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- [00:03]
Kurt Nickish
You're listening to Is Business Broken, A podcast from the Merotra Institute for Business Markets and Society at Boston University Questrom School of Business. I'm Kurt Nickish. These last few episodes we've been talking about executive compensation, how it's set, how company boards craft those incentives, and how shareholders perceive the pay packages and weigh in on them. For this episode, we're exploring some of the big questions that researchers are tackling today, like how much of CEO pay is driven by luck? Have these pay packages gotten too complex? And are CEOs being fairly rewarded or punished for the risks they take? Our guests today are Anna Albuquerque, associate professor of accounting at BU Questrom School of Business, and Charlie Tharp, professor of the Practice at BU Questrom. Anna and Charlie, thanks for being here.
- [01:03]
Anna Albuquerque
Thanks for having me.
- [01:05]
Charlie Tharp
Thank you.
- [01:06]
Kurt Nickish
So we've learned over the first two episodes on this topic that A, executive compensation has gotten so high in large part because of the complexity that CEOs have to manage today. It's a lot harder job than it used to be. B, we've learned that pay packages have themselves grown increasingly complex with a complicated mix of short and long term incentives. What has driven this rise in complexity in the pay packages themselves?
- [01:34]
Anna Albuquerque
Well, my co authors and I actually analyzed this issue and what we found is that in the process of boards writing efficient contracts, directors try to appease institutional investors and proxy advisors and try to avoid any type of controversies. And so as a result, what we see is pay packages that become too complex because the board is trying to make sure that if proxy advisors now want certain provisions in the contract, those provisions will be there to avoid any type of negative scion pay. Actually, there has been some research recently where a survey done by Edmonds and all at LBs where they find that 65% of the directors are are actually willing to sacrifice firm value that may result from having compensation packages that are not fully aligned with the interests of shareholders just to make sure that they avoid any type of controversies. Also, they also find that about 70% of directors indicated that proxy advisors influenced pay more than what they should.
- [02:56]
Kurt Nickish
I mean, reading these, it's almost like a whole bunch of if then statements, right? It gets really complicated. It reminds you a lot of how complex just a contract for a joint venture gets. Because what if this happens? Let's put it in what if this happens? Let's put in a safeguard for that and all of a sudden it just becomes this very complicated giant thing that feels extremely transactional. Almost. Right? Absolutely. Charlie, you've lived this and you Teach this is that kind of a fair picture of how pay packages have gotten so complex?
- [03:30]
Charlie Tharp
So compensation packages have been increasing in complexity over time, which in certain respects, as Anna pointed out, reflects the complexity of companies. But I would say it also reflects the complexity of the external influences on compensation. You know, tax law has a tremendous impact on the design of compensation. The other is accounting. But I think the major influence on complexity has been the general trend in companies, public companies, to move from a strictly shareholder centric model of the company to stakeholder model. There are a lot of different stakeholders who have an interest in the company's performance, not just company value, as the Edmunds analysis focused on, but in terms of reputation, in terms of the impact on the community, the diversity of the workforce, a variety of issues that have resulted in performance metrics that are much more complicated than just stock price or profit, and the forms of pay, which are both annual and long term to avoid what's often criticized as short termism, and also to provide skin in the game for executives that they're aligned with shareholders through the stock program. But just the final point I'd make on that, there's a difference between complexity and purposeful complexity. And I think the challenge for companies, their boards of directors, is to ensure that the complexity that's being built into compensation programs for executives that really are purposeful in terms of the strategy of the company, the talent that they need to attract, and which stakeholders they really want to appeal to through the communication of the different pay programs.
- [05:29]
Kurt Nickish
How long have these contracts gotten? Like, how many pages are we looking at?
- [05:35]
Anna Albuquerque
Proxy statements have become very long. I don't know. Well, it depends on the font, right?
- [05:41]
Kurt Nickish
Yeah. Some of your research I saw show that a lot of shareholders just can't read them all, right? They don't like, they only get a certain way through. And the portion that people are reading is actually going down with this complexity.
- [05:53]
Anna Albuquerque
Yes, yes.
- [05:55]
Kurt Nickish
Let's talk about some of the motivations for crafting these pay packages the way they are. And one common Critique is that CEOs get compensated for lucky events. So if you're at the crest of a rising market, if it's a boom time, stock values are gonna go up and CEOs are essentially gonna benefit because they were at the right place at the right time, not because of anything they did. Who's making this critique and what is the substance of this pay for luck argument?
- [06:27]
Charlie Tharp
There's a lot of academic literature on this, and to be honest, that's true. Just as companies are impacted by luck Was there a tariff on their industry? Did the raw material go up or down? Did their consumer group change their for different purchases? So luck has a lot to do with most things in life, including company performance and correspondingly, executive pay. But the argument often waged against compensation for executives under the thought that it has a lot to do with luck is that so much of executive pay is in the form of stock equity. And as you might imagine, one of the biggest influences on the value of a company stock is what the overall market does during the 2009 recession following the financial meltdown. If you were performing well, your stock probably still went down. But having said that, that is probably not a bad thing because you want executives interest to be aligned with shareholders. And if the stock's going up, why wouldn't they benefit? And if the stock's going down, their compensation would be less valuable.
- [07:43]
Kurt Nickish
Anna, what got you interested in researching that and what did you find?
- [07:47]
Anna Albuquerque
Yeah, so what got us interested in doing research on that is that it's really hard to distinguish whether there is pay for luck or pay for the CEO to act upon luck. So, you know, if the stock performance goes up and it goes up for everyone, is the CEO getting compensated maybe with more performance shares, for example, or was the CEO compensated because he had the far sight to see that the market was going up and it took certain actions to benefit the company from riding that positive wave?
- [08:26]
Kurt Nickish
Got it.
- [08:27]
Anna Albuquerque
So what we did it was we looked at a setting which is changes in real estate prices. And we saw whether the CEO was rewarded for luck in real estate prices or for taking actions that increase shareholder value. And so what we find is that what we found it was that CEOs that acted upon that luck, for example, by doing a sale and lease back or by taking some financing that was at lower cost because now collateral was higher. Those CEOs were rewarded for taking those actions. So we actually refined that. The pay for luck is actually pay for action.
- [09:13]
Kurt Nickish
Interesting. So is there anything about this issue that's still problematic? Is there something more that boards should be doing to ensure that CEOs are rewarded based on their actual contributions rather than external factors beyond their control? Or is it set up pretty well as it is right now?
- [09:32]
Anna Albuquerque
So what we have seen is that in the last 10 years is that companies have adopted more and more, what it's called relative performance evaluation, which is when companies are deciding on maybe the number of shares to award a CEO, they look at the stock performance of the firm relative to that of a peer group. And if the Firm stock performance is higher than the median, then the CEO is awarded some stock, for example. And so the use of relative performance evaluation, which is something that proxy advisors have pushed quite significantly for, has increased substantially. So we see that in our analysis that the number of firms adopting what it's called as rp, has increased substantially. And that is a way to not only insulate the CEO against negative shocks that affect all firms within the industry, but also avoid that CEOs are compensated for just good luck.
- [10:35]
Kurt Nickish
Okay, so RP being relative performance evaluation. Yeah. And so the idea being that if, you know, rising tide is lifting all boats, have you been able to lift your boat a little bit more than everybody else around you? That's what you're looking at.
- [10:50]
Anna Albuquerque
That's what you will be compensated for. And also, if stock performance is bad, but not as bad as that of the peers, you still get rewarded because you did a little bit better than your peer group.
- [11:05]
Kurt Nickish
So how do boards select those companies? Is it just. Is it your competitors?
- [11:09]
Anna Albuquerque
Yeah, that is a good question. So usually companies have two sets of groups that they rely on. One is a set of group to benchmark performance. And those companies tend to be peers or competitors that are within the same industry. Because peers that are within the same industry are exposed to some supply chain disruptions. Exactly. So they are exposed to the same type of economic shocks. Another factor is companies in selecting the peer group for performance evaluation purposes is size. And the reason for that is that if you are a Coca Cola really large company, the way you are going to weather some of the economic shocks is very different from a very small beverages firm. So size and industry tend to be the primary criteria to select peers to benchmark the performance. Now, there is another group that companies also rely on, which is called the compensation peer group. And those peers are firms that the board relies on to figure out how much to pay the CEO for their talent.
- [12:30]
Kurt Nickish
Why would that be different than your industry peers?
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Anna Albuquerque
Right. So that can be different because if you are the CEO of a Coca Cola, maybe you could also be the CEO of another large company. If you look for example, to the compensation peer group for Merck, you not only see some companies like Eli Lilly, but you also see companies like IBM, Walt Disney, Boeing Annual being part of the compensation peer group. So what the board is trying to figure out is what are other CEOs at the helm of other companies that have kind of similar talent, that maybe exhibit kind of some level of leadership, have had past performance that is similar to our company. So it's a Bit more broad than just sticking to the industry.
- [13:25]
Kurt Nickish
Yeah. In one of your studies there was an example of the CEO Vidal Sassoon, sort of a hair care cosmetic company, essentially appear for that role was the CEO of Starbucks, who gets paid a lot more. And there was some criticism of that, but there's a rhyme and reason to that.
- [13:44]
Anna Albuquerque
There has been a lot of research on that and debate on that. Where the companies tend to pick peers for self serving purposes just to justify paying more to their CEOs.
- [13:55]
Kurt Nickish
Got it. And this is partly just to justify why they're trying to get the person that they got essentially.
- [14:00]
Anna Albuquerque
Right. It's an open question, right? Like are they picking larger peers to just justifying paying more to their CEOs or are they picking peers that actually have talent that it's similar to that of your CEO?
- [14:13]
Kurt Nickish
It's very, it's. Yeah, it's very debatable.
- [14:15]
Anna Albuquerque
It's very debatable. I actually have work on data and we found that once you control for the past performance of the CEOs and the visibility of the CEOs, actually we see that the vast majority of the companies that are picking larger peers is because they feel that the CEO talent is similar.
- [14:34]
Kurt Nickish
Interesting. Let's talk about another balance that's really hard to strike and that's risk taking. Right. You want a CEO to take risks, justified ones. You don't want them to coast. You also don't want them running wild out there and cavalierly taking high risks that aren't prudent. You're trying to reward the right kind of risk taking. Do you think that the way compensation packages are set up right now, that chief executives are fairly compensated for taking good risks?
- [15:07]
Anna Albuquerque
Yeah. So that is interesting. And that is hard to measure. So in a recent paper, my co authors and I have taken advantage of exact granular contract details available to us, which are fairly complicated because as Charlie mentioned before, CEOs get not only a salary, a cash bonus, but long term incentive plans, equity options. And so we looked at, for example, in looking at the bonus, we look at the thresholds, minimum maximum threshold. We try to simulate future performance for not only stock price measures, but also accounting measures. And so through this simulation we find that CEOs get about 14% more of pay to compensate them for the volatility, the expected volatility of their pay packages. Now is that too little or too high? So from what we know from other academic studies, it seems that 14% is actually surprisingly low to what our expectation was.
- [16:26]
Kurt Nickish
Yeah, that's interesting. What the research finds. Charlie, in practice, do you see that as well?
- [16:32]
Charlie Tharp
Yeah, in practice, there is a significant focus on risk. And in fact, starting after 2009, following the financial meltdown, the compensation committee of the board must assess and then they disclose the extent to which the compensation arrangements are reasonably likely to cause an adverse impact to the company due to excessive risk.
- [17:00]
Kurt Nickish
I love that term, reasonably likely. Right. That's just. That's the classic judgment call language.
- [17:06]
Charlie Tharp
Well, actually, yeah, it's language from the securities and Exchange Commission, which kind of rests between remote, not going to happen and probable. They use that as a term of art, often that it's not reasonably likely. And so what do companies do? Incentive plans have a maximum payout. Most of them are 200% of target because you can imagine if they were uncapped and you could earn as much money, you'd be encouraged to take as much risk as possible. Secondly, you tend to have ownership requirements. You can pump the stock and do whatever if it's risky. Most executives have to own six times their salary in shares they actually own, can't sell. So if you do things to take excessive risk, you're going to live with that as a shareholder. And then finally, the balance of long term and short term pay having different performance metrics, those are all risk mitigating actions that companies take to prohibit excessive risk. It doesn't address the question, are executives paid proportionally for risk? That's the variability. But then the final tool they have is called a clawback. Companies can take back whatever an executive earns if in fact their actions expose the company either to a restatement of earnings or if they had material reputation harm. So I think there's a lot of safeguards against excessive risk. But I agree with Ana. It's very hard to quantify if the risk inherent in the executive pay programs are commensurate with the personal risk an executive might take in terms of the variability of their pay.
- [18:59]
Kurt Nickish
Yeah, that's really interesting. Are the benchmarks used to measure performance then? Are they too easy to achieve?
- [19:13]
Anna Albuquerque
There is also, I know of an academic paper that looks at that. If the performance metrics were too easy to achieve, then you would see CEOs being compensated for those. In this study, the author looks at that and actually does not find evidence that targets are just too easy because in many cases the target is not achieved, which is a way to test that. But to also, also to your point on, does the CEO have a say or an opportunity to influence the target? So, yeah, we do see sometimes performance metrics that are adjusted or are known GAAP numbers. Right. Where maybe certain expenses are excluded from the metrics, whether that is acceptable or justifiable or not. It's maybe open for discussion. But the board does spend a lot of time thinking about these issues. They are non trivial. Right. And again, everything is open. There are no hidden metrics per se. You go and figure out what did the firm disclosed on the 10k, you do the adjustment yourself and you figured out what the number should be. So there is a lot of transparency.
- [20:39]
Kurt Nickish
Yeah. So let's talk about complexity. Do you believe that these kind of highly complex contracts, it sounds like, are beneficial the way they are or problematic in the sense that they're like a concoction of a lot of different incentives, a lot of levers. There's a reason for it, but it also makes it harder to understand and it makes it harder for the executives to act too. In some ways, they have to understand and act with all of those incentives. Have they gotten too complex for their own good?
- [21:14]
Anna Albuquerque
That's a great question. Executives are used to make very complex decisions every day.
- [21:21]
Kurt Nickish
That's why they're there.
- [21:22]
Anna Albuquerque
That's why they are there and they are paid the big bucks. And my co authors and I, we pose that question. Is it the case that more complex contracts have maybe a negative impact versus a simpler contract?
- [21:37]
Kurt Nickish
And that is like. Or there's a movement in legal contracts, right, to make it more relational and less transactional and to have it be simpler, a little bit less specific, allowing for more changes and adjustments as things go along, rather than trying to set everything in stone and foresee every possible possibility.
- [21:58]
Charlie Tharp
You know, I'm always reminded of the Einstein quote that everything should be as simple as practicable, but never simpler. So I think there is a little rethinking and I think we're going to see more questions on that in the coming years.
- [22:11]
Kurt Nickish
And what did you find out in your research?
- [22:14]
Anna Albuquerque
In our research, what we did. So first we developed a measure of complexity. And what we did it was we basically looked at the number of performance metrics that companies include, the number of different time horizons, the different components of PI, as well as whether the performance metrics had relative performance conditions or not. For each company or CEO contract, we assigned a complexity measure. And so after developing that, we do find that complexity has increased substantially through time. And then we looked at what were the consequences of that. And so what we find is that CEOs that have more complex contracts actually perform poorly compared to CEOs that have simpler Compensation contracts. And a possible reason could be that if you have a very complex contract with performance metrics that maybe go against each other, so you have maybe earnings per share, but you also have another metric that is related to sustainability investment, and the result of that investment is going to occur in the future, but is going to probably have a negative impact on earnings per share today. And so you have this conflicting metrics. At the same time, if you have a contract that has many performance metrics, like in a balanced scorecard, the CO could have incentives to focus on the ones that are easier to achieve. So those are maybe some of the reasons why we see the results that we see. But interestingly, one thing that we also did was looking what if a compensation contract is very complex with many performance metrics, but they are highly correlated? So we find that when the performance metrics are highly correlated, then we do not see the negative impact or the negative association with having a complex contract and the poor performance, because it's kind of, you have different signs, but they are all pointing towards the same direction. So the CEO, by optimizing a performance metric or taking actions to increase a performance metric, is increasing all of them. So in those instances, if the contract is written in such a way, we don't find a negative impact for complex contracts.
- [24:43]
Kurt Nickish
Okay, so to sum it up, the research suggests that the complexity works well if it's done well. And if it's a bad complexity, it's not going to work well.
- [24:55]
Anna Albuquerque
Exactly. And actually it kind of guiles towards the point of what Charlie mentioned before. What did you say?
- [25:02]
Kurt Nickish
Purposely complex.
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Anna Albuquerque
Purposely complex.
- [25:03]
Charlie Tharp
Exactly.
- [25:04]
Anna Albuquerque
And also, you know, it's also going back to the external factors influencing complexity. If the board is just adopting certain performance metrics like esg, that it might not make sense for that particular company just because everyone is doing it. Or if the board is adopting relative performance metrics when there is not a good peer group to benchmark the firm's performance just because everyone is doing it or because proxy advisors are putting a lot of pressure that the firm does it. So in those instances is also when we might see some of those negative implications of complexity.
- [25:46]
Kurt Nickish
I want to ask a little bit about your research and the future of your research. It's clear, Anna, from reading your studies that your research depends heavily on financial reporting, Right? Just as an example, the Dodd Frank act of 2010 requires disclosures of performance benchmarking. And you study that data to come to the conclusions that you have. That's just one example of how transparency helps shareholders. But it also Helps researchers figure out what's actually happening. Are you concerned in the current climate that we're entering or are in now of financial deregulation that you're going to lose access to some of this or that the benefit of that transparency is going to be clouded somewhat?
- [26:31]
Anna Albuquerque
I think it would be very hard to take away the information that it's already available to investors and the public in general. I think it would be very hard to claim like now we no longer required companies to provide information about or detailed information about CEO pay packages or executive pay packages.
- [26:53]
Kurt Nickish
I mean, there's the red tape argument that it's too much bureaucracy and it's too. And it's costly, it costs companies and they shouldn't be be burdened with this.
- [27:00]
Anna Albuquerque
Yeah, that is interesting because at the same time investors value that information. So it could be the case that yes, it's very costly, but investors value that information. Companies might do it anyhow because they see a benefit reflected in the stock price.
- [27:18]
Kurt Nickish
Essentially, investors will be more likely to invest in your company, buy your stock because you are sharing that data.
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Anna Albuquerque
Exactly, exactly.
- [27:27]
Kurt Nickish
Okay.
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Charlie Tharp
Yeah. There probably is an area where in fact that might change and it's the amount of information companies currently disclose on things like diversity in esg, which is often incorporated in incentive plans. And you'll probably see less of that now given the current political environment.
- [27:46]
Kurt Nickish
Okay, Anna, like what gets you excited about this field today? What's your hope for what research helps uncover and inform in the years to come? Like where do you want to see more research done and what are you interested in in this area?
- [28:03]
Anna Albuquerque
One thing that we are also looking at is, for example, we mentioned that proxy advisors have a big impact on compensation. Right.
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Kurt Nickish
They've helped make these pay packages complex and they're a big part of that.
- [28:17]
Anna Albuquerque
Yeah, yeah. Because institutional investors usually follow the advice of proxy advisors. Right. Whatever they recommend, institutional investors might follow their advice. So they have a big voice. And is it what they are recommending? Is it good or bad for incentives? I think it's an open question. Executives have a huge impact on firms performance and the lives of many employees. So making sure that we have contracts that provide them with incentives to improve the life of employees and the community in general is very important and that gets me excited about what I do.
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Kurt Nickish
That's great. Charlie, what are you looking forward to?
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Charlie Tharp
Yeah, I agree with Ana that it is an exciting time and to see what changes in terms of the relative impact of these various influencers. Be it proxy advisors, be it more of the agenda oriented investors who care about either gender, pay equity or the environment, how that's all going to evolve. But I'm a total optimist, as you probably gathered from my remarks, that with some fine tuning, which I think it does need, I think the model so far of corporate governance and executive pay has led to some pretty tremendous growth in the economy and the value to different environments, investors and pension funds. And I think that hopefully will only get better. That's what makes me optimistic.
- [29:53]
Kurt Nickish
Well, I've really enjoyed learning about this. Anna and Charlie, thank you so much.
- [29:57]
Anna Albuquerque
Thank you.
- [29:58]
Charlie Tharp
Thank you.
- [30:01]
Kurt Nickish
That's bu questrom Professors Anna Albert Kirke and Charlie Tharp. Next week we have one one final episode on executive compensation. How do those pay packages affect the work culture at the companies? What's the impact of those disparities and pay inequality within firms? That's next week. To get that episode and more, please follow the show on Apple Podcasts, Spotify or wherever you listen. Thanks for listening to Is Business Broken? I'm Kurt Nickish, SA.