Executive compensation has been a point of emphasis within many companies for decades. Scrutiny from shareholders, the media, and the general public makes executive compensation a particularly complex issue. As the conversation around executive pay grows louder, due to reasons including growing income disparities and the financial certainty brought about by the coronavirus crisis, FCLTGlobal will undertake new research on the impacts of long-term CEO compensation. An essential step of the research process is seeking insights from experts who have conducted work in this area for many years. In that spirit, we recently spoke with Robert (Bob) Pozen, a Senior Lecturer at the MIT Sloan School of Management, and a non-resident Senior Fellow at the Brookings Institution. He is a former president of Fidelity Investments and executive chairman of MFS Investment Management.  

FCLTGlobal: Bob, let’s start by talking about your article, Decoding CEO Pay, in Harvard Business Review. You reveal a noteworthy pattern in that article: companies commonly “adjust” their accounting performance away from the GAAP standard and, when they do, it tends to result in the CEO’s performance appearing better relative to her or his metrics. What implications does this have specifically for long-term companies and long-term investors? 

Bob Pozen: Long-term investors want accurate measures of how companies are doing, like revenue or earnings, because they buy or sell stock based on their views about how companies’ businesses will perform over time rather than how short-term numbers may move stock prices. However, you can only do that if you have understandable information about the company’s business. 

The market uses GAAP as a basis for this comparison, and when companies deviate from this standard, it is critical to know exactly how they deviate and why they are using it instead of the standard measures. Often the compensation disclosure and analysis section of proxy statements is hard for investors to understand because companies – about 80-90% of companies in the S&P 500 – use non-GAAP measures, many without fully explaining their adjustments. 

A few years ago, the Council of Institutional Investors (CII) submitted a proposed solution to the SEC asking that the SEC to take the same position on compensation reports as it does on earnings releases. Specifically, under the proposal, when companies use a non-GAAP metric, they would have to reconcile to GAAP and include a rationale for why the non-GAAP measure is the better option.  

We know that some companies in the S&P 500 do already reconcile to GAAP in appendices to their proxy statements. This practice has gained popularity since the CII’s request to the SEC, with 30% of companies in the S&P 500 reconciling to GAAP in supplementary reports. These companies demonstrate how this practice is feasible to execute. 

FCLTGlobal: You suggest in the article that “the most problematic exclusions are expenses for grants of restricted shares or stock options.” Why is that most problematic, and does it remain true when considering specifically the perspective of long-term investors and companies? 

Bob Pozen: Long-term investors should be very interested in the expenses that are accrued for stock options and restricted shares, as well as how these expenses are reflected in the criteria the compensation committee is using to determine an executive’s performance. By excluding these expenses, we are returning to an old argument. In the past, tech companies argued that stock options are not expenses, however, to a shareholder they are. Stock options have dilutive effects that are very expensive and to exclude them is to look at CEO compensation as if they did not actually receive stock compensation. 

FCLTGlobal: You have made the short-term nature of these practices very apparent. At least two separate behaviors are involved: the adjustments of accounting figures themselves and also the board compensation committee’s use of these figures. Is the first step toward longer-term behavior to change the quantitative adjustments or to address the governance culture that permits this? 

Bob Pozen: The two are quite interrelated. Management teams announce their earnings every quarter, and 90% of companies announce non-GAAP numbers. Compensation committees recognize that these are the numbers emphasized by management. This results in an implicit continuity of figures. Change would result in a discontinuity of accounting performance: in effect, the compensation committee would be disagreeing with management publicly. 

My focus is to get the adjusted and GAAP accounting performance figures reconciled in the compensation disclosure and analysis section of proxy statements, with an explanation why the committee favors these adjustment metrics. Investors can then decide whether the adjusted metrics better reflect the company’s long-term performance.  

FCLTGlobal: Your “Decoding CEO Pay” article also critiques the way that companies measure CEOs’ performance relative to peer groups. Is peer-group benchmarking necessary for long-term companies and investors to evaluate the performance of their executives? If so, in what ways might long-term investors focus on improving peer-group construction? 

Bob Pozen: I believe companies need both peer groups and internal benchmarks. Institutional shareholders are still interested in relative stock price, and the best way to measure this is to have a peer group. However, peer groups currently tend to be biased towards larger market-cap companies with higher paid executives. Compensation committees need to better justify the peer group that they use, paying close attention to market cap and level of CEO pay.  

FCLTGlobal: Thank you for your time and insight today. Let’s conclude with one broader question. The Business Roundtable recently revised its statement of corporate purpose to emphasize a stakeholder approach. What implications does that have for our conversation about CEO pay? 

Bob Pozen: Long-term investors must decide for themselves if they are in favor of the stakeholder approach. Part of that will involve discerning whether this statement is merely a public relations effort or a true policy change.  

Some companies want to consider stakeholders like employees and customers, because keeping them happy will increase shareholder value in the long-term. This is an instrumental view. Other companies, especially in the evolving ESG regime in Europe, aim to do well by their employees and promote the environment because those policies would be better for society. These are two very different approaches, and most investors are likely to favor the instrumental view.  

The  objective  of FCLTGlobal’s  work  is to  identify provisions  that are  useful for any  organization’s  compensation planning, and  that can be put in place  independent of any regulatory change that may occur.  It is our hope that  investors, boards, and executives will view new provisions as balanced and  capable of driving  real, tangible  impact.   If you are interested in learning more about FCLTGlobal’s research on compensation, please contact Matt Leatherman, Research Director.