3rd annual AYS study: Overpaid execs produce poor returns

In the midst of this year's proxy season, the recurrent debate over CEO pay has vigorously resumed.  But as we've previously touched upon, widening income inequality throughout the world is intensifying scrutiny and prompting renewed demands to rein in CEO compensation.  High-levels of CEO payouts are typically justified as necessary to attract and retain highly competent executives in an intensively competitive marketplace.  You get what you pay for, after all.  Moreover, shareholders by and large have seemed reluctant to oppose paying top dollar for executives, CEOs and other named executives, so long as they are perceived to have delivered adequate returns.  Are a significant proportion of CEOs overpaid and how can such instances of excessive compensation be determined?

Jumping into the fray, and not pulling any punches, As You Sow, backed by the Steven Silberstein Foundation and the Roy and Patricia Disney Family Foundation, among others, recently released its third annual report investigating the interrelationships among CEO pay, company performance and institutional investors' oversight.  The report is provocatively entitled: THE 100 MOST OVERPAID CEOs: Are Fund Managers Asleep at The Wheel?  The report opens by citing the Economic Policy Institute's assertion that, "CEO pay grew an astounding 943% over the past 37 years, greatly outpacing the growth in the cost of living, the productivity of the economy, and the stock market, disproving the claim that the growth in CEO pay, reflects the 'performance' of the company, the value of its stock, or the ability of the CEO to do anything but disproportionately raise the amount of his pay."

As You Sow forcefully makes the case that there is a pervasive and growing problem of misalignment among executive pay and performance, in some instances "devastating" shareholder returns and owing predominantly to certain institutional investors "failing in their fiduciary duty".  Although representative of a sizable portion of the corporate governance community, the report's wide-ranging findings and conclusions are not all necessarily endorsed here.

The report purportedly highlights the "100 most overpaid CEOs" of S&P 500 companies and the corresponding votes of major shareholders on their pay packages.  The report finds that executive pay continued to increase last year.  The report commends some mutual funds and pension funds for "doing better at exercising their fiduciary responsibility by more frequently voting their proxies against some of the most outrageous CEO pay packages."

The report again asserts that the system in place to govern corporations has failed in the area of executive compensation.  Like all the best governance systems, the report notes, corporate governance relies on a balance of power.  That system envisions directors representing shareholders and guarding the company's assets from waste.  It also envisions shareholders holding companies and executives accountable.

The governance system, the authors recall, comes from a time when it was assumed that unhappy investors would simply sell their stakes if sufficiently dissatisfied with the governance of a company.  It reflects a time when there were fewer intermediaries between beneficial owners and corporate executives.  However, today more and more investors own shares through mutual funds, often investing in S&P 500 index funds.  Individual investors are not in a position to sell their stakes in a specific company.  The funds themselves are subject to a number of conflicts of interest and to what economists refer to with the oxymoronic-sounding term "rational apathy," to reflect the expense of oversight in comparison to a pro rata share of any benefits.

Today, the report contends, those casting the votes on the behalf of shareholders frequently do not represent the shareholders' interests.

The report maintains that CEO compensation as it is currently structured does not work; rather than incentivize sustainable company growth, compensation plans increase increase disproportionately by every measure.  Too often CEOs are rewarded for mergers and acquisitions instead of improving company performance.  As noted in the Financial Crisis Inquiry Report, "Those [compensation] systems encouraged the big bet - where the payoff on the upside could be huge and the downside [for the individual executive] limited.  This was the case up and down the line - from the corporate boardroom to the mortgage broker on the street."  The authors note that the downside, which could include such features as environmental costs, may be limited for the individual and instead born by the larger society.

Paying one individual excessive amounts of money can lead people to make the false assumption that such compensation is justified and earned, the authors continue.  It undermines essential premises of capitalism: the robust 'invisible hand' of the market as well as the confidence of those who entrust capital to third parties.  The report alleges that confusing disclosure coupled with inappropriate comparisons are then used to justify similar packages elsewhere.  These systems perpetuate and exaggerate the destabilizing effects of income inequality, and may contribute to the stagnating pay of frontline employees, the report posits.

As the report is now in its third year, the analysts look back to see what happened to the companies in our report two years ago. We've been saying the most overpaid CEO's under-deliver for shareholders.  In examining this data from the following two years of the report, the analysts find dramatic results - not only does the group of most overpaid CEO companies of the S&P 500 underperform the S&P 500 by 2.9 percentage points, but the firms with the 10 most overpaid CEOs underperformed the S&P 500 index by an "amazing" 10.5 percentage points and actually had a negative return, reducing the actual value of the companies' shares by 5.7 percent.  In summary, according to the report, the firms with the most overpaid CEO's devastated shareholder value since our first report published in February 2015.

Shareholders now supposedly have the right, since the enactment of the Dodd-Frank financial reform act, the report notes, to cast an advisory vote on compensation packages.  However, in today's world, most shareholders have their shares held and voted by a financial intermediary.  This means that this critical responsibility is in the hands of a fiduciary at a mutual fund, an ETF, a pension fund, a financial manager, or people whose full-time job is to analyze the activities of the companies they invest in and monitor the performance of their boards, their CEOs, and their compensation.

A key element of the report was to analyze how mutual funds and pension funds voted on these pay packages.  This year the list of funds looked at was vastly expanded.  In response to excessive and problematic CEO pay packages, it should be noted that every fund manager has the power to vote against these compensation plans and withhold votes for the members of the board's compensation committee who created and approved them.  In some cases, institutional should request meetings with members of the compensation committees to express their concerns.  Institutional investors should be prepared to explain their votes on executive pay to their customers, and individuals should hold their mutual funds accountable for such decisions by expressing their displeasure directly to those that are also well compensated to protect and represent them.

Again this year, directors who serve on the compensation committees of these boards did not escape the keen eye of the AYS analysts.

If readers would excuse the length of this post, as it will serve as a ready reference for this point of view regarding executive pay v. performance.