What Does It Mean for an Executive to Make 1 Million

8/3/2019 What Does It Mean for an Executive to Make 1 Million

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CLOSER LOOK SERIES:TOPICS,ISSUES, AND CONTROVERSIES IN CORPORATE GOVERNANCE

CGRP-22DATE: 12/14/11

Professor David F. Larcker, Allan McCall, and Brian Tayan prepared this material as the basis for discussion.Larcker and Tayan are co-authors of the bookCorporate Governance Matters. The Corporate Governance ResearchProgram is a research group within the Stanford Graduate School of Business. For more information, visit:http://www.gsb.stanford.edu/cgrp/or contact Associate Director Michelle E. Gutman at [email protected].

Copyright 2011 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

WHAT DOES IT MEAN FOR AN EXECUTIVE TOMAKE$1MILLION?

INTRODUCTION

In 2008, Vikram Pandit became the CEO of Citigroup. Pandit had joined the company sixmonths prior as head of investment banking and alternative investments after Citigrouppurchased the hedge fund he managed, Old Lane Partners, for $800 million. Between the $165.2million in proceeds Pandit accrued in the sale and the $40 million compensation package he wasoffered when appointed CEO, the New York Times dubbed him Citigroups quarter-billiondollar man.1

Despite the headlines, however, Pandit never actually received this amount of money. By thetime Pandits share of Old Lane Partners was liquidated in May 2008, it was worth a fraction ofthe original value, and the nearly $40 million in restricted shares and stock options awarded tohim at promotion were worth only $4 million when they vested years later (see Exhibit 1).2

As this example suggests, executive compensation figures are not always what they seem.Executive pay packages contain a diverse mix of cash and non-cash incentives, payable in one ormultiple years and subject to accruals, estimates, and restrictions that often render their ultimatevalue quite different from their expected value. The Securities and Exchange Commissionstandardizes the manner in which compensation is quantified and disclosed to investors in theannual proxy.3 However, even there, compensation figures comingle forward- and backward-

1

As part of his employment agreement, Pandit promised to retain the after-tax proceeds of the sale as an investment

interest in Old Lane. Source: Eric Dash, All Told, the Price Tag for Citigroups New Chief is $216 Million, TheNew York Times, Mar. 14, 2008.2

Citigroup, Forms DEF-14A filed Mar. 20, 2009 and Mar. 12, 2010 with the SEC.3

The Internal Revenue Service also standardizes the calculation of income for tax purposes. Its method is different

from that employed by the SEC and is also different from those discussed below.


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What Does It Mean for an Executive to Make $1 Million? CGRP-22 p. 2

looking amounts, as well as fixed and contingent payments, that make it difficult for investors tounderstand what compensation has been promised to executives and what they eventually earn.

MEASURING EXECUTIVE COMPENSATION

Executive compensation can be measured in many ways, three of which include:

Expected compensation represents the total expected value of compensation promised to anexecutive in a given year. Because not all compensation is received in the year it is awarded,the value of certain elements must be estimated. The precision of these estimates will varydepending on performance- and market-related sensitivities. For example, the expectedvalue of a salary is known with a fairly high degree of certainty, because it is delivered on apro rata basis throughout the year based on a promised and fixed amount. The expectedvalue of a cash bonus is typically known with less, but still some, precision because it fallswithin a range (minimum, target, and maximum) that is bounded by the achievement ofpredetermined objectives.4 The value of long-term incentives such as restricted stock, stockoptions, and long-term cash plans is known with far less certainty because these elements aresubject to multi-year strategic, financial, and stock price results that are unknown inadvance.5 The expected value of long-term incentives is therefore measured using aprobable-outcome estimate or market-based valuation.

Earned compensation represents the total value of compensation that an executive earns theright to keep as cash is delivered and vesting restrictions are removed from equity-linkedelements. Salary and annual bonuses are earned over one-year periods. Long-term cashawards are typically earned at the end of multiple-year periods.6 Equity awards are earned asthey vest. In the case of restricted stock, the earned value is determined based on the stockprice on the vesting date. The earned value of stock options is based on either the Black-Scholes value or the intrinsic value on the vesting date.7 Note that if the stock price has

appreciated or declined materially since the original grant date, the earned value might differconsiderably from the original expected value. In most cases, the total compensation earnedin a year comprises some elements awarded in the current year and other elements awardedin previous years.

Realized compensation represents the total value of compensation that an executive convertsto cash in a given year. For cash awards (salary, bonus, and long-term cash plans), the

4The degree of precision is largely driven by the plans design.

5Furthermore, financial and stock-price performance might be influenced by macroeconomic factors that are largely

outside of the executives control.6 Because long-term cash awards require an executive to be employed through the payment date, they are earned as

received (rather than accrued over the performance period) even though their final value is generally based on multi-year performance.7

The Black-Scholes model takes into account the current price, strike price, expected volatility, risk-free rate,

dividend yield, and time to expiration. When companies value stock option grants they typically apply a haircut tothe time to expiration to take into account the fact that compensatory options are often non-transferable andgenerally not held to expiration because executive tend to exercise them early. Intrinsic value is a simpler methodfor estimating earned value because it is calculated by subtracting the exercise price from the current stock price.However, it does not take into account the potential for future gain.


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earned value is the same as the realized value.8 For equity awards, the realized value is theamount of cash received when the executive ultimately sells shares or exercises (and sells)stock options.

9If the executive cashes out these pay elements on the vesting day, the earned

amount will approximate the realized amount. If the executive holds equity awards beyondthe vesting date, the realized amount will be higher or lower than the earned amount

depending on whether the stock price subsequently increased or declined. Earned equitycompensation that is retained after the vesting date therefore remains at risk until it hasbeen sold. Like earned compensation, realized compensation often comprises pay elementsawarded over multiple years and the realized amount is a function of firm performance overthis period.

These distinctions are important because each figure conveys different information to corporatestakeholders. Expected compensation is a forward-looking view of the reward opportunitiesavailable to an executive. It reflects both the target level of compensation to attract and retainqualified talent in a competitive labor market and the mix of pay opportunities to motivate anexecutive to achieve corporate targets.

10The size and mix of expected compensation therefore

provide insight into the incentives offered to management. By contrast, earned and realizedcompensation are backward-looking views of the rewards that an executive actually received forhis or her efforts. These values can be compared to corporate performance during themeasurement period to assess the relative pay versus performance relationship in thecompensation plan. When earned compensation is highly correlated with improvements instrategic, financial, and stock price results, the compensation plan can be said to offer strong payfor performance. When earned compensation is uncorrelated with these, the plan does not offerpay for performance.11 Finally, earned compensation that has not been realized continues toprovide incentive to the executive because his or her efforts can enhance its future value; once anexecutive realizes this value by cashing out equity grants it no longer provides incentive.

12

Unfortunately, the information to assess the incentive value of compensation and pay forperformance is not readily available to shareholders. This is because expected, earned, andrealized compensation in a given year are rarely disclosed to the public. Althoughcomprehensive information is mandated by the SEC and included in the annual proxy, it is not

8In many companies, executives are eligible to participate in non-qualified deferred compensation plans and

supplemental executive retirement plans (SERPs). In these instances, amounts are earned as they accrue andbecome vested; however, because they will not become payable until sometime in the future, they effectivelybecome debt instruments (and executives face the same risks as other debtholders) and pay is therefore notrealized until that future date.9

That is, earned compensation is the amount of pay that an executive can cash in, while realized compensation is

the amount of pay that an executive actually cashes in.10

The compensation mix will include pay elements that are short- or long-term, accounting- or stock-price based,and fixed or contingent (risky). To determine the size and mix of incentive compensation, the board of directorstypically benchmarks the compensation program against those of a peer group of companies that are similar in size,industry, complexity, etc.11

There will almost certainly be pay-for-performance in any contract that includes large amounts of contingent

compensation awards (restricted shares, stock options, long-term cash plans, etc), because the value of realized payis directly related to operating and stock price results. The Pandit example above illustrates this point.12

For a discussion of the incentive value of equity, see David F. Larcker and Brian Tayan, Sensitivity of CEO

Wealth to Stock Price: A New Tool for Assessing Pay for Performance, CGRP-10, Sep. 19, 2010, available at:http://www.gsb.stanford.edu/cgrp/research/closer_look.html.


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explicitly summarized along the dimensions discussed above. Instead, the annual proxy containsa Summary Compensation Table that combines expected, earned, and realized amounts (seeExhibit 2). The investor must comb through the explanatory notes to calculate these metrics.

13

Furthermore, proxy advisory firms do not assist in the matter. For example, in formulating a

recommendation on executive compensation plans, Institutional Shareholder Services (the largestproxy advisory firm) compares the year-over-year change in reported compensation to previousone- and three-year total shareholder return. This approach is flawed because it takes acompensation figure that is predominantly forward-lookingand compares it to backward-lookingstock-price changes. A more reasonable methodology would compare the change in earnedcompensation to the change in stock-price during the same measurement period. In addition, ISSlikely overstates the expected value of stock option plans by assuming that executives hold theiroptions for the full term (generally ten years) before exercising them, when research shows thatexecutives routinely exercise stock options early.14 As a result, the expected value assigned byISS tends to exceed the value that is reported in the Summary Compensation Table.15

Finally, journalists do not consistently distinguish between earned and expected compensation.For example, a recent article in theNew York Times reported that Viacom CEO Philippe Daumanreceived total compensation of $84.5 million in 2010, more than twice the amount awarded theprevious year. The article quoted a compensation consultant as stating, This is spectacularmoney but where are the spectacular results? Noting that the companys stock price had barelymoved in three years, he asked: Is that really worth this award?16 Had the article reportedDaumans compensation on an earned, rather than expected, basis the numbers would havelooked quite different. Rather than report a 150 percent increase in compensation from $34million to $84.5 million, the article would have shown a 26 percent increase from $17.2 millionto $21.6 million. Furthermore, one-quarter of the nearly 500,000 options that Dauman had beenawarded in previous years vested out-of-the-money in 2010, indicating that unless he

13In some cases, companies choose to voluntarily disclose realized compensation in a supplemental disclosure, but

this is rare. For example, in its most recent proxy, Computer Sciences Corporation outlines the compensationrealized by CEO Michael Laphen during the previous fiscal year: The table below provides a different perspectiveon compensation that is supplemental to the information contained in the Summary Compensation Table. This tableprovides details of actual pre-tax income realized by our CEO during Fiscal 2011 from base salary, annual incentivecompensation from long-term incentive compensation regardless of the year in which the equity award wasgranted. In addition, this table facilitates comparison of approved or award date values versus actual incomeearned and received for each component of compensation. As such, it provides further evidence of the pay forperformance underpinning of our executive compensation program by demonstrating diminished realized income,especially in our annual and long term incentive programs, relative to potential during a period of minimalappreciation in shareholder value. Whereas the company had granted Laphen cash and equity awards with anoriginal expected value of $7.6 million, he only realized $4.0 million from these awards. This is significantly lessthan the $12.5 million reported in the Summary Compensation Table for the same year. Source Computer SciencesCorporation, Form DEF 14A, filed Jun. 24, 2011.14

For this reason, the Financial Accounting Standards Board (FASB) allows companies to value stock option grants

using an expected term based on previously observed behavior. Source: Chip Heath, Steven Huddart, and MarkLang. Psychological factors and stock option exercise. Quarterly Journal of Economics (May 1999).15

This methodology significantly disadvantages stock options relative to restricted stock and other forms of

compensation. As a result, if a company wants to lower its total compensation to gain approval from ISS, the easiestplace to start is to replace stock options with restricted shares or long-term cash plans (for better or worse).16

Graham Bowley, Pay Doubles for Leaders at Viacom, The New York Times, Jan. 22, 2011.


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subsequently increased the stock price he stood to earn no value from these awards, despite thefact that they were originally reported with an expected value of more than $7 million.Similarly, much of the $84.5 million in compensation granted to Dauman in 2010 was in theform of stock options and performance units, suggesting that their future value would dependheavily on his ability to increase shareholder value (see Exhibit 3).17 This article is but one

example of the confusion that is prevalent between the incentives that expected compensationprovides for future performance and the rewards that earned compensation offers for previousperformance.

WHY THIS MATTERS

1. Executive compensation figures are frequently cited by the press and other third-partyobservers. However, these sources rarely distinguish between expected and earnedcompensation. What does it actually mean when we read that a CEO made $1 million in ayear?

2. Exhibit 4 shows summary statistics for expected and earned compensation across a largesample of companies in fiscal 2010. Among the largest 250 companies, median earned paywas 18 percent less than median expected pay. Within the sample, individual amounts varyeven more significantly (higher and lower) based on individual performance. Why dontcompanies voluntarily disclose these figures so corporate stakeholders can more readilyassess both the incentive value of compensation and pay for performance?

3. The Dodd-Frank Wall Street Reform Act requires that companies calculate and disclose theratio of CEO-to-average-worker pay in the annual proxy. However, corporate observers tendto calculate this ratio based on the expectedpay of the CEO and earnedpay of the averageworker. Wouldnt a more fair comparison use the same figure for the numerator anddenominator, such as earned pay for both? In many cases, this would greatly change the

reported results.18

17Viacom, Forms DEF 14A filed Apr. 30, 2007, Apr. 18, 2008, Apr. 17, 2009, Apr. 16, 2010, and Jan. 21, 2011

with the SEC.18

For a further discussion of the shortcomings of this ratio, see David F. Larcker and Brian Tayan, Seven Myths in

Executive Compensation, CGRP-17, Jun. 6, 2011, available at: http://www.gsb.stanford.edu/cgrp/research/closer_look.html


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Exhibit 1

Reported versus Earned and Realized Compensation: Citigroup

Vikram Pandit, CEO:ReportedCompensation

Year Salary Bonus Stock OptionsNon-Equity

Plan

Pension

ChangeOther Total

2008 958,333 0 28,830,000 8,432,911 0 0 16,193 38,237,437

2009 125,001 0 0 0 0 0 3,750 128,751

2010 1 0 0 0 0 0 0 1

Reported compensation includes salary, bonus, and payments under long-term cash bonus plans plus the expectedvalue of restricted stock and stock options on the grant date. In February 2009, Pandit announced a voluntaryreduction in salary to $1.

Vikram Pandit, CEO:EarnedCompensation


Plan

Pension

ChangeOther Total

2008 958,333 0 1,961,250 0 0 0 16,193 2,935,776

2009 125,001 0 1,132,504 0 0 0 3,750 1,261,2552010 1 0 1,346,903 0 0 0 0 1,346,904

Earned compensation includes salary, bonus, and payments under long-term cash bonus plans plus the value ofvested restricted stock and stock options as of the vesting date. Restricted shares are valued based on the stock priceon the vesting date; stock options are valued based on their intrinsic value on the vesting date (the amount by whichthey are trading in the money).

Vikram Pandit, CEO:RealizedCompensation


Plan

Pension

ChangeOther Total

2008 958,333 0 119,500 0 0 0 16,193 1,094,026

2009 125,001 0 125,239 0 0 0 3,750 253,9902010 1 0 130,798 0 0 0 0 130,799

Realized compensation includes salary, bonus, and payments under long-term cash bonus plans plus the value ofrestricted stock sold and stock options exercised and sold on the sale date. Realized compensation excludes theproceeds from non-cumulative preferred stock that was sold and reinvested in common stock on Jul. 24, 2009. Allstock sales between 2008 and 2010 were made to satisfy tax withholding obligations associated with vesting.

Source: Citigroup, Forms DEF-14A and Forms 4 filed 2008-2010.

$

$5

$10

$15

$20

$25

$30

$35

Jan08 Jul08 Jan09 Jul09 Jan10 Jul10

Citigroup(C)StockPriceHistory 2008to2010


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Exhibit 2

Elements of Executive Compensation

Compensation

ElementExpected Earned Realized

Summary

Compensation Table

Salary Target amount Actual amount Earned, Realized

Cash Bonus Target amountActual amount (between the minimum

and maximum amount)Earned, Realized

Restricted StockFair value on grantdate (stock price)

Fair value onvesting date

Value realizedupon sale

Expected

Stock OptionsFair value on grant

date (Black-Scholes)

Fair value onvesting date

Value realizedupon sale

Expected

Non-EquityPlans

Target amount Actual amount(lump sum)

Earned, Realized

Pension Actuarial amountActual amount in

retirementExpected, Earned

Other Benefits Actual amountExpected, Earned,Realized

Example: Keith Wandell, CEO: Harley Davidson (2010)

Expected Earned Realized ReportedSalary $ 975,000 $ 975,037 $ 975,037 $ 975,037

Bonus 0 0 0 0

Stock Awards 1,381,199 0 0 1,381,199

Option Awards 1,636,681 698,906 0 1,636,681

Non-Equity Plans 2,600,357 2,340,090 2,340,090 2,340,090

Pension 0 0 0 0

Other Benefits 83,490 83,490 67,289 83,490

Total $ 6,676,727 $ 4,097,523 $ 3,382,416 $ 6,416,498

Notes: 2009 restricted stock awards first vest in 2011 and therefore no restricted stock was earned in 2010. Theearned value of option awards is calculated as the intrinsic (in-the-money) value of options on the vesting date.Wandell did not exercise any option awards or sell stock awards in 2010. The expected value of cash plans equalsthe target amount for 2010, payable in 2011 and 2013. The realized value of other benefits excludes a non-qualifieddeferred compensation plan contribution of $16,201.

Source: Harley-Davidson, Forms DEF-14A, filed Mar. 19, 2010 and Mar. 25, 2011 with the SEC.


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Exhibit 3

Reported versus Earned Compensation: Viacom

Philippe Dauman, CEO: Viacom (2009 and 2010)

2010 Reported Earned

Salary $ 2,625,000 $ 2,625,000Bonus 0 0Stock Awards 41,833,309 5,919,015Option Awards 28,620,000 1,599,827Non-Equity Plans 11,250,000 11,250,000Change in Pension 45,793 45,793All Other 141,206 141,206

Total $ 84,515,308 $ 21,580,841

Options Original Grant Strike Value (1/4) Notes1/31/2006 3,171 $41.48 0 out of the money5/29/2007 491,400 $43.86 0 out of the money

6/4/2008 521,739 $35.26 86,087 $35.92 on 6/4/20106/3/2009 458,015 $22.70 1513740 $37.00 on 6/3/2010

Restricted Shares Original Grant Value (1/4)9/11/2006 287,242 $ 2,424,322 $33.76 per share

Performance Units1/1/2007 113,796 $ 3,494,675 $30.71 per unit

2009 Reported Earned

Salary $ 2,500,000 $ 2,500,000

Bonus 0 0Stock Awards 12,688,932 1,869,227Option Awards 5,999,997 0Non-Equity Plans 12,540,000 12,540,000Change in Pension 37,911 37,911All Other 243,150 243,150

Total $ 34,009,990 $ 17,190,288

Options Original Grant Strike Value (1/4) Notes

1/31/2005 1,465 $47.10 0 out of the money1/31/2006 3,171 $41.48 0 out of the money5/29/2007 491,400 $43.86 0 out of the money6/4/2008 521,739 $35.26 0 out of the money

Restricted Shares Original Grant Value (1/4)9/11/2006 287,242 $ 1,869,227 $26.03 per share

Source: Viacom, Forms DEF 14A, filed Apr. 30, 2007, Apr. 18, 2008, Apr. 17, 2009, Apr. 16, 2010, and Jan. 21,2011 with the SEC.


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Exhibit 4

Summary Statistics: Total CEO Compensation, Various Methods

Mean Compensation (2010)

Decile

Market

Capitalization

(in millions)

Summary

Compensation

Table

Institutional

Shareholder

Services

Expected

Value

Earned

Value

Highest $ 39,982 $ 14,130,597 $ 17,595,544 $ 13,181,418 $ 12,018,347

7,132 7,904,858 9,911,257 7,380,223 7,034,703

3,375 6,037,811 7,781,580 5,879,114 5,229,651

2,079 4,646,368 5,760,233 4,547,047 3,910,954

1,326 3,872,349 4,833,941 3,888,635 3,377,383

863 2,877,698 3,642,764 2,862,030 2,444,539

585 2,520,118 3,038,112 2,512,779 2,124,444

378 1,988,675 2,563,376 2,126,550 1,768,966246 1,516,684 1,836,673 1,570,411 1,282,740

Lowest 143 1,160,671 1,405,679 1,238,572 1,029,749

Median Compensation (2010)

Decile

Market

Capitalization

(in millions)

Summary

Compensation

Table

Institutional

Shareholder

Services

Expected

Value

Earned

Value

Highest $ 22,522 $ 12,220,817 $ 15,312,751 $ 11,210,876 $ 9,218,322

6,895 6,932,325 8,878,721 6,763,005 5,696,422

3,257 5,245,581 6,669,452 4,837,471 3,799,896

2,061 4,046,318 5,006,225 3,942,680 3,046,327

1,312 3,093,924 4,024,939 3,159,052 2,437,328

853 2,360,580 3,129,763 2,328,114 1,873,891

574 2,074,024 2,574,915 2,073,491 1,700,898

372 1,415,159 1,894,097 1,577,976 1,200,413

241 1,190,955 1,411,867 1,226,952 976,996

Lowest 149 858,204 1,045,605 865,041 794,706

Sample includes 2,471 companies with fiscal years ending between June 2010 and January 2011. Summary

Compensation Table data represents the total value of compensation as reported in the annual proxy. InstitutionalShareholder Service data reflects total compensation under ISS methodology. In particular, ISS calculates the valueof stock option grants using the full term (generally ten years) rather than an abbreviated term. Expected and earnedcompensation values are calculated using the methodologies discussed earlier, with earned stock option value basedon intrinsic value.

Source: Equilar compensation data. Calculations by the authors.

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What Does It Mean for an Executive to Make 1 Million