discussion.
Furthermore, there is widespread confusion about how to think about payment for performance in the current academic literature. Researchers perform annual pay regressions on contemporary or late stock returns and/or dividends and assume that higher explanatory power (R-squared in terms) indicates more pay-for-performance. Some of this thinking is also reflected in the SEC law.
This is what I would suggest instead, if I were the SEC. If CEO pay actually reflects shareholder performance, the CEO needs to internalize the pain the shareholder is feeling. Hence, I will conduct the following thought experiment. Suppose an average shareholder in Joe bought shares of IBM on the same day as the day the CEO was granted stock/options by the Compensation Committee. Further, suppose the average Joe shareholder sells IBM stock on the day the option/stock is issued as part of a CEO package. Calculate the return, including dividends paid during this period, earned by the average Joe.
Compare the return earned by Joe’s average with some reasonable criteria: (i) a reasonable estimate of the cost of equity capital; or (ii) how an aggregate market index such as the S&P 500 or the sector index to which the company is closely related is. If the average Joe does not earn a reasonable return relative to some agreed-upon criteria, institutional investors should ask whether the CEO is worth the option/equity grant.
Let me explain using a concrete example of IBM. IBM 2022 agent statement on page 54 states that IBM CEO Arvind Krishna has been awarded 151,030 shares, valued at $20.2 million. I can track the exact grant dates, and the nature of the grant (RSUs, Restricted Stock Units, Primary Sampling Units, Performance Stock Units, RRSUs, Restricted Hold Stock Units, RPSUs, or Retain Performance Share Units) for 145,312 of these shares worth $18.6 million. Tracking these details required a fair amount of investigative work as I had to compare the unvested shares as mentioned in the IBM Agent 2022 (covering the year ending 12/31/21) with the IBM Agent 2021 (covering the year ending 12/31 /) 20). See the following table, which summarizes the work.
IBM: Pay for performance?
To understand the calculations, let’s look at the first RSU scholarship in the table given on 6/8/2017. It was not immediately clear to me when this RSU scholarship would actually be awarded in calendar year 2021. Therefore, I assumed all due dates in 2021 are set on 12/31/21.
If our average Joe had bought IBM stock on 8/6/2017 and sold that stock on 12/31/21, he would have made 13.7%, dividend included. If the average Joe had instead invested the same money in the S&P 500, he would have made 95.83%. Alternatively, had he put that money into the S&P IT Index, he would have gained 210.29%. If you assume a modest 7% cost of equity capital for IBM, the stock must have returned at least 24.5% during the three-and-a-half year period under consideration for the 6/8/2017 grant. Despite this massive underperformance, the CEO of IBM awarded this bonus of 2,250 shares worth $301,500 and a package worth approximately $18.6 million.
This is because the same intuition is repeated grant after grant, as evidenced by column (6) calculating the adjusted return on purchase and retaining earnings for several other average Joe experiments for each grant awarded in 2021. Column (6) yawning shows a gap between the mean What Joe has achieved for alternatives like the S&P 500 and the S&P IT Index. The entire $18.6 million package I was looking at is clearly a far cry from performing.
The people I’ve talked to about who are private equity holders love my approach. Directors and CEOs of public companies, as might be expected, are not fans of this metric. They often say things like, “Oh, we need to pay the guy, or he’s going to quit.” this is good. He recalled the $18.5 million in retention bonus and avoided mentioning pay-for-performance on the agent’s statement.
Why is my method better than the way the SEC suggests? The SEC schedule only takes into account the change in the fair value of the stock or option contracts for the year. Most options and stock awards are due between two and five years. Unless the purchase and retention return is considered for the entire vesting period, which spans from the grant date to the actual vesting date, it’s hard to average the joe calculations I’m suggesting.
The question, of course, is whether institutional investors, or at least state pension funds, are going to press management hard on CEO compensation based on my average calculations. We might then really move to a world where wages track performance in US companies.
