We need to connect CEO pay to total stakeholder value
John Mansfield , March 02, 2017
Executive pay is broken. Can we fix it by linking remuneration to total stakeholder value?
Warren Buffet once said 'price is what you pay, value is what you get'. His words are never truer than when considering the broken executive pay system. We need a paradigm shifts that sets a meaningful and relevant basis for determining CEO pay. That is what the Maturity Institute’s (MI) CEO remuneration model attempts to do, in linking CEO pay to total stakeholder value.
The MI’s organisational maturity index, OMINDEX, rates organisations on their ability to optimise organisational value. Organisational value is a whole system measure and is defined by MI through its 10 Pillars, which include learning organisation, innovation and continuous improvement. These drivers of value creation inform the OMINDEX, whose ratings are presented in a league table that mirrors the S&P ‘AAA’ scale.
In the CEO Rem Model the company’s Price-to-Book (P/B) ratio also plays a key role; it is a measure of market value divided by book value, where market value is synonymous with market capitalisation and book value with net asset value. A company’s P/B serves to highlight the premium that the market places on business intangibles such as intellectual capital, intellectual property and brands.
This model proposes that CEO pay be determined solely on the basis of the value they add to organisations. This can be measured by combining MI’s OMINDEX and the companies' P/B into a composite measure of value, what we consider as Total Stakeholder Value (TSV).
A skewed distribution exists in CEO pay and company value. The graph below shows most CEOs lead organisations that generate well below their potential value, while CEOs of more mature companies, with long track records of improvement and value creation (such as Toyota, Handelsbanken and Costco), have significantly different pay characteristics than comparator CEOs.
Peer group benchmarking is the default method for determining CEO pay levels, but we recommend that the practice be discontinued as data is no longer credible. CEO benchmarking data, over the past three decades, has become seriously skewed by the ‘ratchet effect’. Since CEO salaries are in the public domain, you have a situation whereby the highest-paid CEO in the peer group becomes the benchmark for the others. Everyone in the group starts ‘chasing the upper quartile’ and sustained pressure is applied, causing salary increases for CEOs to rise exponentially, far exceeding the average market movements for other executives. This brings the underlying motive for this practice into question and raises ethical concerns.
We also need to remedy the underlying problem of ‘short-termism’. This is achieved by integrating one (or more) long-term sustainability goals into the company’s short-term targets. In addition, to give this process traction we suggest these long-term goals be designated as ‘gates’. A gate is something you have to go through to reach your destination, and in this case it means that the long-term goal must be achieved before the short-term incentive is allowed to vest. For example, in the mining industry a safety target is often set and designated as a gate. Should the mine have a fatality no bonuses are paid regardless of how well the mine performs. This should optimise an organisation’s ability to create total shareholder value in the short term.
Figure 1: MI evidence on CEO pay: sub-optimal TSV
John Mansfield is global lead of remuneration at The Maturity Insitute