Too Much of a Good Thing

Originally posted June 2009.

We saw an interesting paper that was highlighted in an article called “Incentives for the Long Run: An Executive Compensation Plan That Looks Beyond the Next Quarter” Published: May 27, 2009 in Knowledge at Wharton. Being strong supporters of longer-term outlooks for executive compensation structure, we were eager to see what this paper was all about.

The article notes that “In a working paper titled, “Dynamic Incentive Accounts, [Wharton finance professor] Edmans, along with Xavier Gabaix and Tomasz Sadzik of New York University, and Yuliy Sannikov of Princeton University, outline a system that escrows compensation for a set period of years stretching into the executive’s retirement.” If you read the academic paper and didn’t entirely understand its complicated formulas, you are in good company because it wasn’t all clear to us either. But in a nutshell, the paper suggests that executive compensation structure could be better if it:

1) Links pay to company performance (check)
2) Rewards long term sustained performance (check)
3) Requires the executive to retain significant stock ownership even after retirement to avoid the attempt to artificially inflate the stock price just before the executive retires. (Hmmm, the jury’s still out on this one as far as we are concerned.)

But, wow! If you include the ability for the executive to diversify his portfolio after achieving a certain level of stock ownership, you have most of what Grahall’s Michael Dennis Graham outlined in his 2008 book entitled “Effective Executive Compensation”. In fact, Chapter 13 specifically deals with what they call “grahall Performance Based Wealth Accumulation and Retention Program” (gPB-Warp). At its core, gPB-Warp is a plan that links an executive’s long-term wealth accumulation to performance above the average of the company’s direct competitors, a stock index or both of these.

We are delighted that the professors find this approach compelling. We would be even more excited if their sophisticated equations and proofs were a bit more comprehensible. But we certainly feel better knowing that the professors have created equations that support this common sense approach to compensating executives, and we hope you do too.

Let me share a bit more about gPB-Warp. It has several key criteria:

1) gPB-Warp is a performance-based incentive, in fact incentives are paid only when executives provide incremental value to shareholder above the mean or appropriate index (or both). It is incremental performance that truly benefits shareholders, and this is what executives should be paid for. Structuring pay for that level of performance is what gPB-Warp is all about. It is about NOT paying executives for average or below average performance.

2) gPB-Warp is “super long term”. It is career based and normally continues until the executive’s retirement. Therefore it is structured to cover more than the length of the average business cycle. Under this approach, executives can’t make money based solely on “buy low and sell high” trading that takes advantage of the natural ups and downs of the American economy or the industry’s normal cycle.

3) gPB-Warp requires investment in company stock up to a certain predetermined exposure or amount of wealth that vests in 7-10 years. As the executive approaches retirement then he or she can diversify out of a portion of that investment held in company stock.

This last item, diversification out of company stock, is where our approach deviates from the Professors’. To some, diversification might seem contrary to the goal of having a CEO’s wealth tied closely to that of the company’s performance. But we believe that CEOs can sometimes play it too safe. This is a radical comment we know in today’s environment where excess risk on the part of some executives resulted in far-reaching economic problems. But hear this out: If a CEO has too much at stake his company’s own stock and is nearing his retirement, might it not be in his best interest to avoid risk — even appropriate risk — if he might not be around to benefit from the longer term outcomes? And wouldn’t that be counterproductive to the shareholders and the company as a whole?

We do not prescribe gPB-Warp for everyone, because we are of the firm belief that “one size does not fit all” when it comes to executive compensation structures. However, we would not be surprised if more and more companies find that at least some of the provisions of gPB Warp could help them structure effective compensation programs to help meet their needs now and in the future.

Contact us and let us help you structure your CEO compensation so that it is balanced and beneficial to shareholders.