What’s The Harm In Excessive CEO Pay? Answer: Long-Term Damage To Shareholders And Pension Funds
As Jeff Immelt takes his final bow as the CEO of General Electric this summer, let’s take a moment to pick apart one of the nastiest open secrets on Wall Street: CEO pay has gotten absurdly out of control, and it’s destabilizing the long-term health and success of many once-great American companies.
Long-term investors can no longer afford to be silent — and we need to propose new methods of compensation for the 21st century that cannot be so easily manipulated by financial engineering in the C-suite. (More on that further down, but for now, back to Immelt.)
For the 16 years he was CEO, Immelt oversaw an empire that declined in market value by about $180 billion, while spending upwards of $81 billion on stock buybacks, according to the company’s SEC filings. Today, the company is worth about $222 billion, down from around $600 billion in August 2000. Year-after-year, GE has posted disappointing results, leaving long-term investors looking at stock price that’s declined about 38% since Immelt took the helm in 2001. (Oh, and it also has a chronically underfunded pension plan, too)
Immelt, meanwhile, has prospered.
In 2016, Immelt pocketed $21.3 million in compensation. In 2015, he made $33 million. According to GE’s 2017 proxy statements, about 71% of Immelt’s pay has been tied to stock price performance. But the party won’t stop even in his retirement: Immelt stands to earn a $211 million payout in retirement, according to Fortune. That’s not bad for a CEO whose performance recently produced this MarketWatch headline:
“GE’s stock is the worst Dow performer since Immelt took charge”
High CEO pay is nothing new. But what is new, however, is a recognition that high CEO pay packages — and the payment structures they are built upon — are causing serious collateral damage to long-term shareholders, pension and index funds, and unsophisticated investors.
Let’s back up for a minute. According to research from the Economic Policy Center, in 2016, CEOs in America’s largest firms made an average of $15.6 million in compensation, or 271 times the annual average pay of the typical worker.
While excessive CEO pay has received plenty of attention from labor rights organizers, media outlets and inspired populist movements like Occupy Wall Street, investors should be just as critical — if not more so — than these groups. Why?
Right now, the current incentive model for most publicly-traded companies is built around hitting short-term milestones — specifically earnings per share — including at GE. The problem with these payment structures is that they don’t truly incentivize long-term strategy, thinking, and innovation. So what happens is that CEOs today tend to find ways to use company cash to enrich themselves by manipulating per share metrics. In 2015, Reuters published a damning report that found that “executives are using stock repurchases to enrich themselves at the expense of long-term corporate health, capital investment and employment.”
So in a nutshell, the problem with high CEO pay isn’t simply that it’s “unfair” or “unjust” to middle class workers — it’s that the incentives themselves cause CEOs to focus on the wrong goals.
Worm Capital / SEC Filings
Buybacks at GE
As we have documented thoroughly in the past on this column, many executives inflate their own pay through stock buybacks. General Electric is no exception. In his tenure, Immelt and his executive team chose to spend over $81 billion on stock buybacks, artificially inflating earnings per share price — and contributing to Immelt’s personal fortune. But have the buybacks done long-term investors any favors or positioned long-term investors for success? Not at all.
Remember, GE could have used that $81 billion for strategic investment, R&D, or any other initiatives that would have benefited long-term holders of the stock. In other words, it could have positioned itself for the long-term: it could have built a cloud service business, or turned itself into company that manufactured personal electronics. It could have doubled-down on its investment in renewable energies or even electric cars. Instead, it bought back stock and focused on industrials like oil and gas.
Obviously, the concept of pay-for-performance is fairly straightforward. We, like everyone else, want to pay executives for positive performance. But structuring incentives is far from straightforward, and paying CEOs on their ability to reach per-share metrics can often lead down a dark path.
At this point, you might be asking: What’s a better way to structure CEO pay? Good question. It’s my belief that corporations should structure all incentives around business-only performance. No more “per share” metrics: Pay executives based on business earnings, not per share earnings. The job of managers is to manage the operations of the business — not manage the stock price!
Here’s what I would propose: Executives should be paid on organic revenue growth, gross profit, and operating earnings (coupled with the elimination of “per share” incentives mentioned above). My investment thesis is predicated on the notion that technological disruption changes everything — including valuation models. And if valuation models are being disrupted, then we need redefine and re-structure CEO pay models as well.
Why these three metrics?
Organic revenue growth: Revenue can be manipulated through acquisitions. Therefore, we suggest incentives based on organic sales growth. One current shareholder problem is that many companies fail to break out organic versus inorganic growth. This needs to change. Right now, too many companies claim growth when they are actually shrinking organically, and growing only because of acquisitions.
Gross profit: We have found that in disrupted verticals, the best way to correlate business success is to analyze both sales growth and gross profit. Gross profit shows whether or not a company is actually winning with customers. If a company is losing (see: IBM), the firm might be able to make EPS targets for a few years through charges, tax rate changes, and buybacks. But eventually, it won’t be able to hide the decline in organic revenue and gross profit. These are two important and shareholder-friendly incentives that are better than EPS and total shareholder return.
Operating earnings: Not “per share!” As investors, we are interested in results only — ignoring the number of shares. An executive’s duty is to operate the business, and not to worry about the stock. In a disrupted industry group — which we estimate to be about ½ of all companies today — earnings as a sole emphasis is dangerous. It could lead to the exact opposite behavior that the industry needs. To successfully pivot, earnings per share may have to temporarily go away. This was the case with Netflix, where their pivot to the international market resulted in success in revenue and gross profit, because their business was winning with customers — even if it did not show up in EPS.
Now, let’s take a step back for a moment. CEO pay was not always what it is today. But by the 1980s, the concept of shareholder value maximization became in vogue, and compensation experts began to make the case that without compensation incentives tied directly to stock price metrics, corporate managers and CEOs would fail to maximize shareholder wealth.
“One particular concern was that managers would cause their firms to take too little risk relative to shareholder desires because managers were less diversified than shareholders,” Gregg D. Polsky and Andrew C.W. Lund write at Brookings Institute.
Of course, the net effect of all of this has become clear — enormous CEO pay packages, fueled by the emphasis on incentive pay correlated to stock value. But even as CEO pay packages have risen in the last 30 years, the point is they have not correlated in terms of business value.
Even back in 2012, Fortune Magazine published a prescient article titled, “It’s the Economy — And CEO Pay, Stupid.” The tongue-in-cheek headline belied more serious research presented in the piece by three researchers from NYU, Pace, and Columbia Business School about how CEO incentives actually hurt the long-term value of the company, particularly by cutting costs.
As reported in Fortune:
Current symptoms of this sort of behavior include widespread cost cutting and a failure to invest in a company’s long-term future. CEOs can easily find themselves in a mode of cost cutting to boost their company’s stock price, which then becomes a self-fulfilling prophecy…CEOs cut costs, the stock price rises, and so they keep cutting costs because it boosts the stock price over the short term.
Over time, this behavior will drive any business into the ground. In their defense, CEOs are merely acting out of rational self-interest. It’s the board’s job to align pay practices to avoid these unintended consequences.
The nasty consequences of excessive pay packages for CEOs are easy to find. Just look at a report prepared by As You Sow, a shareholder activist group based in Oakland, California. In February 2017, the group released a report that highlights the forces behind disproportionate pay and the fund managers who continue to approve these pay packages.
Perhaps the most damning segment of the report was that the top paid managers are actually leading some of the worst performing companies. The top 25 included Jeffrey Immelt of GE, Mary T. Barra of GM, Steven Temares of Bed, Bath, and Beyond — and plenty of other familiar names.
The point is, incentives for CEOs are out of date. They are not designed for a rapidly-changing economy marked by technological disruption. CEO’s are getting historically rich by chasing quarterly earnings per share targets to the detriment of shareholders, particularly index funds investors, pension funds, and unsophisticated investors.
Right now, we have an environment marked by disruption, rapid change, and with it, we need new incentives. These incentives should reflect the change in environment. They should be hard to manipulate, but mostly, they should be aligned with shareholders — not against shareholders.
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