An important task for boards is to oversee executive compensation. The effectiveness of boards in carrying out this monitoring responsibility, however, is widely debated. In the paper, The Effect of Disclosure on the Pay-Performance Relation, forthcoming in the Journal of Accounting and Public Policy, we argue that disclosure improves board effectiveness. First and as a general point, disclosure can improve transparency, which facilitates the monitoring of management and hence causes managers to act more in the interests of shareholders. Such monitoring is potentially valuable since managers will not always act in the best interest of shareholders.
Posts Tagged ‘Pay for performance’
Current views regarding the proper pay plan design to achieve pay for performance vary. This post discusses the three dimensions of pay for performance, demonstrates how to measure them using historical pay data, and presents a simple pay plan that achieves perfect pay for performance (PP4P) using annual grants of performance shares. It also highlights pay practices that weaken pay for performance and offers recommendations for directors to deepen their understanding of pay-for-performance issues.
Pay for performance. As the dust settles from year two of Say on Pay proxy voting, and more companies coalesce around accepted pay practices, the top issue for both shareholders and companies is whether pay is aligned with performance. While there is general acceptance that the performance side of that equation should primarily be based on total shareholder return (TSR), there is not yet a commonly accepted definition for pay. The result is that widely divergent compensation numbers currently are being used in pay for performance analysis, leaving shareholders and others unclear on how to evaluate this critical issue.
Why 2012 Was the Year of Pay for Performance
Whether the pay of a company’s CEO and other executive officers is aligned with the company’s performance has been the single most important and controversial executive pay issue for U.S. public companies since the advent of mandatory say-on-pay votes under the Dodd-Frank Act, which applied to most U.S. public companies in 2011; smaller reporting companies will face these votes and issues in 2013. As we wrote in our Director Notes “Proxy Season 2012: The Year of Pay for Performance,” 2012 was indeed the year of “pay for performance.” This has been proven by the over 2,000 say-on-pay vote results reported through September 5, 2012.
The stage for the 2012 pay-for-performance debate was set in 2011, when Institutional Shareholder Services Proxy Advisory Services (ISS), which is widely regarded as the most influential U.S. proxy adviser, applied a crude two-step test to assess pay for performance in making its say-on-pay voting recommendations.
Generally, under its 2011 test, ISS concluded that a pay-for-performance “disconnect” existed if:
In the paper, Ten Myths of “Say on Pay”, my co-authors (Allan McCall, Gaizka Ormazabal, and Brian Tayan) and I review many widely held misconceptions regarding the shareholder voting practice called “say on pay.” “Say on pay” is a prominent issue today, given its unique position at the intersection of executive compensation and shareholder democracy—two topics which themselves are of deep interest to investors, stakeholder, regulators, and the media. Despite this interest, several misconceptions have developed which continue to be commonly accepted. Fortunately, academics have devoted considerable effort studying “say on pay,” shareholder democracy, and executive compensation. As a result, a lengthy empirical record exists against which “say on pay” can be examined. Our intention is to review “say on pay” in light of the scientific evidence so that practitioners have a better understanding of the limits and consequences of granting shareholders the right to vote on executive compensation.
In our paper, The Impact of Regulatory Governance Mandates on Poorly Governed Firms, which was recently made publicly available on SSRN, we investigate the relation between regulatory governance mandates and firm value by assessing the impact of recent governance mandates on the firms that were most affected by changes in governance regulation. We exploit the cross-sectional variation in compliance with governance mandates in the pre-regulatory period to identify firms that were most affected by the governance mandates promulgated by congressional action and the associated changes to NYSE and Nasdaq listing requirements (“affected firms”) and firms that were less affected by such mandates (“control firms”). We use propensity score trimming (Crump et al. 2009; Imbens and Wooldridge 2009) to form a sample of affected and control firms that display covariate balance, facilitating comparisons across the pre- (1996 through 2004) and post-regulatory (2005 through 2009) periods. An important objective of recent governance mandates was to improve board monitoring. Hence, we identify affected and control firms using the governance mandates most closely related to board monitoring (please see our paper for more details). Our research design helps to mitigate endogeneity concerns by combining a quasi-natural experiment with the identification of firms differentially affected by the regulatory governance mandates.
It is common knowledge that people are not driven solely by the prospect of financial rewards. Yet, in business, motivational tools for top executives—particularly the CEO—almost singularly comprise financial incentives. In 1980, only 10 percent of the UK’s largest FTSE100 companies utilized incentive arrangements (in the form of cash and stock-based variable pay). Today, they are universally employed as a matter of best practice and variable pay accounts for approximately two-thirds of total compensation.
Widespread adoption of financial incentives has contributed to substantial pay increases, in absolute and relative terms. In the United Kingdom, the average compensation of FTSE100 CEOs climbed from £1 million in 1998 to £4 million a decade later, with the ratio of CEO pay to average employee pay nearly tripling. (The figures are, of course, higher for American executives.) The rise in top executive pay has far outstripped growth in share price and other indicators of company performance, with certain incentive arrangements proving counterproductive by encouraging excessive risk-taking and accounting manipulation.
Amid growing sensitivity to widening income inequality in many countries, it is no wonder that executive pay has remained a visible target.
As in 2011, executive compensation is the single most important corporate governance issue for companies, boards, and investors for the 2012 proxy season. This Director Notes discusses the evolving analytics and issues around pay for performance (P4P) and suggests ways for companies and their boards to analyze the alignment of P4P, counter negative recommendations by proxy advisers, and draft their proxies to obtain shareholder support for their pay programs.
In 2011, approximately 3,000 companies held their first mandatory shareholder say on pay (SOP) and say on frequency votes; approximately 1,500 “smaller reporting companies” are not required to do so until January 21, 2013. Overall, 42 companies that held SOP votes in 2011 received less than 50 percent shareholder support. More than 90 percent of companies received shareholder support of 70 percent or higher, and more than 70 percent received shareholder support of 90 percent or higher. On the issue of say on frequency, shareholders at more than 75 percent of companies supported annual SOP votes, while shareholders at a majority of the remaining companies supported triennial votes, and a few supported biennial votes. Following the votes, the vast majority of companies adopted the vote frequency preference supported by a plurality of their shareholders.
One unexpected development during the 2011 proxy season was the large volume of publicly filed disputations between public companies and Institutional Shareholder Services (ISS) and Glass Lewis, the two most influential U.S. proxy advisers, over their negative SOP recommendations. While some of the negative recommendations and the controversies that followed were related to pay practices labeled “problematic” or “egregious” by the proxy advisers, most of the negative recommendations and controversies stemmed from negative recommendations based on those proxy advisers’ P4P voting policies.
In the paper, Mandatory IFRS Adoption and the Contractual Usefulness of Accounting Information in Executive Compensation, forthcoming in the Journal of Accounting Research, we investigate the contracting implications of the transition to IFRS. Specifically, we examine how the mandatory adoption of IFRS affects the contractual usefulness of accounting information in executive compensation, as reflected in pay-for-performance sensitivity (PPS) and relative performance evaluation (RPE). These tests allow us to infer whether compensation committees of European companies view IFRS as leading to increased earnings quality and comparability.
The mandatory adoption of International Financial Reporting Standards (IFRS) on January 1, 2005, by the European Union (EU) and several other countries (e.g., Australia; South Africa) marks major progress toward a single set of high-quality, globally accepted accounting standards (Daske et al., ). IFRS is primarily aimed at enhancing earnings quality and achieving a high degree of comparability of financial statements (Regulation (EC) No. 1606/2002 of the European Parliament and of the Council). The extant research, however, has provided mixed evidence on whether mandatory IFRS adoption has achieved these goals (e.g., Barth et al., , Ahmed et al. , DeFond et al. , Lang et al. ).
In our paper, Earnings Management from the Bottom Up: An Analysis of Managerial Incentives below the CEO, which was recently made publicly available on SSRN, we analyze all components of compensation packages for CEOs and for managers at levels below that of the CEO. Pay-for-performance contracts are a critical instrument to align the interests of principals and agents (Jensen and Meckling, 1976). While it can be optimal to make the agent the residual claimant of the firm’s profit, under numerous conditions principals are better off employing weaker incentives. These include situations with poor measures of performance and multitasking environments, when agents reduce their motivation in response to financial incentives, and when principal and agent have differing priors.
Another cost of high-powered incentives is that they provide managers with incentives to manipulate the firm’s reported earnings. For example, equity incentives can entice managers to boost reported earnings just before they exercise options or sell stock. There are now a number of academic studies – and many anecdotes – that document this link between the structure of chief executive officer (CEO) compensation and various measures of earnings manipulation (e.g., Beneish and Vargus, 2002; Bergstresser and Philippon, 2006; Peng and Roell, 2008). These papers generally focus on one component of compensation for the top position—equity incentives for the CEO. In this paper, we extend this literature by analyzing all components of compensation packages for CEOs and for managers at lower levels. To our knowledge, this study is the first that analyzes the relationship between CEO, division manager, and chief financial officer (CFO) compensation and earnings management in a large sample of firms.