By Kevin O’Farrell, CHRP, Crekof Inc.
The most recent edition of The Economist presents a valiant and fair attempt to shed light on the complex area of executive pay (“Neither rigged nor fair” –July 1, 2016). As the title suggests, it both condemns and condones current practices as they have evolved to define the current state; one where shareholders, even when they can, rarely reject excessive pay packages; where Boards and Compensation Committees dutifully allow self-selected peer-company benchmarks to justify “market rates” and senior executives and CEO’s in particular come to believe that their infallibility and indispensability command astronomical rewards, even when they and/or their companies have performed unexceptionally, poorly, or even in some cases, illegally.
Beyond the plausible reasons to explain how we got here, the fundamental inescapable disconnect comes from the construct of the pay packet itself: Annual base pay is stable; short-term incentive pay and long-term incentives (usually the promise of increased value of stock options) provide some semblance of variability that may represent foregone earnings in lean times, but never result in a true correction, recalibration or resetting of a new, lower overall value.
When a company’s stock price or the market in general undergoes a correction the full price is simply reset downwards. There are no safeguards or floors. There is a true downside, not just a diminished upside. If this principle were to be applied to executive compensation, fundamental levels would be re-established periodically (based on factors that could include stock price) such that market and peer company comparisons could become meaningful and relevant again.
Otherwise senior pay will simply continue to spiral upward in a lock-step, self-fulfilling manner, thereby exacerbating the gaps in CEO/average workers pay ratios and fueling the perceptions and reality of increasing and unsolvable societal inequalities. This is no longer just a compensation issue. Institutional investors and Boards need to move this item to the top of their governance and risk-management agenda.