Prodding a CEO with a Deep Pay Cut
13/07/2012
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Recent research by H. Gao, J. Harford, and K. Li, published in the Journal of Finance, studied large decreases in CEO remuneration as a response to poor performance.  It found that sharp pay cuts often serve as a substitute for outright dismissals, and that boards use extreme reductions in pay as a way to motivate underperforming managers.

The researchers found that more than twice as many CEOs are subjected to sharp pay cuts as are forced out. The result is typically beneficial to both sides: Company performance improves, and the CEOs remain at the helm with their remuneration eventually restored.

The researchers analyzed more than 3,000 U.S. companies, and focused on CEOs who were in office for at least three years from 1994 through 2005. To isolate extreme pay cuts, the researchers identified 927 CEOs whose remuneration was slashed at least 25 percent from the previous year, and who had not received a pay boost that previous year of more than 25 percent. In other words, the drastic cuts in the sample were not routine fluctuations in pay or adjustments following a spike in remuneration.

The researchers matched that database to another covering the same period that tracked instances in which CEOs were fired or pressured to retire or resign. There were 388 instances of such terminations, suggesting that pay cuts could be a more frequently-used corrective method by boards.

The median cut in the sample was US$1.2 million from the prior year, which translates into an average decline in remuneration of 46 percent. After controlling for company, industry, and CEO characteristics, the authors found that most of the reduction came in the form of smaller awards of stock and options. In the sample, the CEOs experienced a median reduction of 60 percent in equity-based pay but only a 12 percent cut in salary and bonuses. While US equity grants are typically labeled long-term incentives, most have not had performance-contingent vesting, which means they are more akin to fixed pay, so the absence of a grant is like a cut in fixed pay. This US method would be more difficult to apply in the Australian context.  In Australia, equity grants generally have vesting that is performance contingent, so pay outcomes are “automatically” aligned with performance outcomes.  Unlike the US, a message is not typically sent to the CEO in cases of more extreme underperformance by docking pay via not giving an equity grant.  This may explain, in part, why the proportion of CEOs who are sacked for poor performance is higher in Australia than in the US.  (Another reason is that Australian boards are typically chaired by an independent chairman, rather than the CEO.)

Next, the researchers examined why the boards decided to slash the CEO’s pay, and found that the reasons were similar to those for forced terminations. Not surprisingly, cuts were more likely to occur following poor company performance — especially in the stock market. But the authors also concluded that companies in poorly performing industries were more likely to slash their CEO’s pay or fire the CEO directly. Although research has shown that CEOs benefit from running companies in surging industries, the authors argue that their evidence proves it’s a two-way street: CEOs in struggling industries can get a “pay cut for bad luck.”

Overall, the results indicate that boards regard pay cuts as a form of discipline, analogous to outright dismissal, in response to poor company performance. The authors found that CEOs were more likely to be fired when they ran poorly performing companies that were large or when they held less equity in the firm.

In the Australian context the research supports the application of more responsive incentive pay.  While LTIs, for all their problems, do tend to align longer-term results with performance, some stakeholders would argue that there is a way to go for most companies to better ensure their short-term incentives are aligned with true performance outcomes.

The research can be found HERE

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