Decoding CEO Pay*

*The truth is buried in the fine print—and that’s a problem.

by

Robert C. Pozen

and

S.P. Kothari

by

Robert C. Pozen

and

S.P. Kothari

From the Magazine (July–August 2017) · Long read

Summary.

Each year most public companies issue reports describing the pay packages of their CEOs. In them compensation committees attempt to explain the rationale behind the pay figures to the shareholders, who often must vote to approve them. The issue is, in their reports many committees adjust performance numbers in obscure and inappropriate ways that lead to overly generous CEO pay. And they do so using nonstandard criteria that are difficult for even sophisticated institutional investors to decode.

In this article, the former executive chairman of MFS Investment Management and an MIT professor of accounting and finance sort through the reports’ fine print and expose practices that stack the deck in CEOs’ favor: Adjusting earnings to be 100% higher than GAAP income. Paying out 80% of an incentive award for bottom-quartile performance. Choosing “peer companies” that are not comparable in size or in industry. And more.

Shareholders should be more skeptical, say the authors, and comp reports must start providing much clearer explanations. But what’s needed most are new standards for compensation design and reporting.

In Brief

The Problem

More than 95% of the time, a firm’s shareholders approve the recommendations of its compensation committee. Yet committees often adjust performance numbers in complex and obscure ways to justify overly generous pay.

How It Happens

Many committees add some costs and charges back into earnings, arguing that they don’t affect operating performance. Many also create a misleading picture of performance by using non-GAAP numbers and benchmarking against inappropriate companies. It’s not feasible for most shareholders to quantify all the nonstandard criteria used by the committee.

The Solution

Compensation committees need to explain the basis of their decisions more clearly in their reports. For their part, investors need to develop a set of best practices for compensation design and reporting.

Each year most public companies issue reports on the pay packages of their top executives, describing how their compensation committees arrived at the numbers. These reports are part of the proxy statements sent to all shareholders, who vote on the packages. The votes are advisory or binding, depending on the country where a company is chartered.

A version of this article appeared in the July–August 2017 issue (pp.78–84) of Harvard Business Review.

A former president of Fidelity Investments, Robert C. Pozen is a senior lecturer at MIT’s Sloan School of Management in Cambridge, Massachusetts, and a nonresident senior fellow at the Brookings Institution. He is the co-author of Remote, Inc.: How to Thrive at Work…Wherever You Are (with Alexandra Samuel).
SK

S.P. Kothari is the Gordon Y. Billard Professor of Accounting and Finance and a former deputy dean at the Sloan School.

Decoding CEO Pay*

In Brief

The Problem

How It Happens

The Solution

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