A new paper from Stanford University’s Rock Center presents a formula that improves on the “static” disclosures about CEO pay on proxies because it reveals a more important metric: variability with performance. The factors:
1. Calculate the “minimum” payout that a CEO is expected to receive in a given year. One might expect that the minimum payment a CEO receives is equal to his or her salary. Typically, however, this is not the case. A CEO will retain time-vested restricted stock without regard to performance. Furthermore, CEOs almost always receive some portion of their annual bonus. Targets are set low enough to be achievable, and a zero payout almost never occurs in practice. Most plans set a lower threshold (hurdle amount) equal to 50% of the target, and we include this figure in the minimum payout. Taking this all together, we assume the “minimum” payout to a CEO as equal to the CEO’s salary, plus restricted stock, plus 50% of the target value of the annual bonus.2. Calculate how much incremental pay the CEO will receive if he or she achieves target-level performance. This amount equals the incremental compensation assuming the annual bonus and long-term incentive plans are paid out at the target level. (We assume no change in stock price, so that all of this incremental compensation comes from additional payments and not change in value of equity awards due to stock price change).3. Calculate incremental pay if maximum bonuses are paid. This amount equals the incremental compensation for achieving the high end of the annual bonus and the high end of the long-term incentive plan. (Again, we assume no change in stock price).Steps 2 and 3 highlight how much upside potential is available to the CEO for achieving performance milestones, even if shareholders see no appreciable return. They also illustrate the potential disconnect that can occur between the financial outcomes of shareholders and the CEO.4. Add the incremental compensation the CEO will receive assuming some reasonable stock-price appreciation. We assume a 50 percent increase, although higher or lower return scenarios are equally valid. This calculation adds the incremental payout from stock options and the appreciation of restricted stock and performance shares. Treating stock-price appreciation as an independent analytical variable allows us to see how equity awards add leverage to the pay package and the degree to which CEO pay outcomes and shareholder interests are aligned.Taken together, this framework provides a foundation for analyzing the scale and structure of CEO pay. It provides a rigorous and systematic method for evaluating critical issues, such as:
- The degree to which pay is “guaranteed” or “at-risk”;
- The degree to which payouts are driven by operating versus stock-price performance;
- The sensitivity of CEO compensation to stock-price returns;
- The importance and rigor of performance metrics;
- The potential risk embedded in the CEO pay package.