There are two parts to the story about CEO pay in 2018.
The most visible part is the extra large raises that many Pacific Northwest CEOs received in 2018: among the 90 publicly traded firms headquartered in Washington, Oregon, and Idaho, the average CEO compensation package jumped by 35 percent over 2017, to $4.81 million, according to executive compensation research firm Equilar.
That increase was far more than the average worker saw — a discrepancy that will only add fuel to the controversy over what some critics refer to as “runaway” CEO pay.
But there was another part to the compensation story in 2018 — a less visible part, perhaps, but arguably the more important one.
In nearly all cases, the bulk of the huge increases in 2018 came in the form of equity — company stock or “options” to buy stock — a pattern that is increasingly common across the corporate world.
Ballooning equity pay was most obvious among the five highest paid CEOs in the Pacific Northwest.
In 2018, equity pay accounted for 81 percent, or $114.83 million, of the combined compensation for the region’s top five. That’s almost double the equity portion of 2017’s top five.
True, the compensation of the top CEOs is, statistically speaking, freakishly large and unrepresentative. But even when you control for such outliers on the 2018 list—for example, by stripping out firms with disproportionately large or small compensation packages— the bump in equity is dramatic, according to an analysis by executive compensation expert David Lough, with Seattle-based Ascend Consulting.
For this more “typical” Northwest firm, Lough says, the average CEO salary increased 7 percent, to $779,000, while stock-based compensation jumped 18 percent, to $3.02 million.
For CEOs, that rising equity share is a bit of a double-edged sword.
On the one hand, it’s probably one reason they’re making so much more these days. On the other, it’s also adding more uncertainty for CEOs about just how much money they’re actually making.
For starters, CEOs rarely actually take possession of all those stocks and options right away. To the contrary, in most cases, those equity awards don’t fully pay out until some future dates or, more often, unless the CEO hits certain performance goals.
According to an analysis by Fred Whittlesey, a compensation expert with Seattle-based Compensation Venture Group, 76 percent of the CEOs on the Pacific Northwest list have compensation plans in which part of their pay is tied to specific goals, such as an increase in company revenues or profits, rather than to being at the discretion of the company’s board of directors.
These performance-based requirements are especially common in the case of stock options, which Whittlesey says were used in 40 percent of Northwest CEO compensation packages in 2018.
Because a stock option merely entitles the CEO to purchase a share of company stock at a set price at some future date, such option “pay” is really only worth something if the share price climbs beyond that set price.
True, when companies award grants of stock options to their CEOs, they usually calculate a predicted dollar value on the grant. But that dollar value is really more of an accounting placeholder for the firm, not a guaranteed amount for the CEO. “It’s the most hypothetical form of payment,” Whittlesey says.
The growing reliance on options and other equity awards complicates the compensation picture in other ways.
For example, it undermines the usefulness of metrics that are meant to measure the fairness of CEO pay. If a huge chunk of a CEO’s pay is hypothetical, how can we know the real gap between that pay and the pay of the median employee?
The rising emphasis on equity awards also obscures factors that historically have been a bigger driver in CEO pay, such as the number of employees a CEO is managing or the annual revenues the company generates.
According to Lough, among those “typical” Pacific Northwest companies, revenues at the average firm in 2018 were $1.4 billion, which represents a 7 percent increase over 2017. That 7 percent increase is right in line with the 7 percent increase in salary that the average company granted its CEO in 2018. But that proportionality is blown to smithereens when you add stock-based compensation, which jumped 18 percent in 2018.
That points to another question often lost in the annual kerfuffle over compensation: why is it rising so rapidly?
More particularly, why did CEO compensation in the Pacific Northwest rise so much faster than did their companies’ underlying financial metrics, such as revenues? Are companies here overpaying their executives? Or have they determined that large, highly structured, equity-heavy compensation plans really do generate better company performance?
Back in the 1980s, that question helped ignite a so-called “shareholder” revolution.
Angered that CEOs of money-losing conglomerates were still receiving huge guaranteed salaries, shareholders demanded that compensation be tied instead to “total shareholder value,” which is share price appreciation plus dividends. From that point on, companies began paying CEOs partly in stock and options, and tying the size of those awards to the growth in shareholder value.
Although compensation packages have since become far more refined — with pay often linked to industry-specific metrics, such cash flow or growth in the number of subscribers — the underlying focus on share price, and on keeping shareholders happy, remains a central component of CEO pay, and one that is rapidly growing. In recent years, “the degree to which executive compensation is tied to [shareholder value] is huge compared to what it used to be,” Lough says.
That’s why so much of the compensation today is either in form of stocks and options, both of which encourage CEOs to move whatever mountains are necessary to keep share prices rising. With stock options in particular, Whittlesey says, companies are essentially telling their CEOs, “OK, we’ll pay you if you can make the stock price go up.'”
And, generally speaking, the CEOs have been delivering. Pacific Northwest company share prices are rising — aided, of course, by a 10-year bull market.
In such circumstances, shareholders, in Pacific Northwest firms and in other firms, are unlikely to balk at the large compensation packages or the big years increases.
Among investors in some of the high-paying companies, “no one is saying, ‘I think $10 million [in compensation] is too much,'” says Whittlesey. “‘I only think $10 million is too much if the company is losing money, the stock price is down, the customers are dissatisfied, and the place is falling apart.”
The big question, however, is whether that trend slows or even reverses if and when the current economic boom cools and stock prices decline. In theory, says Lough, that should not only reduce the value of options and other stock-based awards; but it should also incline companies to penalize their CEOs with smaller equity awards.
“There’s something to watch here,” says Lough. “Those kinds of incentive equity awards — I’m not concerned at the moment. But if we don’t see a flip-side effect in a down market, then I’m concerned.” In such a case, Lough said, investors — and voters and politicians — will be asking, “Why are the rewards going up no matter what?”