HBR Blog Network
Who Should Actually Have Say on Pay?
by Justin Fox | 8:00 AM May 30, 2013
season at American corporations. What shareholders have been saying, in
overwhelming numbers, is yes! At 74% of the 1,471 companies that
have voted so far in 2013, according to Equilar's
say-on-pay tracker, the "yes" percentage exceeded 90%. That's up from
69% in 2012 and 2011. Only 31 companies (2%) have gotten sub-50%
no-confidence votes in 2013.
One key reason for
shareholders' positive tone is that the stock market has been doing well.
Since say-on-pay hit the U.S. in 2011 (it was part of the
Dodd-Frank Act), academic researchers have found that the chief
determinants of how shareholders vote appear to be (a)
stock performance, and (b)
the voting recommendations of proxy-voting advisors ISS and Glass-Lewis,
which are based in part on returns to shareholders over the previous three
years. To a large extent, say-on-pay — which was introduced in the UK in
2002 and has spread to several other countries,
most recently Switzerland — is a simple exercise in bandwagon-following.
That's not all
it is, though. The size, growth, and design of paychecks do play into both
the voting recommendations from ISS and Glass Lewis and
the votes of shareholders. There is
evidence that say-on-pay votes have led British companies to make
executive paychecks more sensitive to poor performance. Say-on-pay votes
do have an impact. The question is, what kind of impact?
Say-on-pay is part
of a big shift in recent years toward giving professional money managers
more tools to affect the governance of (and in some cases discipline the
managers of) corporations. Most of these theoretically increase the power of
individual investors, too, but for the most part individuals aren't a factor
in corporate elections. Professionals
appear to control somewhere around 60% of the shares of American
corporations, and have an even higher percentage of the vote in
corporate elections. (Individual investors tend not to vote, and while
brokerage firms used to vote the shares of customers who didn't get around
to voting themselves — almost invariably siding with management — the
SEC stopped allowing that practice three years ago.)
changes is a widespread belief that more needs to be done to hold CEOs and
boards accountable. That's understandable. But it's far from clear that
professional money managers have what it takes to play the role of effective
watchdog. When it comes to executive pay in particular, these people are a
deeply compromised bunch.
In the latest issue
of the Journal of Economic Perspectives,
economist Burton J. Malkiel argues that most of the gigantic growth in
asset-management-industry profits since 1980 "is likely to represent a
deadweight loss for investors." His reasoning,
as I discussed in an earlier post, is that active money managers as a
group underperform the market indices and that, while active management does
play a key role in setting stock market prices, there's no evidence that
today's gigantic active management industry is doing that job any better
than its much smaller precursor of three decades ago. American corporations
outside the financial sector may have many flaws, but I'm pretty sure their
increase in profits over the past few decades hasn't been a "deadweight
loss" to the economy.
What's more, the
asset management industry — in particular the alternative-asset subset of
hedge funds and private equity — has exported many of its pay practices into
the corporate sector. The idea was to get away from paying CEOs "like
bureaucrats," as Michael C. Jensen and Kevin J. Murphy urged in a
famous 1990 HBR article. It was a successful campaign: CEO paychecks
came to consist mostly of stock options.
This shift to
financial-markets-based compensation had some of the promised impact — CEOs
become less risk-averse (bureaucrat-like) in their decision-making. But
it also inflated what Mihir Desai
has dubbed a "giant financial incentive bubble". In Desai's telling:
cannot be relied upon in simple ways to evaluate and compensate
individuals because they can't easily disentangle skill from luck.
Widespread outsourcing of those functions to markets has skewed incentives
and provided huge windfalls for individuals who now consider themselves
entitled to such rewards. Until the financial-incentive bubble is popped,
we can expect misallocations of financial, real, and human capital to
Say-on-pay has done
nothing to deflate this bubble; executive pay
has kept going up in the U.S. and UK. Which makes sense — most asset
managers have a shared interest with CEOs in keeping top-of-the-scale
paychecks high. If we wanted to have a real impact on executive pay
levels, we should probably have employees vote.
While highly paid
hedge fund and mutual fund managers set the tone for the CEO-pay discussion,
though, they do not as a rule get involved in the details of pay packages
and say-on-pay votes. Instead, they mostly outsource the decision-making to
Glass Lewis and ISS. The people who set the
guidelines at these two firms are not paid like CEOs or hedge
fund managers, and lots of thought and empirical research go into their
They have, however,
bought into the argument that the main metric of executive performance
should be shareholder returns and that most executive pay should be in the
form of stock. They're supposed to represent shareholder interests, so this
seems logical. But beyond the compensation bubble that stock-based
pay has helped create, its incentive effects are also potentially perverse.
As Roger Martin argued in his book
Fixing the Game, stock prices are all about (often incorrect)
expectations of future earnings. Linking top executives' pay to stock prices
thus rewards them more for creating high expectations than for running their
company well. With banks there's an even bigger problem: shareholders
provide only a tiny percentage of their funding, and are thus motivated to
encourage risk-taking that endangers depositors and taxpayers. So paying
bank CEOs mostly in stock is a
recipe for a financial crisis.
The proxy advisers
do attempt to counteract these forces somewhat, by frowning upon stock and
option grants that aren't linked to other performance metrics. But it's not
clear that their approach yields better results. One
recent study by David F. Larcker, Allan L. McCall, and Gaizka Ormazabal
found that the stock market reacts negatively when companies adjust
their compensation policies to adhere to the proxy advisory firms'
recommendations. I'm not convinced that really proves anything one way or
the other, but I do think the current state of knowledge about the impact of
executive pay on corporate performance is muddled enough that standardizing
pay practices to conform with what ISS and Glass Lewis think is best is
probably a bad idea. Sometimes a board of directors will have a better sense
than the stock market or a proxy advisory firm of how well a CEO is
performing. Do we really want to make it impossible for boards to exercise
It's not that
say-on-pay is necessarily a disaster. Unlike
some other corporate-governance reforms, it hasn't imposed major
regulatory burdens on anybody (public corporations were already holding
annual shareholder votes), and for the vast majority of companies it has
been a nonissue. The votes are non-binding, and there's at least a chance
that they're changing pay practices for the better.
But it's worth
remembering that the explosion in American executive pay over the past three
decades coincided with and was in part driven by an increase in shareholder
clout. It may be that shareholders just had the wrong tools in the past, and
say-on-pay will allow for a more surgical approach to governing CEO
compensation. It's also at least possible, though, that the shareholders
have been the problem all along.
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