Fair Pay Fair Play

Fair Pay Fair Play Plot Summary

Introduction

Executive compensation has become a lightning rod for controversy, especially in the wake of financial crises and perceived excesses in corporate America. While media coverage often focuses on outliers—astronomical pay packages that seem disconnected from performance—the true issue lies deeper in the systematic misalignment between executive pay and shareholder value. This misalignment undermines the fundamental relationship between corporate leadership and owners, eroding trust in the capitalist system itself. Fair pay is about more than just reining in excessive compensation; it requires establishing a clear, defensible framework for determining what executives should earn based on their performance relative to peers and market conditions. The key insight developed through extensive research and analysis of over 44,000 cases of executive compensation reveals that proper alignment—where executives are paid appropriately for the value they create—serves everyone's interests better than the current patchwork of ad hoc decisions, conventional goal-setting approaches, and compensation systems that inadvertently reward short-term gains at the expense of long-term value creation.

Chapter 1: The Misalignment Problem: Performance and Pay

The relationship between executive compensation and company performance has long been contentious, but pinpointing the exact nature of the problem has proven elusive. Contrary to popular belief, median executive pay levels are not inherently problematic. The real issue lies in alignment—ensuring that compensation varies appropriately with performance relative to relevant markets and industry standards. When examining compensation data across thousands of companies over fifteen years, a striking pattern emerges: approximately two-thirds of the data points fall outside what could reasonably be considered an "Alignment Zone"—the range where pay properly corresponds to performance. This means that most companies are either overpaying for underperformance or underpaying for superior results, creating fundamental inequities in the system. Alignment failures take several recognizable forms. "Compensation Flatliners" show little sensitivity between pay and performance—executives receive similar compensation regardless of results. "Compensation Riskseekers" demonstrate excessive pay variability, with compensation soaring above reasonable bounds when performance is strong. "Compensation Doglegs" maintain high pay despite performance declines. "Compensation Highfliers" consistently pay above market regardless of results, while "Compensation Lowliers" systematically underpay even when performance excels. These misalignment patterns stem from five fundamental design flaws: aggressive target pay positioning, turbo-charged incentive leverage, conventional goal-setting approaches, short-term focus, and mechanisms that flatten the relationship between performance and rewards. Additionally, two decision-making dynamics—ad hoc interventions and human biases—further amplify these design weaknesses. The impact extends beyond individual companies. Misalignment erodes trust in corporate leadership, invites government intervention, creates unnecessary controversy, and ultimately represents a failure of the system to deliver fair compensation for true value creation. The challenge lies in developing objective, transparent methods to evaluate and establish proper alignment.

Chapter 2: Measuring True Performance: Total Shareholder Return

Total Shareholder Return (TSR)—stock price appreciation plus reinvested dividends—provides the most comprehensive indicator of executive performance from the owners' perspective. TSR reflects everything management does to create value over time and serves as the ultimate scorecard for those entrusted with shareholders' capital. This metric effectively captures the company's financial performance, strategic positioning, operational excellence, and future prospects. Analysis shows that median cash earnings growth and median TSR track closely over time, confirming that when executives improve financial performance, they generally improve stock price. While not a perfect relationship, this correlation strengthens over longer periods as market inefficiencies even out. TSR also incorporates the effect of risk-taking, which became painfully evident during the 2008 financial crisis when institutions that appeared successful collapsed due to unrecognized risks. When properly measured over multi-year periods, TSR reflects not just current performance but the sustainability of that performance—the ability to create enduring value rather than fleeting gains. However, using TSR as the primary performance measure requires important contextual adjustments. Since TSR varies significantly with broader market conditions (the S&P 1500 median three-year TSR has ranged from -7% to 22% in different periods), and industry factors (technology companies show greater TSR variability than utilities), these external influences must be accounted for when evaluating executive performance. A "portfolio approach" provides the most balanced assessment. This involves examining absolute TSR over long periods as the primary measure, while considering relative performance against peers, industry benchmarks, or broader indices to isolate management's contribution from market factors. Strategic measures that indicate the sustainability of future performance—customer satisfaction, operational achievements, employee engagement, and appropriate risk management—further complete the picture. This comprehensive approach to performance measurement maintains the primacy of shareholder value while recognizing that TSR alone, without proper context and complementary indicators, provides an incomplete evaluation of executive effectiveness.

Chapter 3: Calculating Performance-Adjusted Compensation

Traditional approaches to executive compensation analysis often focus on target pay—what companies intend to pay executives before performance happens. However, this provides an incomplete picture that fails to capture what executives actually receive for the performance they deliver. Performance-Adjusted Compensation (PAC) fills this critical gap by measuring the actual value delivered to executives after performance occurs. PAC represents annualized total compensation over three-year rolling periods, including salary, actual bonuses earned, the Black-Scholes value of stock options granted during the period (valued at the end of the period based on actual stock price), the value of restricted shares granted, performance shares earned and vested, long-term cash incentives paid, and benefits provided. This methodology separates compensation gains from investment gains, measuring pay to the executive rather than wealth accumulated through ownership. By analyzing PAC across the S&P 1500 companies over fifteen years, several important patterns emerge. Company size strongly influences compensation, with a 30% correlation between revenue and pay—larger companies generally pay more due to greater complexity, scarcity of executives with large-company experience, and higher economic impact of leadership decisions. The pay gap between CEOs and other named executive officers has remained remarkably consistent, with secondary executives typically earning one-third to one-half of CEO compensation. The risk profile of executive pay has increased significantly over time. In the mid-1990s, approximately 60% of PAC was variable; more recently, that figure has risen to 70%. The composition of long-term incentives has shifted dramatically from predominantly stock options to a more balanced mix of options, restricted stock, and performance shares. This evolution partly resulted from tax code changes (IRC Section 162(m)) that eliminated deductibility for non-performance-based compensation above $1 million, inadvertently encouraging greater use of incentives and ultimately contributing to higher overall compensation levels. PAC allows shareholders, boards, and executives to analyze whether actual pay outcomes align reasonably with performance results. Without this perspective, companies operate with significant blind spots in their compensation systems, unable to determine whether their stated goal of "aligning pay with performance" is being achieved in practice. This measurement provides the foundation for objective alignment analysis that can guide better compensation decisions.

Chapter 4: The Alignment Zone: Setting Fair Pay Standards

Nearly every public company states in its proxy materials that a primary objective of its compensation system is to align executive pay with performance. Yet few companies define precisely what this alignment means or how it should be measured. Important questions remain unaddressed: What constitutes performance? Over what time period? How should performance be measured—absolutely or relatively? What happens when alignment conflicts with other objectives like talent retention? The Alignment Zone concept provides a structured framework to answer these questions. It defines aligned pay as compensation that fluctuates with Total Shareholder Return (TSR) within an acceptable range compared to the relevant market over time. Rather than prescribing a single "correct" pay level for a given performance outcome, the Zone acknowledges that reasonable compensation can fall within a range, reflecting both market observations and typical incentive structures. The upper and lower boundaries of the Alignment Zone establish the realm of reasonableness. Pay that exceeds the upper boundary for a given level of TSR falls into the "Upper Alignment NOzone," where executives receive a better deal than shareholders. Pay below the lower boundary enters the "Lower Alignment NOzone," where shareholders get a better deal than executives. Analysis shows approximately equal numbers of companies in each NOzone, though public attention focuses primarily on Upper NOzone cases. Empirical analysis of nearly 50,000 data points reveals that only 49% of the variance in CEO compensation can be explained by company size, industry group, and performance combined. Company size accounts for 30% of the variance, industry group explains 11%, and TSR explains just 8%. This limited correlation between pay and performance confirms investors' concerns that alignment, not absolute pay levels, constitutes the primary problem in executive compensation. The Alignment Zone acknowledges both the empirical market relationships between pay and performance and the leverage inherent in typical executive compensation programs. While the observed market relationship between pay and performance is flatter than what typical incentive programs would theoretically produce, the Zone encompasses both, providing a balanced standard that respects market realities while promoting proper alignment principles. This approach allows compensation committees to exercise professional judgment within reasonable boundaries, avoiding both excessive rigidity and unlimited discretion—a practical middle ground that can satisfy both shareholder expectations and the need for compensation systems tailored to specific company circumstances.

Chapter 5: Calculating Performance-Adjusted Compensation

Traditional approaches to executive compensation analysis often focus on target pay—what companies intend to pay executives before performance happens. However, this provides an incomplete picture that fails to capture what executives actually receive for the performance they deliver. Performance-Adjusted Compensation (PAC) fills this critical gap by measuring the actual value delivered to executives after performance occurs. PAC represents annualized total compensation over three-year rolling periods, including salary, actual bonuses earned, the Black-Scholes value of stock options granted during the period (valued at the end of the period based on actual stock price), the value of restricted shares granted, performance shares earned and vested, long-term cash incentives paid, and benefits provided. This methodology separates compensation gains from investment gains, measuring pay to the executive rather than wealth accumulated through ownership. By analyzing PAC across the S&P 1500 companies over fifteen years, several important patterns emerge. Company size strongly influences compensation, with a 30% correlation between revenue and pay—larger companies generally pay more due to greater complexity, scarcity of executives with large-company experience, and higher economic impact of leadership decisions. The pay gap between CEOs and other named executive officers has remained remarkably consistent, with secondary executives typically earning one-third to one-half of CEO compensation. The risk profile of executive pay has increased significantly over time. In the mid-1990s, approximately 60% of PAC was variable; more recently, that figure has risen to 70%. The composition of long-term incentives has shifted dramatically from predominantly stock options to a more balanced mix of options, restricted stock, and performance shares. This evolution partly resulted from tax code changes (IRC Section 162(m)) that eliminated deductibility for non-performance-based compensation above $1 million, inadvertently encouraging greater use of incentives and ultimately contributing to higher overall compensation levels. PAC allows shareholders, boards, and executives to analyze whether actual pay outcomes align reasonably with performance results. Without this perspective, companies operate with significant blind spots in their compensation systems, unable to determine whether their stated goal of "aligning pay with performance" is being achieved in practice. This measurement provides the foundation for objective alignment analysis that can guide better compensation decisions.

Chapter 6: Root Causes of Misalignment and Their Solutions

Misalignment between executive performance and pay typically stems from five fundamental compensation design flaws and two decision-making amplifiers that exacerbate these problems. Understanding these root causes is essential for developing effective solutions that restore proper alignment. The first design flaw, aggressive target pay, occurs when companies deliberately position executive compensation above market norms regardless of performance, either through explicit policy, peer group manipulation, problematic analytics, or implicit practices like special awards. This practice creates Compensation Highfliers who consistently overpay relative to performance. The solution lies in adopting 50th-percentile pay positioning strategies, scrutinizing peer group composition, understanding analytical methodologies, and using alignment reports to verify actual pay positioning. Turbo-charged upside refers to incentive plans providing outsized rewards for above-market performance, including extreme risk-oriented pay mixes, highly leveraged incentives, uncapped awards, and "big hit" opportunities. These designs turn companies into Compensation Riskseekers or Doglegs by creating excessive upside potential without corresponding downside risk. Solutions include modeling the full range of potential outcomes before implementation and establishing clear philosophical agreement on how downside scenarios will be handled. Conventional goal-setting approaches frequently produce misalignment by focusing on internal budgets rather than shareholder expectations or competitive benchmarks. The "mark-to-budget" process typically aims for motivational targets with high probability of achievement rather than performance levels that would generate competitive returns for shareholders. Shifting to "mark-to-shareholder" approaches that start with required performance to deliver competitive TSR, complemented by externally contextualized benchmarks, significantly improves alignment. Short-term orientation creates misalignment when executives can harvest substantial rewards before the sustainability of performance is proven. The typical executive compensation package has an effective time horizon of just three years, insufficient for aligning with long-term shareholder interests. Solutions include narrowing the window period for stock options, extending vesting schedules, implementing clawbacks, requiring stock retention beyond vesting, and establishing meaningful ownership guidelines. Flattening the curve occurs when companies make a series of decisions that reduce pay sensitivity to performance, creating Compensation Flatliners. The solution involves analyzing alignment reports to identify how program design and ad hoc decisions dampen performance sensitivity, then implementing changes to strengthen this relationship. These design problems are amplified by two decision-making influences: ad hoc interventions outside established compensation plans and human biases in the decision-making process. Addressing these requires establishing clear boundaries around discretion, tracking discretionary decisions, and creating awareness of common biases like asymmetric performance attribution, peer comparison tendencies, and false assumptions about retention risks.

Chapter 7: Creating and Maintaining Alignment Through Fair Play

Achieving sustained alignment between executive performance and pay requires more than analytical frameworks; it demands the development of a compensation culture and decision-making processes that consistently produce fair outcomes. These fair play practices transform alignment from an aspiration to an operational reality. The foundation begins with philosophical clarity. Compensation committees must engage in deep discussions about their definitions of alignment, addressing questions like: What constitutes fair pay for median versus exceptional performance? How should discretion be bounded? Does alignment trump retention in priority? These discussions should yield explicit principles that guide decisions, particularly during challenging periods when the temptation to deviate from alignment principles intensifies. Disciplined program design follows this philosophical grounding. Companies should construct compensation programs with appropriate pay mix, incentive leverage, performance measures, and time horizons to maintain alignment across various performance scenarios. Particularly important is how goals are established—the shift from "mark-to-budget" approaches (focused on internal targets) to "mark-to-shareholder" frameworks (focused on external performance required for competitive returns) represents a fundamental reorientation toward alignment. Process discipline proves equally critical. Ad hoc decisions outside established programs frequently undermine alignment, often in the name of retention or responding to exceptional circumstances. Companies committed to alignment establish clear parameters around discretion, require formal analysis of how potential decisions impact alignment before implementation, and systematically track discretionary interventions over time to identify problematic patterns. Human factors require explicit attention. Decision-making biases—like attribution bias (crediting executives for successes while blaming external factors for failures), peer comparison tendencies, and false assumptions about retention risks—significantly impact alignment. Effective compensation committees develop awareness of these influences and design processes to counteract them, including independent analysis, diverse perspectives, and formal examination of assumptions. Transparency and accountability complete the alignment ecosystem. Regular use of alignment reports allows compensation committees to visualize how their decisions affect the relationship between performance and pay over time. Making this analysis available to shareholders and board members promotes accountability and facilitates more productive conversations about executive compensation. Companies that consistently maintain alignment typically demonstrate several common characteristics: they operate from clear principles rather than reactive positions; they apply disciplined analysis before making exceptions; they recognize the dangers of precedent-setting decisions; and they commit to transparency about the relationship between performance and pay over extended periods.

Summary

The fundamental premise that executives should be paid based on how well they perform for shareholders represents both a simple concept and a profound challenge. While nearly every company proclaims alignment between executive pay and performance as a core principle, the evidence reveals pervasive misalignment—approximately two-thirds of companies fall outside reasonable alignment parameters. This disconnect arises not from malicious intent but from subtle, cumulative decisions that gradually erode the relationship between performance outcomes and compensation. Fair Pay requires more than just getting the numbers right; it demands Fair Play—the development of compensation philosophies, design approaches, and decision processes that consistently produce aligned outcomes. The Alignment Zone concept provides a practical framework for evaluating whether executive compensation falls within reasonable bounds relative to performance, while still respecting the legitimate differences between companies and industries. By addressing the root causes of misalignment—from aggressive target pay to conventional goal-setting to ad hoc decision-making—companies can establish compensation systems that truly deliver on the promise of paying for performance. The result benefits all stakeholders: shareholders receive appropriate returns on their compensation investment, executives receive fair rewards for genuine value creation, and the legitimacy of the broader economic system is strengthened through demonstrable fairness in how corporate leaders are compensated.

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Robin A. Ferracone

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