Executive pay is a touchy but misunderstood subject

Editor’s note: This post originally appeared in The Financial Times on August 2, 2015.

Executive compensation is closely scrutinised by politicians and public investors. Oracle, the software company, was criticised last year for paying its three top executives more than $35m each.

Yet public reports of executive pay have often been misunderstood because they include accounting estimates of contingent compensation that may never be received. As such, I welcome the recent proposal from the SEC, the US financial regulator, that would mandate the reporting of pay actually received by corporate executives.

The key differences between accounting-based compensation and actual compensation is down to stock awards, restricted shares and stock options, which most companies (including Oracle) award their top executives.

These differences are caused by two main factors. First, stock-related awards are often subject to vesting conditions. Options may vest only after the executive has been in office for a specified number of years, or the stock-related awards might be tied to company performance.

As such, the estimated value of the compensation assigns a probability to these conditions being met, but this estimate will be far off the actual compensation if these conditions are not met.

Second, there may be a significant change in stock price between the time it is granted and the time of receipt of stock-related compensation. If the stock price is higher than the assumption, the actual compensation earned will be higher than the estimate. Conversely, the executive could actually earn far less than the estimate if the stock underperforms.

Let us take a simple example to illustrate how actual compensation can differ from accounting estimates. Company X awards 100,000 shares of restricted stock to its chief executive when the share price is $1 per share; 25,000 of these shares will vest each year over the next four years, but only if Company X’s revenue growth exceeds 7 per cent during that year.

The company may value these restricted shares at $75,000 at the time it is granted, assuming the earnings meet the target in two of the four years and that the share price rises to $1.50. However, the chief executive might end up earning zero if growth never exceeds 7 per cent. Or the package could be worth $400,000 if earnings surge ahead every year and the stock price zooms up to $4.

Similarly, Company Y awards its chief executive 100,000 stock options when its shares are trading at $1 per share. The options have an exercise price of $1 per share; they vest after 4 years and expire 10 years after being granted. 

The value of these options might be $30,000 at the date they are granted. However, the range of compensation the chief executive actually receives can vary significantly. If the stock price stays the same or declines for 10 years, those options will be worth zero. If the stock price rises to $2 in the fourth year, the chief executive could exercise the options to realise an income of $100,000.

The difference is clearly significant.

Canada and Australia require disclosure of all components of executive pay on the date it is granted, similar to the current US model. In contrast, the UK has adopted an approach much like the one proposed by the SEC, providing information both when compensation is awarded and when it is earned.

Elsewhere, detailed compensation reporting is not universally required; it is optional in some countries in the EU. Reporting may be required for company directors only, which means that there may not be data for highly paid executives who do not sit on the management board. And regulations may not be specific, giving companies considerable leeway on what needs to be reported and when.

In short, regulators in all countries should clarify who is covered by their disclosure rules on executive compensation, and how exactly stock-related awards should be reported under their rules. Moreover, regulators should follow the lead of the SEC in requiring public companies to report the actual compensation received by their top executives each year. Such reports will help public investors better assess whether the actual compensation of top executives reflects the actual performance of their companies in a given year.