stanord closer look series 3
What Does It Mean for an executIve to “Make” $1 MIllIon?
exceed the value that is reported in the Summary Compensation able.
Finally, journalists do not consistently distin-guish between earned and expected compensation.For example, a recent article in
Te New York imes
reported that Viacom CEO Philippe Dauman re-ceived total compensation o $84.5 million in2010, more than twice the amount awarded theprevious year. Te article quoted a compensationconsultant as stating, “Tis is spectacular money but where are the spectacular results?” Noting thatthe company’s stock price had barely moved in threeyears, he asked: “Is that really worth this award?”
Had the article reported Dauman’s compensationon an earned, rather than expected, basis the num-bers would have looked quite dierent. Rather thanreport a 150 percent increase in compensation rom$34 million to $84.5 million, the article wouldhave shown a 26 percent increase rom $17.2 mil-lion to $21.6 million. Furthermore, one-quarter o the nearly 500,000 options that Dauman had beenawarded in previous years vested out-o-the-money in 2010, indicating that unless he subsequently in-creased the stock price he stood to earn no valuerom these awards, despite the act that they wereoriginally reported with an expected value o morethan $7 million. Similarly, much o the $84.5 mil-lion in compensation granted to Dauman in 2010 was in the orm o stock options and perormanceunits, suggesting that their uture value would de-pend heavily on his ability to increase shareholdervalue (see Exhibit 3).
Tis article is but one ex-ample o the conusion that is prevalent betweenthe incentives that expected compensation providesor uture perormance and the rewards that earnedcompensation oers or previous perormance.
Why thIs Matters
1. Executive compensation gures are requently cited by the press and other third-party observ-ers. However, these sources rarely distinguish be-tween expected and earned compensation. Whatdoes it actually mean when we read that a CEO“made” $1 million in a year?2. Exhibit 4 shows summary statistics or expectedand earned compensation across a large sampleo companies in scal 2010. Among the largest250 companies, median earned pay was 18 per-cent less than median expected pay. Within thesample, individual amounts vary even more sig-nicantly (higher and lower) based on individualperormance. Why don’t companies voluntarily disclose these gures so corporate stakeholderscan more readily assess both the incentive valueo compensation and pay or perormance?3. Te Dodd-Frank Wall Street Reorm Act re-quires that companies calculate and disclose theratio o CEO-to-average-worker pay in the an-nual proxy. However, corporate observers tendto calculate this ratio based on the expectedpay o the CEO and earned pay o the average worker. Wouldn’t a more air comparison use thesame gure or the numerator and denominator,such as earned pay or both? In many cases, this would greatly change the reported results.
As part o his employment agreement, Pandit promised to retain theater-tax proceeds o the sale as an investment interest in Old Lane.Source: Eric Dash, “All old, the Price ag or Citigroup’s New Chie is $216 Million,”
Te New York imes
, Mar. 14, 2008.
Citigroup, Forms DEF-14A led Mar. 20, 2009 and Mar. 12, 2010 with the SEC.
Te Internal Revenue Service also standardizes the calculation o in-come or tax purposes. Its method is dierent rom that employed by the SEC and is also dierent rom those discussed below.
Te degree o precision is largely driven by the plan’s design.
Furthermore, nancial and stock-price perormance might be in-fuenced by macroeconomic actors that are largely outside o theexecutive’s control.
Because long-term cash awards require an executive to be employedthrough the payment date, they are earned as received (rather thanaccrued over the perormance period) even though their nal valueis generally based on multi-year perormance.
Te Black-Scholes model takes into account the current price, strikeprice, expected volatility, risk-ree rate, dividend yield, and time toexpiration. When companies value stock option grants they typi-cally apply a haircut to the time to expiration to take into accountthe act that compensatory options are oten non-transerable andgenerally not held to expiration because executive tend to exercisethem early. Intrinsic value is a simpler method or estimating earnedvalue because it is calculated by subtracting the exercise price romthe current stock price. However, it does not take into account thepotential or uture gain.
In many companies, executives are eligible to participate in non-qualied deerred compensation plans and supplemental executiveretirement plans (SERPs). In these instances, amounts are “earned”as they accrue and become vested; however, because they will not be-come payable until sometime in the uture, they eectively becomedebt instruments (and executives ace the same risks as other debt-holders) and pay is thereore not “realized” until that uture date.
Tat is, earned compensation is the amount o pay that an executivecan cash in, while realized compensation is the amount o pay thatan executive