It’s easy to be angered when looking at some of the outrageous figures corporate executives are paid.
- Tim Cook, CEO of Apple Inc. (NASDAQ:AAPL): $4.2 million
- Michael Corbal, CEO of Citigroup Inc (NYSE:C): $11.5 million
- Indra Nooyi, CEO of PepsiCo, Inc. (NYSE:PEP): $12.6 million
But as shareholders, we should care less about how much managers are compensated – but rather how they’re paid.
Incentives matter
A good pay package should encourage managers to run companies correctly, to consider the long term and avoid taking excessive risks. But in many cases, compensation schemes not only fail to achieve that goal but actually encourage destructive behavior.
For example by linking pay to profits, managers can juice returns by writing risky sub-prime loans and leave before the defaults occur.
Or executives can increase profitability by scrimping on research and development spending.
This may benefit the share price in the short term, but only at the expense of the company’s long-term health.
Solutions
However, there are some possible solutions to this problem.
Pay them in debt: Many executive compensation plans are just stock and cash, but many would benefit by paying managers in debt as well. This structure will significantly reduce risk taking because managers have less upside from risky bets and are exposed to the downside.
Equity investors may wonder why they should consider the interests of debt holders. But paying CEOs in debt results in fewer restrictive covenants and lower interest rates on loans. Ultimately, that saves shareholders money.
Make them wait: Lengthen the time executives must wait to cash in their shares and options. Too many compensation packages only lock in pay for one to two years which encourages short-term thinking. Pay packages should be extended to encourage managers to consider the long-term implications of their decisions.
How long? That depends on the nature of the business. Industries that operate on long cycles, like pipelines and pharmaceuticals, should lengthen pay packages as far out as seven to 10 years.
Positive developments
Fortunately, shareholders are aware of this problem and are starting to make their voices heard in the boardroom.
Last February, Apple Inc. (NASDAQ:AAPL) shareholders pushed for major compensation reform.
Back by activists like David Einhorn and the California Public Employees Retirement System, shareholders passed an amendment that requires executives to hold a greater amount of stock. The amendment is an effort to get them to think less like employees and more like owners.
Executives are now required to hold three times their base salary in stock. CEO Tim Cook is required to hold 10 times his salary in shares.
In February, disgruntled Citigroup Inc (NYSE:C) shareholders pushed for major changes to the company’s executive compensation program.
In 2011, the bank was criticized for paying executives at the discretion of the board of directors. After the amendment, bonuses are calculated based on a formula that incorporates share price performance relative to peers and the company’s return on assets. While the formula isn’t perfect, it’s a major improvement to the scheme that was in place before.
