Stephen F. O’Byrne, President of Shareholder Value Advisors, Inc., has issued a compelling memorandum that challenges the prevailing narrative surrounding executive compensation in the United States. The core of his analysis centers on the long-standing objectives of executive pay—incentivizing value creation, retaining key talent, and controlling shareholder costs—and how these are managed through two primary dimensions: the percentage of pay at risk and the company’s target pay percentile. While conventional wisdom suggests that a high percentage of pay at risk, coupled with a market-competitive pay percentile (typically the 50th), effectively balances these objectives, O’Byrne’s research, informed by recent disclosures, reveals a more complex and often disappointing reality for many companies.
The Conventional Wisdom Under Scrutiny
For decades, the U.S. corporate world has largely adhered to a set of principles governing executive remuneration. Shareholders, through their representatives on boards and compensation committees, aim to align executive interests with their own by ensuring that a significant portion of an executive’s total compensation is "at risk." This means that a substantial part of their pay is contingent on achieving specific performance targets, most notably the company’s financial performance and, by extension, its shareholder value. Simultaneously, companies seek to avoid the risk of losing top executives to competitors, necessitating a compensation package that is competitive within the relevant market—usually defined by industry and company size. The 50th percentile, or median pay, has become a widely accepted benchmark for this market competitiveness. The theory posits that by setting a high "pay at risk" percentage, executives are strongly motivated to drive performance. By anchoring target pay at the 50th percentile, the company limits its exposure to excessive costs while mitigating retention risk, as pay is unlikely to fall below a competitive level.
A Significant Shift: The Rise of "Pay at Risk"
Over the past thirty years, the United States has witnessed a dramatic increase in the proportion of executive compensation deemed "at risk." This trend reflects a growing acceptance of the "pay for performance" philosophy, at least in theory. Data from O’Byrne’s analysis indicates that for CEOs in the S&P 1500 index, the average percentage of pay at risk has surged from 46% in 1993 to a striking 78% in 2023. For other top executives within these companies, the increase is similarly substantial, rising from 41% in 1993 to 70% in 2023. This shift is not merely a change in numbers; it signifies a fundamental alteration in how executive rewards are structured, with a greater emphasis placed on variable, performance-contingent compensation. Furthermore, the composition of executive pay packages has become more standardized across companies, with the variation in pay mix decreasing significantly since 2006. Companies frequently highlight this high percentage of pay at risk as a testament to their commitment to paying for performance.
The Growing Embrace of "Competitive Pay Policy"
Parallel to the rise in pay at risk, there has been a discernible trend towards adopting "competitive pay policies." This approach standardizes target pay at a predetermined market percentile, typically the 50th, irrespective of past performance. The rationale is to ensure that a company’s compensation offering remains attractive and competitive within its industry and size peer group. Evidence of this growing commitment is seen in the decreasing pay dispersion within industry-size groupings. One study revealed a 45% decline in pay dispersion since 2007, indicating that companies are converging towards paying very close to the median for similar executive roles. This standardization simplifies the process for compensation committees and consultants, offering a clear, albeit potentially simplistic, framework for setting pay levels.
A Consensus on Well-Designed CEO Pay?
This confluence of increased pay at risk and adherence to competitive pay policies has fostered a widely held belief among corporate directors, compensation consultants, proxy advisors, and institutional investors that U.S. executive compensation is, on the whole, well-designed and effective. Firms specializing in executive compensation, such as Pay Governance, have publicly stated that corporate governance, particularly concerning executive pay, has seen dramatic improvements over the past two decades.
Supporting this sentiment, leading proxy advisor Institutional Shareholder Services (ISS) reported in its 2024 proxy review that failed "say-on-pay" resolutions had fallen to a record low, with less than 1% of S&P 500 companies experiencing such outcomes. ISS further noted that many compensation committees appear to be more adept at addressing investor concerns, particularly following a low shareholder vote on pay. This perceived success in aligning pay with shareholder interests, or at least in navigating shareholder sentiment, contributes to the prevailing consensus that the current system is functioning adequately.
The Unsettling Criticisms That Are Often Dismissed
Despite the apparent consensus and positive trends in pay structure, O’Byrne’s analysis brings to light two significant criticisms that are frequently brushed aside by proponents of the current system.
The Low Correlation Between Pay and Performance
One persistent criticism is the often low correlation observed between CEO pay and company performance. Numerous studies and observers have highlighted this disconnect, suggesting that executives may be handsomely rewarded regardless of their company’s actual results. The conventional wisdom’s response to this criticism is to dismiss it as largely irrelevant. The argument is that the CEO pay reported in proxy statements typically reflects "target pay," which, by design, is intended to be independent of short-term or past performance. The variable component of pay, the "at risk" portion, is designed to fluctuate with performance, but the base salary and other fixed elements are often seen as a necessary component of a competitive package for talent retention, irrespective of immediate results.
The "Performance Penalty" in Equity Grants
The second major criticism, which the consensus view largely overlooks, concerns the creation of a systematic "performance penalty" through the structure of equity grants. This penalty arises from the mechanics of how equity compensation is awarded and valued. When a company’s stock price increases, the number of shares granted in an equity award is effectively reduced in value from the perspective of future grants to maintain a target dollar value. Conversely, when the stock price declines, a larger number of shares is granted to achieve the same target dollar value. This creates a situation where a stock price increase is "penalized" by a reduction in future equity shares, while a stock price decrease is "rewarded" by an increase in future equity shares. Advocates of the conventional wisdom, however, maintain that pay for performance is ultimately achieved because the value of equity grants—both current and unvested—moves up and down with performance after the grant has been made, thereby aligning long-term incentives.
New Disclosures Offer a Crucial Test of "Pay for Performance"
Until recently, rigorously testing the conventional wisdom regarding "pay for performance" was challenging, primarily because equity compensation was never consistently reported on a "mark-to-market" basis. This meant that the true value of equity grants, as they fluctuated with company performance throughout the year, was not transparently reflected in executive pay disclosures.
This situation changed with the advent of new "Pay versus Performance" disclosures mandated by regulatory bodies. These disclosures require companies to report "Compensation Actually Paid" (CAP) on a mark-to-market basis. CAP is a comprehensive measure that includes not only the reported compensation but also the year-end value of current-year equity grants, as well as the change in value during the year of unvested grants made in prior years. This new disclosure mechanism provides an unprecedented opportunity to objectively assess the correlation between CEO pay and company performance at an individual company level.
A Stark Reality: "Good" Companies vs. "Bad" Companies
By plotting relative CEO pay against relative Total Shareholder Return (TSR) and utilizing the CAP data, it is now possible to measure CEO pay for performance at the company level. This analysis allows for the identification of "good" companies—those where relative TSR explains at least half of the variation in relative CEO pay, and where the pay premium at industry-average performance is modest. Conversely, "bad" companies are those that fail one or both of these critical tests.
The results of this analysis are, as O’Byrne notes, "startling." When applying these metrics, "good" companies, where pay genuinely appears to be aligned with performance, constitute a mere 15% of the total companies analyzed. In stark contrast, the remaining 85% are categorized as "bad" companies, exhibiting a significant disconnect between reported pay and actual shareholder returns. For the 163 identified "good" companies, relative TSR explains a robust 82% of the variation in relative CEO pay. However, for the vast majority—932 "bad" companies—relative TSR accounts for only a meager 5% of the variation in relative pay. This disparity presents a formidable challenge to the widely held belief that U.S. executive compensation practices are effectively driving performance.
Implications and Future Directions
The implications of this research are significant. The conventional wisdom, which has guided compensation practices for years, appears to be failing a substantial majority of U.S. companies. The new "Pay versus Performance" disclosures have provided the data necessary to move beyond anecdotal evidence and theoretical assumptions, offering a data-driven assessment of compensation effectiveness.
The finding that only 15% of companies demonstrate a strong pay-for-performance link suggests that the remaining 85% may be overpaying executives without achieving commensurate shareholder value creation. This raises questions about the efficacy of compensation consultants, the oversight of compensation committees, and the influence of proxy advisors like ISS. While ISS and firms like Pay Governance may perceive improvements, this data suggests a systemic issue that remains largely unaddressed.
In a forthcoming analysis, O’Byrne intends to delve deeper into the characteristics of both "good" and "bad" companies, offering further insights into the impact of the "performance penalty" embedded in equity grants. He also plans to examine how advocates of the conventional wisdom, including ISS and Pay Governance, are attempting to interpret and respond to these new disclosures. This ongoing research is poised to significantly shape the future of executive compensation discussions and practices in the United States, potentially ushering in a new era of greater accountability and genuine pay-for-performance alignment.
