Topics, Issues, and Controversies in Corporate Governance and Leadership

What Does It Mean for an Executive to “Make” $1 Million?
By David F. Larcker, Allan L. McCall, and Brian Tayan December 14, 2011


Measuring Executive Compensation

In 2008, Vikram Pandit became the CEO of Citigroup. Pandit had joined the company six months prior as head of investment banking and alternative investments after Citigroup purchased the hedge fund he managed, Old Lane Partners, for $800 million. Between the $165.2 million in proceeds Pandit accrued in the sale and the $40 million compensation package he was offered when appointed CEO, the New York Times dubbed him “Citigroup’s quarter-billion dollar man.”1 Despite the headlines, however, Pandit never actually received this amount of money. By the time Pandit’s share of Old Lane Partners was liquidated in May 2008, it was worth a fraction of the original value, and the nearly $40 million in restricted shares and stock options awarded to him at promotion were worth only $4 million when they vested years later (see Exhibit 1).2 As this example suggests, executive compensation figures are not always what they seem. Executive pay packages contain a diverse mix of cash and non-cash incentives, payable in one or multiple years and subject to accruals, estimates, and restrictions that often render their ultimate value quite different from their expected value. The Securities and Exchange Commission standardizes the manner in which compensation is quantified and disclosed to investors in the annual proxy.3 However, even there, compensation figures comingle forward- and backward-looking amounts, as well as fixed and contingent payments, that make it difficult for investors to understand what compensation has been promised to executives and what they eventually earn.

Executive compensation can be measured in many ways, three of which include: • Expected compensation represents the total expected value of compensation promised to an executive in a given year. Because not all compensation is received in the year it is awarded, the value of certain elements must be estimated. The precision of these estimates will vary depending on performance- and market-related sensitivities. For example, the expected value of a salary is known with a fairly high degree of certainty, because it is delivered on a pro rata basis throughout the year based on a promised and fixed amount. The expected value of a cash bonus is typically known with less, but still some, precision because it falls within a range (minimum, target, and maximum) that is bounded by the achievement of predetermined objectives.4 The value of long-term incentives such as restricted stock, stock options, and long-term cash plans is known with far less certainty because these elements are subject to multi-year strategic, financial, and stock price results that are unknown in advance.5 The expected value of long-term incentives is therefore measured using a probableoutcome estimate or market-based valuation. • Earned compensation represents the total value of compensation that an executive “earns the right to keep” as cash is delivered and vesting restrictions are removed from equity-linked elements. Salary and annual bonuses are earned over one-year periods. Long-term cash awards are typically earned at the end of multiple-year periods.6 Equity awards are earned as they vest.

stanford closer look series


What Does It Mean for an Executive to “Make” $1 Million?

In the case of restricted stock, the earned value is determined based on the stock price on the vesting date. The earned value of stock options is based on either the Black-Scholes value or the intrinsic value on the vesting date.7 Note that if the stock price has appreciated or declined materially since the original grant date, the earned value might differ considerably from the original expected value. In most cases, the total compensation earned in a year comprises some elements awarded in the current year and other elements awarded in previous years. • Realized compensation represents the total value of compensation that an executive converts to cash in a given year. For cash awards (salary, bonus, and long-term cash plans), the earned value is the same as the realized value.8 For equity awards, the realized value is the amount of cash received when the executive ultimately sells shares or exercises (and sells) stock options.9 If the executive cashes out these pay elements on the vesting day, the earned amount will approximate the realized amount. If the executive holds equity awards beyond the vesting date, the realized amount will be higher or lower than the earned amount depending on whether the stock price subsequently increased or declined. Earned equity compensation that is retained after the vesting date therefore remains “at risk” until it has been sold. Like earned compensation, realized compensation often comprises pay elements awarded over multiple years and the realized amount is a function of firm performance over this period. ­­­ These distinctions are important because each figure conveys different information to corporate stakeholders. Expected compensation is a forwardlooking view of the reward opportunities available to an executive. It reflects both the target level of compensation to attract and retain qualified talent in a competitive labor market and the mix of pay opportunities to motivate an executive to achieve corporate targets.10 The size and mix of expected compensation therefore provide insight into the incentives offered to management. By contrast, earned and realized compensation are backwardlooking views of the rewards that an executive

actually received for his or her efforts. These values can be compared to corporate performance during the measurement period to assess the relative pay versus performance relationship in the compensation plan. When earned compensation is highly correlated with improvements in strategic, financial, and stock price results, the compensation plan can be said to offer strong pay for performance. When earned compensation is uncorrelated with these, the plan does not offer pay for performance.11 Finally, earned compensation that has not been realized continues to provide incentive to the executive because his or her efforts can enhance its future value; once an executive realizes this value by cashing out equity grants it no longer provides incentive.12 Unfortunately, the information to assess the incentive value of compensation and pay for performance is not readily available to shareholders. This is because expected, earned, and realized compensation in a given year are rarely disclosed to the public. Although comprehensive information is mandated by the SEC and included in the annual proxy, it is not explicitly summarized along the dimensions discussed above. Instead, the annual proxy contains a Summary Compensation Table that combines expected, earned, and realized amounts (see Exhibit 2). The investor must comb through the explanatory notes to calculate these metrics.13 Furthermore, proxy advisory firms do not assist in the matter. For example, in formulating a recommendation on executive compensation plans, Institutional Shareholder Services (the largest proxy advisory firm) compares the year-over-year change in reported compensation to previous one- and three-year total shareholder return. This approach is flawed because it takes a compensation figure that is predominantly forward-looking and compares it to backward-looking stock-price changes. A more reasonable methodology would compare the change in earned compensation to the change in stock-price during the same measurement period. In addition, ISS likely overstates the expected value of stock option plans by assuming that executives hold their options for the full term (generally ten years) before exercising them, when research shows that executives routinely exercise stock options early.14 As a result, the expected value assigned by ISS tends to
stanford closer look series 2

What Does It Mean for an Executive to “Make” $1 Million?

exceed the value that is reported in the Summary Compensation Table.15 Finally, journalists do not consistently distinguish between earned and expected compensation. For example, a recent article in The New York Times reported that Viacom CEO Philippe Dauman received total compensation of $84.5 million in 2010, more than twice the amount awarded the previous year. The article quoted a compensation consultant as stating, “This is spectacular money but where are the spectacular results?” Noting that the company’s stock price had barely moved in three years, he asked: “Is that really worth this award?”16 Had the article reported Dauman’s compensation on an earned, rather than expected, basis the numbers would have looked quite different. Rather than report a 150 percent increase in compensation from $34 million to $84.5 million, the article would have shown a 26 percent increase from $17.2 million to $21.6 million. Furthermore, one-quarter of the nearly 500,000 options that Dauman had been awarded in previous years vested out-of-the-money in 2010, indicating that unless he subsequently increased the stock price he stood to earn no value from these awards, despite the fact that they were originally reported with an expected value of more than $7 million. Similarly, much of the $84.5 million in compensation granted to Dauman in 2010 was in the form of stock options and performance units, suggesting that their future value would depend heavily on his ability to increase shareholder value (see Exhibit 3).17 This article is but one example of the confusion that is prevalent between the incentives that expected compensation provides for future performance and the rewards that earned compensation offers for previous performance.
Why This Matters

250 companies, median earned pay was 18 percent less than median expected pay. Within the sample, individual amounts vary even more significantly (higher and lower) based on individual performance. Why don’t companies voluntarily disclose these figures so corporate stakeholders can more readily assess both the incentive value of compensation and pay for performance? 3. The Dodd-Frank Wall Street Reform Act requires that companies calculate and disclose the ratio of CEO-to-average-worker pay in the annual proxy. However, corporate observers tend to calculate this ratio based on the expected pay of the CEO and earned pay of the average worker. Wouldn’t a more fair comparison use the same figure for the numerator and denominator, such as earned pay for both? In many cases, this would greatly change the reported results.18 
As part of his employment agreement, Pandit promised to retain the after-tax proceeds of the sale as an investment interest in Old Lane. Source: Eric Dash, “All Told, the Price Tag for Citigroup’s New Chief is $216 Million,” The New York Times, Mar. 14, 2008. 2 Citigroup, Forms DEF-14A filed Mar. 20, 2009 and Mar. 12, 2010 with the SEC. 3 The Internal Revenue Service also standardizes the calculation of income for tax purposes. Its method is different from that employed by the SEC and is also different from those discussed below. 4 The degree of precision is largely driven by the plan’s design. 5 Furthermore, financial and stock-price performance might be influenced by macroeconomic factors that are largely outside of the executive’s control. 6 Because long-term cash awards require an executive to be employed through the payment date, they are earned as received (rather than accrued over the performance period) even though their final value is generally based on multi-year performance. 7 The Black-Scholes model takes into account the current price, strike price, expected volatility, risk-free rate, dividend yield, and time to expiration. When companies value stock option grants they typically apply a haircut to the time to expiration to take into account the fact that compensatory options are often non-transferable and generally not held to expiration because executive tend to exercise them early. Intrinsic value is a simpler method for estimating earned value because it is calculated by subtracting the exercise price from the current stock price. However, it does not take into account the potential for future gain. 8 In many companies, executives are eligible to participate in nonqualified deferred compensation plans and supplemental executive retirement plans (SERPs). In these instances, amounts are “earned” as they accrue and become vested; however, because they will not become payable until sometime in the future, they effectively become debt instruments (and executives face the same risks as other debtholders) and pay is therefore not “realized” until that future date. 9 That is, earned compensation is the amount of pay that an executive can cash in, while realized compensation is the amount of pay that an executive actually cashes in.

1. Executive compensation figures are frequently cited by the press and other third-party observers. However, these sources rarely distinguish between expected and earned compensation. What does it actually mean when we read that a CEO “made” $1 million in a year? 2. Exhibit 4 shows summary statistics for expected and earned compensation across a large sample of companies in fiscal 2010. Among the largest

stanford closer look series


What Does It Mean for an Executive to “Make” $1 Million?

The compensation mix will include pay elements that are short- or long-term, accounting- or stock-price based, and fixed or contingent (risky). To determine the size and mix of incentive compensation, the board of directors typically benchmarks the compensation program against those of a peer group of companies that are similar in size, industry, complexity, etc. 11 There will almost certainly be pay-for-performance in any contract that includes large amounts of contingent compensation awards (restricted shares, stock options, long-term cash plans, etc), because the value of realized pay is directly related to operating and stock price results. The Pandit example above illustrates this point. 12 For a discussion of the incentive value of equity, see David F. Larcker and Brian Tayan, “Sensitivity of CEO Wealth to Stock Price: A New Tool for Assessing Pay for Performance,” CGRP-10, Sep. 19, 2010, available at: closer_look.html. 13 In some cases, companies choose to voluntarily disclose realized compensation in a supplemental disclosure, but this is rare. For example, in its most recent proxy, Computer Sciences Corporation outlines the compensation realized by CEO Michael Laphen during the previous fiscal year: “The table below provides a different perspective on compensation that is supplemental to the information contained in the Summary Compensation Table. This table provides details of actual pre-tax income realized by our CEO during Fiscal 2011 from base salary, annual incentive compensation from long-term incentive compensation regardless of the year in which the equity award was granted…. In addition, this table facilitates comparison of approved or award date values versus actual income earned and received for each component of compensation. As such, it provides further evidence of the pay for performance underpinning of our executive compensation program by demonstrating diminished realized income, especially in our annual and long term incentive programs, relative to potential during a period of minimal appreciation in shareholder value.” Whereas the company had granted Laphen cash and equity awards with an original expected value of $7.6 million, he only realized $4.0 million from these awards. This is significantly less than the $12.5 million reported in the Summary Compensation Table for the same year. Source Computer Sciences Corporation, Form DEF 14A, filed Jun. 24, 2011. 14 For this reason, the Financial Accounting Standards Board (FASB) allows companies to value stock option grants using an expected term based on previously observed behavior. Source: Chip Heath, Steven Huddart, and Mark Lang. Psychological factors and stock option exercise. Quarterly Journal of Economics (May 1999). 15 This methodology significantly disadvantages stock options relative to restricted stock and other forms of compensation. As a result, if a company wants to lower its total compensation to gain approval from ISS, the easiest place to start is to replace stock options with restricted shares or long-term cash plans (for better or worse). 16 Graham Bowley, “Pay Doubles for Leaders at Viacom,” The New York Times, Jan. 22, 2011. 17 Viacom, Forms DEF 14A filed Apr. 30, 2007, Apr. 18, 2008, Apr. 17, 2009, Apr. 16, 2010, and Jan. 21, 2011 with the SEC. 18 For a further discussion of the shortcomings of this ratio, see David F. Larcker and Brian Tayan, “Seven Myths in Executive Compensation,” CGRP-17, Jun. 6, 2011, available at: closer_look.html.

David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Allan McCall is a Ph.D. candidate in accounting at the Stanford Graduate School of Business and cofounder of Compensia, a national executive compensation consulting firm. Brian Tayan is a researcher with Stanford’s Center for Leadership Development and Research. Larcker and Tayan are coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit: Copyright © 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

stanford closer look series


What Does It Mean for an Executive to “Make” $1 Million?

Exhibit 1 — Reported versus Earned and Realized Compensation: Citigroup Citigroup (C) Stock Price History 2008 - 2010
$35 $30 $25 $20 $15 $10 $5 $0 1/2/08






Vikram Pandit, CEO: Reported Compensation
Year 2008 2009 2010 Salary 958,333 125,001 1 Bonus 0 0 0 Stock 28,830,000 0 0 Options 8,432,911 0 0 Non-Equity Plan 0 0 0 Pension Change Other 0 0 0 16,193 3,750 0 Total 38,237,437 128,751 1

Reported compensation includes salary, bonus, and payments under long-term cash bonus plans plus the expected value of restricted stock and stock options on the grant date. In February 2009, Pandit announced a voluntary reduction in salary to $1.

Vikram Pandit, CEO: Earned Compensation
Year 2008 2009 2010 Salary 958,333 125,001 1 Bonus 0 0 0 Stock 1,961,250 1,132,504 1,346,903 Options 0 0 0 Non-Equity Plan 0 0 0 Pension Change Other 0 0 0 16,193 3,750 0 Total 2,935,776 1,261,255 1,346,904

Earned compensation includes salary, bonus, and payments under long-term cash bonus plans plus the value of vested restricted stock and stock options as of the vesting date. Restricted shares are valued based on the stock price on the vesting date; stock options are valued based on their intrinsic value on the vesting date (the amount by which they are trading “in the money”).

Vikram Pandit, CEO: Realized Compensation
Year 2008 2009 2010 Salary 958,333 125,001 1 Bonus 0 0 0 Stock 119,500 125,239 130,798 Options 0 0 0 Non-Equity Plan 0 0 0 Pension Change Other 0 0 0 16,193 3,750 0 Total 1,094,026 253,990 130,799

Realized compensation includes salary, bonus, and payments under long-term cash bonus plans plus the value of restricted stock sold and stock options exercised and sold on the sale date. Realized compensation excludes the proceeds from noncumulative preferred stock that was sold and reinvested in common stock on Jul. 24, 2009. All stock sales between 2008 and 2010 were made “to satisfy tax withholding obligations associated with vesting.” Source: Citigroup, Forms DEF-14A and Forms 4 filed 2008-2010.

stanford closer look series


What Does It Mean for an Executive to “Make” $1 Million?

Exhibit 2 — Elements of Executive Compensation
Compensation Element Salary Expected Target amount Earned Realized Actual amount Summary Compensation Table Earned, Realized

Cash Bonus

Target amount

Actual amount (between the minimum and maximum amount) Fair value on vesting date Fair value on vesting date Value realized upon sale Value realized upon sale

Earned, Realized

Restricted Stock

Fair value on grant date (stock price) Fair value on grant date (Black-Scholes)


Stock Options


Non-Equity Plans

Target amount

Actual amount (lump sum) Actual amount in retirement

Earned, Realized


Actuarial amount

Expected, Earned

Other Benefits

Actual amount

Expected, Earned, Realized

Example: Keith Wandell, CEO: Harley Davidson (2010)
Expected Salary Bonus Stock Awards Option Awards Non-Equity Plans Pension Other Benefits Total $ 975,000 0 1,381,199 1,636,681 2,600,357 0 83,490 $ 6,676,727 Earned $ 975,037 0 0 698,906 2,340,090 0 83,490 $ 4,097,523 Realized $ 975,037 0 0 0 2,340,090 0 67,289 $ 3,382,416 Reported $ 975,037 0 1,381,199 1,636,681 2,340,090 0 83,490 $ 6,416,498

Notes: 2009 restricted stock awards first vest in 2011 and therefore no restricted stock was earned in 2010. The earned value of option awards is calculated as the intrinsic (“in-the-money”) value of options on the vesting date. Wandell did not exercise any option awards or sell stock awards in 2010. The expected value of cash plans equals the target amount for 2010, payable in 2011 and 2013. The realized value of other benefits excludes a non-qualified deferred compensation plan contribution of $16,201.

Source: Harley-Davidson, Forms DEF-14A, filed Mar. 19, 2010 and Mar. 25, 2011 with the SEC.

stanford closer look series


What Does It Mean for an Executive to “Make” $1 Million?

Exhibit 3 — Reported versus Earned Compensation: Viacom Philippe Dauman, CEO: Viacom (2009 and 2010)
2010 Salary Bonus Stock Awards Option Awards Non-Equity Plans Change in Pension All Other Total Options 1/31/2006 5/29/2007 6/4/2008 6/3/2009 Restricted Shares 9/11/2006 Performance Units 1/1/2007 113,796 $ 3,494,675 $30.71 per unit Reported $ 2,625,000 0 41,833,309 28,620,000 11,250,000 45,793 141,206 $ 84,515,308 Original Grant 3,171 491,400 521,739 458,015 Original Grant 287,242 Strike $41.48 $43.86 $35.26 $22.70 Earned $ 2,625,000 0 5,919,015 1,599,827 11,250,000 45,793 141,206 $ 21,580,841 Value (1/4) 0 0 86,087 1513740 Value (1/4) $ 2,424,322 $33.76 per share Notes out of the money out of the money $35.92 on 6/4/2010 $37.00 on 6/3/2010

2009 Salary Bonus Stock Awards Option Awards Non-Equity Plans Change in Pension All Other Total Options 1/31/2005 1/31/2006 5/29/2007 6/4/2008 Restricted Shares 9/11/2006

Reported $ 2,500,000 0 12,688,932 5,999,997 12,540,000 37,911 243,150 $ 34,009,990 Original Grant 1,465 3,171 491,400 521,739 Original Grant 287,242 Strike $47.10 $41.48 $43.86 $35.26

Earned $ 2,500,000 0 1,869,227 0 12,540,000 37,911 243,150 $ 17,190,288 Value (1/4) 0 0 0 0 Value (1/4) $ 1,869,227 $26.03 per share Notes out of the money out of the money out of the money out of the money

Source: Viacom, Forms DEF 14A, filed Apr. 30, 2007, Apr. 18, 2008, Apr. 17, 2009, Apr. 16, 2010, and Jan. 21, 2011 with the SEC.

stanford closer look series


What Does It Mean for an Executive to “Make” $1 Million?

Exhibit 4 — Summary Statistics: Total CEO Compensation, Various Methods Mean Compensation (2010)
Market Capitalization (in millions) $ 39,982 7,132 3,375 2,079 1,326 863 585 378 246 Lowest 143 Summary Compensation Table $ 14,130,597 7,904,858 6,037,811 4,646,368 3,872,349 2,877,698 2,520,118 1,988,675 1,516,684 1,160,671 Institutional Shareholder Services $ 17,595,544 9,911,257 7,781,580 5,760,233 4,833,941 3,642,764 3,038,112 2,563,376 1,836,673 1,405,679 Earned Value $ 12,018,347 7,034,703 5,229,651 3,910,954 3,377,383 2,444,539 2,124,444 1,768,966 1,282,740 1,029,749

Decile Highest

Expected Value $ 13,181,418 7,380,223 5,879,114 4,547,047 3,888,635 2,862,030 2,512,779 2,126,550 1,570,411 1,238,572

Median Compensation (2010)
Market Capitalization (in millions) $ 22,522 6,895 3,257 2,061 1,312 853 574 372 241 Lowest 149 Summary Compensation Table $ 12,220,817 6,932,325 5,245,581 4,046,318 3,093,924 2,360,580 2,074,024 1,415,159 1,190,955 858,204 Institutional Shareholder Services $ 15,312,751 8,878,721 6,669,452 5,006,225 4,024,939 3,129,763 2,574,915 1,894,097 1,411,867 1,045,605 Earned Value $ 9,218,322 5,696,422 3,799,896 3,046,327 2,437,328 1,873,891 1,700,898 1,200,413 976,996 794,706

Decile Highest

Expected Value $ 11,210,876 6,763,005 4,837,471 3,942,680 3,159,052 2,328,114 2,073,491 1,577,976 1,226,952 865,041

Sample includes 2,471 companies with fiscal years ending between June 2010 and January 2011. Summary Compensation Table data represents the total value of compensation as reported in the annual proxy. Institutional Shareholder Service data reflects total compensation under ISS methodology. In particular, ISS calculates the value of stock option grants using the full term (generally ten years) rather than an abbreviated term. Expected and earned compensation values are calculated using the methodologies discussed earlier, with earned stock option value based on intrinsic value. Source: Equilar compensation data. Calculations by the authors.

stanford closer look series


Sign up to vote on this title
UsefulNot useful