Executive Compensation – Underpaying the Best, Overpaying the Rest?

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Despite good intentions, executive compensation in industrials is rarely linked to value creation. Key questions can help corporate governance develop more equitable performance incentives.

Over the last five years, average compensation of the CEOs of 1,244 publicly listed industrial companies has reached $5.8 billion, growing at a compound annual growth rate of 6 percent. Has this growth been a fair representation of the shareholder value created?

To answer this question, we developed the Fernweh Executive Compensation Index (FECI), which measures the efficacy of a company’s CEO compensation plan based on its link to shareholder value creation, and calculated the index for CEO compensation packages at the 1,244 companies we studied. Only a quarter of CEOs have compensation packages aligned with shareholder value creation, while another quarter are underpaid and the majority are overpaid. The most likely to be underpaid are high-performing CEOs and CEOs of smaller companies.

Further analysis shows five main causes of the misalignment with shareholder value creation: (1) across CEO compensation packages, there is a regression to the median; (2) targets are too easy to differentiate high performers; (3) long-term incentives are skewed toward annual, not performance-based, elements; (4) adjustments to compensation targets are not linked to financial performance; and (5) high performers are compensated only incrementally more than average.

Corporate governance can realign executive compensation with value creation by rethinking the process and challenging the status quo. After shining a light on shortcomings of the current executive compensation framework, we offer a framework for approaching the task with an eye on fairness and shareholder value creation.

Fernweh Executive Compensation Index

Industrial companies promote a compensation philosophy anchored around common principles aimed at attracting the best talent and reinforcing the link with shareholder value creation. They aim to achieve that by applying a framework with three main components: a base salary, short-term incentives, and long-term incentives. Long-term incentives combine a mix of time-based incentives (restricted stock units and stock options granted annually) and performance-based incentives (performance stock units granted based on meeting the goals in a performance plan).

Despite companies’ best intentions, the Fernweh Executive Compensation Index (FECI) highlights that executive compensation in industrials is rarely linked to value creation with 51% of CEOs compensated more than the value they generated and 24% being underpaid (Exhibit 1). We also found that underpaid executives are not evenly distributed, but they are most likely to be found among top performers and among companies with revenues less than $5 billion.

Exhibit 1

Leading causes of the disconnect with shareholder value creation

Analyzing in detail the compensation packages of the 1,244 CEOs, we found five main causes of the weak link with shareholder value creation:

  • Regression to the median: Across CEO compensation packages, there is significant variation, both in total amount and structure. However, when we look at CEO compensation packages by subsegments and revenue clusters, we find regression to the median, with CEOs’ compensation packages looking increasingly similar within each cluster or subsegment. The strongest pattern emerges when we categorize compensation packages by company size: compensation packages are consistently larger for larger companies, and long-term incentives are a greater share of compensation at larger companies. Perhaps most notable, however, is how little compensation varies within revenue clusters (Exhibit 2). Pay is closer to average for the cluster than performance differences would account for. Most CEOs earn within plus or minus $1.5 million.
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Exhibit 2

  • Underwhelming targets: We also have observed that a large number of CEOs are achieving their target compensation and more, so we pressure-tested whether this is driven by outstanding performance or enabled by easy-to-achieve targets. We found that during the 2016–20 period, only 17 percent of the companies in our sample posted returns above the industrial S&P 500, but almost half of the CEOs exceeded their target compensation (Exhibit 3).

Exhibit 3

This is driven by the common practice of setting targets as incremental improvements relative to the previous year’s performance, rather than based on the true full potential a company could achieve.

  • Long-Term Incentives That Are Significantly Time Based: At the highest level, a heavily performance-based plan would include a significant share of performance stock units; however, we don’t see this happening. On the contrary, we see that long-term incentives are heavily skewed toward time-based elements, totaling 31 to 47 percent of total compensation. This diminishes the weight of performance-based incentives.
  • Arbitrary Annual Adjustments: Each element of a CEO’s compensation package is adjusted every year. In a pay-for-performance culture, we would expect target CEO compensation packages to evolve in line with the company’s intrinsic performance. However, at the companies in our analysis, annual adjustments to target compensation were unrelated to the most important performance metrics, such as total shareholder returns, EBITDA growth, and free cash flow.
  • Inadequate Compensation of High Performers: The top performers—the CEOs of companies that outperformed the S&P 500 industrials over the 2016–20 time frame—received only ~7% more than CEOs who achieved positive returns but below the sector benchmark (Exhibit 4). Even CEOs who moved their companies to top-quartile performance earned payouts that were in line with the average.

Exhibit 4

To bring CEO compensation at industrial companies into alignment with value creation, corporate governance ought to consider three questions: What is the right absolute target compensation? What is the right structure? And how should we measure performance?

Answering these questions will require careful analysis of the company’s starting point, an understanding of its true potential, and recognition of the transformative effort required to achieve that. Company governance may be tempted to revert to benchmarking and set targets as incremental improvements versus previous years. Virtuous ones, however, will do the hard work required for linking compensation to value, which offers the double benefit of protecting shareholder value and rewarding their CEOs fairly.

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