Human Capital & Careers

Executive Pay Prognosis: Marginal Change

The market for senior management pay is likely to keep compensation up—even in the face of more disclosure.
David KatzJune 27, 2006

Despite the growing outcry from institutional investors about the size of senior management pay packages and the increased scrutiny from regulators worried about cloudy reporting, there won’t be a sea-change in compensation structures any time soon, experts say.

Instead, board compensation committees may make a number of changes at the margins. They might, for instance, insert a range of performance metrics into their stock-option plans, particularly by linking option grants to operational gauges like cash flow. In order to allay concerns about unmerited pay, directors could choose to curb supplemental executive pension plans, severance payouts, and travel perks. And they might even choose to close the gap between chief executive pay and that of other top managers where it is yawning.

But the economics of the top-end labor market are too deeply entrenched for there to be large-scale cutbacks in what top management is paid, says Ira Kay, Watson Wyatt’s global director global of compensation consulting. “The executives have enormous labor-market power because they can leave and get higher paying jobs elsewhere,” he says. “The boards are truly terrified that executives are going to leave, [and] it wreaks enormous economic havoc when they do leave.”

Further, while the Securities and Exchange Commission’s proposed rules aimed at improving executive-pay disclosure pay might give shareholders and creditors a better grasp of corporate comp structures, they may have little effect on pay levels themselves. To be sure, the rules would encourage companies to provide “a more complete discussion of how executive pay is set,” including the metrics that they use, says Ken Bertsch, a managing director at Moody’s Investors Service.

Oft-cited benefits of the SEC’s proposal are that it would require companies to include in their proxies a total pay figure comprising all compensation and a discussion-and-analysis section. Those elements “should make it somewhat more easy to spot outliers and hidden pay,” according to Bertsch. But corporations can still muddy their reporting by, for example, providing laundry lists of their criteria for awarding bonuses without giving meaningful information, he adds.

Nevertheless, Moody’s itself is putting pressure on corporations to avoid what may be excessive pay packages—pressure that could in itself spur changes if other rating agencies follow suit. Last week, the rating service issued its first definitive report on what it regards as the credit implications of executive pay structures. Bertsch, who said that Moody’s move was not related to the current options back-dating scandal, noted that the reason it issued its report was that it was asked to “provide a broader context” for executive comp risks in its corporate governance assessments.

The rating agency sees three areas of executive comp that pose special credit risks: the use of both stock options in themselves and the employment of earnings per share and total shareholder return as options performance metrics. All three can move a company to buy back shares rather than keep the cash within the firm, thereby increasing its risk of nonpayment to creditors, Bertsch explains. That’s true even though issuing options rather than paying out cash compensation can increase cash-flow in the near term, because options and share-price metrics can move executives to much higher levels of cash-squandering, according to Moody’s.

The rating agency also favors using multiple performance metrics — it seems to have a particular taste for operating cash flow and free cash flow — rather than relying on a single measuring rod for incentive payouts. While that approach can lead to an overabundance of complexity, a pay structure focused “on just one dimension of success is more likely to be gamed,” according to the Moody’s report.

Watson Wyatt’s Kay sees an ongoing wrangle between boards and institutional investors in terms of the performance metrics each group favors in option structures, with investors hooked on EPS and directors more mindful of operating metrics. “Investors just want stock prices to go up, and stock is a blunt instrument,” he says. For their part, while directors care about maintaining a high share price, they favor applying “more surgical tools.”

In its report, Moody’s says it keeps a close watch on the difference between chief executive compensation and the pay of other top executives. Too hefty a divergence could signal the existence of an “imperial CEO” and a company too dependent on a single person, says Bertsch. While a company that pays its chief executive officer twice what it pays its next highest earning manager would be adhering to the norm, the company would get a rater’s attention if it paid the CEO five times more, he added.

The Moody’s director says his firm doesn’t tend to single out CFO pay for much scrutiny because the title is too “malleable” in terms of the job functions it can include. Still, “it has jumped out a few times where the CFO has been paid extremely well,” he says, adding that “it would raise eyebrows if it were the controller.”