Recently, Heidrick & Struggles and the Rock Center for Corporate Governance at Stanford University and the Rock Center for Corporate Governance at Stanford University surveyed 107 CEOs and directors of Fortune 500 companies to understand their perception of CEO pay practices among the largest U.S. corporations.
The research finds that public company directors give CEOs considerable credit for corporate success, believing that 40 percent of a company’s overall results, on average, are directly attributed to the CEO’s efforts.
“We find that directors give CEOs considerable credit for corporate performance,” says Professor David F. Larcker of Stanford Graduate School of Business. “While it is difficult to measure a CEO’s contribution to performance, directors take the viewpoint that CEOs are instrumental in the success or failure of an organization. These findings help to explain why CEO pay levels are as high as they are among the biggest U.S. companies: if you believe CEOs are largely responsible for their company’s success, it is understandable that you would want to offer a lot of money to encourage them to be successful.”
Nonetheless, the efforts of directors to align pay and performance are not resonating with the general public. “When most directors think CEO pay is reasonable but most Americans believe that CEO pay is a problem, then you have a serious perception gap,” cautions Nick Donatiello, lecturer in corporate governance at Stanford Graduate School of Business. “With more and more of the American public owning stock through retirement accounts, pensions, and mutual funds, public outrage over CEO pay invites legislative or regulatory intervention. Directors need to make the case clearly and convincingly that the pay they offer is not only tied to performance but that it is deserved based on market realities, performance, and the CEO contribution to that performance.”
Corporate Leaders Believe That CEOs Are Paid the Correct Amount (With Some Caveats)
Seventy-six percent of CEOs and directors believe that CEOs are paid correctly, based on the expected value of compensation awards at the time they are granted. CEOs (84 percent) are slightly more likely than directors (71 percent) to have this opinion. Conversely, a sizable minority of directors (25 percent) do not believe that CEOs receive the correct level of pay.
CEOs and directors are somewhat less likely to believe that CEOs receive the correct level of pay based on the amount they realize when compensation awards are earned or converted to cash. Sixty-five percent believe realized pay levels are correct. The decrease in support from expected pay levels is most pronounced among the CEO population, where only 65 percent believe take-home pay levels are correct — a 19 percentage point difference. Twenty-six percent of CEOs and 30 percent of directors do not believe CEOs receive the correct level of take-home pay. Based on their commentary, some respondents believe that some CEOs are paid too much.
CEOs and Directors Believe In “Pay for Performance”…
CEOs and directors overwhelmingly believe that CEO pay is aligned with performance. Ninety-five percent of CEOs and 87 percent of directors believe this to be the case.
More than three-quarters (77 percent) also believe that compensation arrangements contain the correct mix of short- and long-term incentives. Responses do not differ considerably between CEOs and directors. Still, a reasonable minority (21 percent) believe that compensation contracts are too short-term. Almost none (3 percent) believe they are too long-term.
CEOs and directors believe that 75 percent of a CEO’s compensation package should be performance-based (rather than fixed or guaranteed). This figure is largely in line with shareholder preferences and existing pay practices.2
… and Give CEOs a Lot of Credit for Corporate Outcomes
When asked to quantify how much of a company’s performance is directly attributable to the efforts of the CEO, corporate leaders give CEOs considerable credit for corporate outcomes. They believe that CEOs are directly responsible for 30 percent of performance results. Directors give more credit to CEOs for performance than CEOs do themselves, believing that they are directly responsible for 40 percent of performance compared with 30 percent according to CEOs.
Similarly, CEOs and directors give the entire senior management team (which includes the CEO) credit for 60 percent of a company’s performance. Directors again attribute a higher percentage of overall performance to the efforts of senior management (73 percent) than CEOs do (50 percent).
“Contribution to performance is a key element in deciding how much a CEO should be paid: What value did the company create, what contribution did the CEO make to that value creation, and how much of that do you want to share with the CEO as compensation. That is the implicit formula for determining CEO pay,” says Professor Larcker. “Directors believe that CEOs contribute a lot to value creation, and so you can see why they are willing to offer the CEO a lot of money to create that value.”
CEOs and Directors Disagree on Performance Metrics and Discretionary Bonuses
Less consensus exists about measuring and rewarding corporate performance. Directors are twice as likely as CEOs to say that stock price performance (total shareholder return) is the single best measure of company performance (51 percent versus 26 percent). By contrast, CEOs are more likely to believe that profitability measures — operating income and free cash flow — are best (49 percent of CEOs versus 20 of directors).
Furthermore, a surprising number of corporate leaders do not believe that CEO performance targets are difficult to achieve. While 58 percent agree or strongly agree that companies select “very challenging” performance goals for compensation plans, fully 14 percent disagree or strongly disagree. Directors (21 percent) are much more likely than CEOs (5 percent) to think that performance targets are not very challenging.
Similarly, CEOs and directors are mixed on whether it is appropriate to pay discretionary bonuses when targets are missed. Forty-six percent of the combined populations agree or strongly agree that it is appropriate to pay a discretionary cash bonus to the CEO if the company misses performance targets because of factors that the board believes are outside the CEO’s control; 31 percent disagree or strongly disagree. CEOs (53 percent) are more likely to agree than directors (43 percent), but even they are mixed with 25 percent of CEOs disagreeing that discretionary bonuses are appropriate.
“These issues are contentious among shareholders, activists, and other governance experts,” observes John Thompson, vice chairman of Heidrick & Struggles. “It should come as little surprise, therefore, that the divide plays out in the boardroom as well. Indeed, the correct performance measures, the correct targets, and the outcomes necessary for awarding contingent compensation are important elements of discussion, and we see directors actively engaging and debating these topics.”
Equity Should Be Performance-Based, Might Cause “Excessive” Risk
The vast majority of CEOs and directors (90 percent) believe that stock awards should have performance features. A smaller portion (58 percent) believe that stock options should have performance-based vesting features. Directors (63 percent) are much more likely than CEOs (49 percent) to favor performance-based stock options.3
CEOs and directors (83 percent) generally do not believe that stock options lead to excessive risk taking. However, a significant minority of CEOs (24 percent) believe that they do.
“Executives are notably risk averse when it comes to compensation arrangements. It is understandable that CEOs would not want additional performance-based features in their stock option plans if they believe that strike prices, by definition, make options ‘performance-based,’” says Professor Larcker. “Whether stock options cause ‘excessive’ risk taking is much more difficult to determine. Researchers have long noted that options encourage executives to take on more corporate risk. Whether or not these risks are ‘excessive’ is unclear. Most CEOs and directors believe they are not, but even among these individuals there is not consensus.”
CEOs Should Share in Value Creation, but Not Extensively
CEOs and directors generally believe that CEOs should share only modestly in the value they create for shareholders. If a company increases in value by $100 million, the typical CEO and director believes the CEO should receive 1.5 percent ($1.5 million) as compensation.
These figures are not substantially higher than what the general American public says when asked the same question. The typical American would share 0.5 percent ($500,000) with the CEO as compensation. The mean value of responses among both groups is strikingly similar: $3.6 million according to CEOs and directors compared with $3.2 million according to the public.4
Corporate Leaders and the Public Disagree on Compensation Limits, and on Government Intervention
A majority of CEOs and directors (55 percent) believe that CEOs are paid the correct amount relative to the average worker; 29 percent believe they are not; and 16 percent have no opinion. While modest, these numbers are considerably more favorable than the opinion of the American public. Only 16 percent of Americans believe CEOs are paid the correct amount relative to the average worker, and 74 percent believe they are not.5
CEOs and directors strongly disagree that there should be a maximum amount that CEOs are paid, relative to the average worker. Only 12 percent support a relative limit to CEO pay, while 79 percent oppose it. These figures, too, are considerably more favorable than public opinion. Two-thirds of Americans (62 percent) favor capping pay, while 28 percent oppose the concept.
Most CEOs and directors (73 percent) do not believe that CEO compensation is a problem; 25 percent believe that it is. Opinion, however, varies between these two groups. Over a third of directors (34 percent) believe that CEO compensation is a problem, while only 12 percent of CEOs believe it to be so. These figures are much less favorable than public opinion, where over two-thirds (70 percent) of Americans believe that CEO compensation is a problem.
Finally, CEOs and directors almost uniformly agree that the government should not do anything to change CEO pay practices. Ninety-seven percent oppose intervention. The American public is more mixed on this issue, with 49 percent favoring government intervention and 35 percent opposing it.
“The gaps in perception between what directors think and what the public thinks are substantial,” says Donatiello. “Clearly directors are in a better position to judge what compensation is required to attract, retain, and motivate qualified CEO talent in a competitive labor market. But with income inequality being such a hot-button issue today, directors need to be careful that they are not inviting the very government intervention that they say they don’t want. It should be a wakeup call to boards that they need to put more efforts into justifying CEO pay.”
1 Public data from the Rock Center for Corporate Governance at Stanford University, “Americans and CEO Pay: 2016 Public Perception Survey on CEO Compensation,” (2016).
2 Institutional investors believe that 70 percent of CEO compensation should be performance-based. Among the largest 100 publicly traded U.S. corporations, approximately 71 percent of CEO pay is performance-based. See RR Donnelley, Equilar, and the Rock Center for Corporate Governance at Stanford University, “2015 Investor Survey: Deconstructing Proxies — What Matters to Investors” (2015). And David F. Larcker and Brian Tayan, Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences, 2nd edition (New York, NY: Pearson Education, 2015).
3 While performance-based stock awards are included in two-thirds of CEO compensation arrangements, performance-based stock options remain rare. See Equilar, “CEO Pay Strategies Report,” (2015).
4 The viewpoint of a “typical” respondent is based on median values, which represent the answer given by the respondent at the 50th percentile. The mean average, by contrast, is the average amount across all responses. Mean averages can be influenced by a relatively small number of outliers, and for this reason median numbers are a better descriptor of the viewpoint of a typical respondent.
5 The Rock Center for Corporate Governance at Stanford University, “Americans and CEO Pay: 2016 Public Perception Survey on CEO Compensation,” (2016).