CGRP22 - What Does It Mean for an Executive To Make $1 Million?

Topics, Issues, and Controversies in Corporate Governance and Leadership

S T A N F O R D C L O S E R L O O K S E R I E S

stanford closer look series 1

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

IntroductIon

In 2008, Vikram Pandit became the CEO of Citi-group. 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 com-pensation 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 ac-tually 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 origi-nal value, and the nearly $40 million in restricted shares and stock options awarded to him at promo-tion were worth only $4 million when they vested years later (see Exhibit 1).2 As this example suggests, executive compensa-tion figures are not always what they seem. Exec-utive pay packages contain a diverse mix of cash and non-cash incentives, payable in one or mul-tiple years and subject to accruals, estimates, and restrictions that often render their ultimate value quite different from their expected value. The Secu-rities and Exchange Commission standardizes the manner in which compensation is quantified and disclosed to investors in the annual proxy.3 How-ever, even there, compensation figures comingle forward- and backward-looking amounts, as well as fixed and contingent payments, that make it dif-ficult for investors to understand what compensa-tion has been promised to executives and what they eventually earn.

By david f. larcker, allan l. Mccall, and Brian tayan

december 14, 2011

MeasurIng executIve coMpensatIon

Executive compensation can be measured in many ways, three of which include:

• Expected compensation represents the total ex-pected value of compensation promised to an ex-ecutive in a given year. Because not all compen-sation 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 sensitivi-ties. For example, the expected value of a salary is known with a fairly high degree of certainty, be-cause it is delivered on a pro rata basis through-out the year based on a promised and fixed amount. The expected value of a cash bonus is typically known with less, but still some, preci-sion 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, fi-nancial, and stock price results that are unknown in advance.5 The expected value of long-term in-centives is therefore measured using a probable-outcome 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 el-ements. 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.


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 ma-terially since the original grant date, the earned value might differ considerably from the original expected value. In most cases, the total compen-sation earned in a year comprises some elements awarded in the current year and other elements awarded in previous years.

• Realized compensation represents the total val-ue 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 eq-uity 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 approxi-mate the realized amount. If the executive holds equity awards beyond the vesting date, the re-alized 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, real-ized 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 fig-ure conveys different information to corporate stakeholders. Expected compensation is a forward-looking 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 backward-looking 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 cor-related 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 Fi-nally, earned compensation that has not been real-ized continues to provide incentive to the executive because his or her efforts can enhance its future val-ue; once an executive realizes this value by cashing out equity grants it no longer provides incentive.12 Unfortunately, the information to assess the in-centive value of compensation and pay for perfor-mance is not readily available to shareholders. This is because expected, earned, and realized compensa-tion 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 ex-pected, earned, and realized amounts (see Exhibit 2). The investor must comb through the explana-tory notes to calculate these metrics.13

Furthermore, proxy advisory firms do not as-sist 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 rea-sonable 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 op-tion plans by assuming that executives hold their options for the full term (generally ten years) before exercising them, when research shows that execu-tives routinely exercise stock options early.14 As a result, the expected value assigned by ISS tends to



exceed the value that is reported in the Summary Compensation Table.15

Finally, journalists do not consistently distin-guish between earned and expected compensation. For example, a recent article in The New York Times reported that Viacom CEO Philippe Dauman re-ceived 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 num-bers 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 mil-lion 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 in-creased 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 mil-lion in compensation granted to Dauman in 2010 was in the form of stock options and performance units, suggesting that their future value would de-pend heavily on his ability to increase shareholder value (see Exhibit 3).17 This article is but one ex-ample 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

1. Executive compensation figures are frequently cited by the press and other third-party observ-ers. However, these sources rarely distinguish be-tween 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

250 companies, median earned pay was 18 per-cent less than median expected pay. Within the sample, individual amounts vary even more sig-nificantly (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 re-quires that companies calculate and disclose the ratio of CEO-to-average-worker pay in the an-nual 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

1 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 in-come 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 in-

fluenced 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 typi-cally 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 non-qualified 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 be-come payable until sometime in the future, they effectively become debt instruments (and executives face the same risks as other debt-holders) 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.



10 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 pro-gram 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 (re-stricted 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. Larck-er 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: http://www.gsb.stanford.edu/cldr/research/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 dur-ing the previous fiscal year: “The table below provides a different perspective on compensation that is supplemental to the informa-tion contained in the Summary Compensation Table. This table pro-vides 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 underpin-ning of our executive compensation program by demonstrating di-minished 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 grant-ed 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 Compensa-tion,” CGRP-17, Jun. 6, 2011, available at: http://www.gsb.stan-ford.edu/cldr/research/ 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 account-

ing at the stanford Graduate school of Business and co-

founder 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 Gov-

ernance Matters. the authors would like to thank Mi-

chelle 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 devel-

opment and research at the stanford Graduate school

of Business and the rock center for corporate Gover-

nance at stanford University. for more information, visit:

http://www.gsb.stanford.edu/cldr.

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stanford Junior University. all rights reserved.

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exhIbIt 1 — reported versus earned and realIzed coMpensatIon: cItIgroup

source: citigroup, forms def-14a and forms 4 filed 2008-2010.

CITIGroup (C) SToCk prICE HISTory 2008 - 2010

VIkraM panDIT, CEo: rEporTED CoMpEnSaTIon

Year salary Bonus stock optionsnon-equity

PlanPensionchange

other total

2008 958,333 0 28,830,000 8,432,911 0 0 16,193 38,237,437

2009 125,001 0 0 0 0 0 3,750 128,751

2010 1 0 0 0 0 0 0 1

VIkraM panDIT, CEo: EarnED CoMpEnSaTIon

VIkraM panDIT, CEo: rEaLIzED CoMpEnSaTIon


PlanPensionchange

other total

2008 958,333 0 1,961,250 0 0 0 16,193 2,935,776

2009 125,001 0 1,132,504 0 0 0 3,750 1,261,255

2010 1 0 1,346,903 0 0 0 0 1,346,904


PlanPensionchange

other total

2008 958,333 0 119,500 0 0 0 16,193 1,094,026

2009 125,001 0 125,239 0 0 0 3,750 253,990

2010 1 0 130,798 0 0 0 0 130,799

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.

earned compensation includes salary, bonus, and payments under long-term cash bonus plans plus the value of vested re-

stricted 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”).

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 non-

cumulative 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.”

$0

$5

$10

$15

$20

$25

$30

$35

1/2/08 7/2/08 1/2/09 7/2/09 1/2/10 7/2/10



exhIbIt 2 — eleMents of executIve coMpensatIon

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.

compensation element

expected earned realizedsummary compensation

table

salary target amount actual amount earned, realized

cash Bonus target amountactual amount (between the minimum and

maximum amount)earned, realized

restricted stockfair value on grant date (stock price)

fair value on vesting date

Value realized upon sale

expected

stock optionsfair value on grant date (Black-scholes)

fair value on vesting date

Value realized upon sale

expected

non-equity Plans target amountactual amount

(lump sum)earned, realized

Pension actuarial amountactual amount in

retirementexpected, earned

other Benefits actual amountexpected, earned,

realized

ExaMpLE: kEITH WanDELL, CEo: HarLEy DaVIDSon (2010)

expected earned realized reported

salary $ 975,000 $ 975,037 $ 975,037 $ 975,037

Bonus 0 0 0 0

stock awards 1,381,199 0 0 1,381,199

option awards 1,636,681 698,906 0 1,636,681

non-equity Plans 2,600,357 2,340,090 2,340,090 2,340,090

Pension 0 0 0 0

other Benefits 83,490 83,490 67,289 83,490

total $ 6,676,727 $ 4,097,523 $ 3,382,416 $ 6,416,498

source: Harley-davidson, forms def-14a, filed Mar. 19, 2010 and Mar. 25, 2011 with the sec.



exhIbIt 3 — reported versus earned coMpensatIon: vIacoM

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.

pHILIppE DauMan, CEo: VIaCoM (2009 anD 2010)

2010 reported earned

salary $ 2,625,000 $ 2,625,000

Bonus 0 0

stock awards 41,833,309 5,919,015

option awards 28,620,000 1,599,827

non-equity Plans 11,250,000 11,250,000

change in Pension 45,793 45,793

all other 141,206 141,206

total $ 84,515,308 $ 21,580,841

options original Grant strike Value (1/4) notes

1/31/2006 3,171 $41.48 0 out of the money

5/29/2007 491,400 $43.86 0 out of the money

6/4/2008 521,739 $35.26 86,087 $35.92 on 6/4/2010

6/3/2009 458,015 $22.70 1513740 $37.00 on 6/3/2010

restricted shares original Grant Value (1/4)

9/11/2006 287,242 $ 2,424,322 $33.76 per share

Performance Units

1/1/2007 113,796 $ 3,494,675 $30.71 per unit

2009 reported earned

salary $ 2,500,000 $ 2,500,000

Bonus 0 0

stock awards 12,688,932 1,869,227

option awards 5,999,997 0

non-equity Plans 12,540,000 12,540,000

change in Pension 37,911 37,911

all other 243,150 243,150

total $ 34,009,990 $ 17,190,288

options original Grant strike Value (1/4) notes

1/31/2005 1,465 $47.10 0 out of the money

1/31/2006 3,171 $41.48 0 out of the money

5/29/2007 491,400 $43.86 0 out of the money

6/4/2008 521,739 $35.26 0 out of the money

restricted shares original Grant Value (1/4)

9/11/2006 287,242 $ 1,869,227 $26.03 per share



exhIbIt 4 — suMMary statIstIcs: total ceo coMpensatIon, varIous Methods

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 calcu-

lated using the methodologies discussed earlier, with earned stock option value based on intrinsic value.

MEan CoMpEnSaTIon (2010)

MEDIan CoMpEnSaTIon (2010)

source: equilar compensation data. calculations by the authors.

decileMarket

capitalization(in millions)

summary compensation

table

institutional shareholder

servicesexpected Value

earnedValue

Highest $ 39,982 $ 14,130,597 $ 17,595,544 $ 13,181,418 $ 12,018,347

7,132 7,904,858 9,911,257 7,380,223 7,034,703

3,375 6,037,811 7,781,580 5,879,114 5,229,651

2,079 4,646,368 5,760,233 4,547,047 3,910,954

1,326 3,872,349 4,833,941 3,888,635 3,377,383

863 2,877,698 3,642,764 2,862,030 2,444,539

585 2,520,118 3,038,112 2,512,779 2,124,444

378 1,988,675 2,563,376 2,126,550 1,768,966

246 1,516,684 1,836,673 1,570,411 1,282,740

lowest 143 1,160,671 1,405,679 1,238,572 1,029,749

decileMarket

capitalization(in millions)

summary compensation

table

institutional shareholder

servicesexpected Value

earnedValue

Highest $ 22,522 $ 12,220,817 $ 15,312,751 $ 11,210,876 $ 9,218,322

6,895 6,932,325 8,878,721 6,763,005 5,696,422

3,257 5,245,581 6,669,452 4,837,471 3,799,896

2,061 4,046,318 5,006,225 3,942,680 3,046,327

1,312 3,093,924 4,024,939 3,159,052 2,437,328

853 2,360,580 3,129,763 2,328,114 1,873,891

574 2,074,024 2,574,915 2,073,491 1,700,898

372 1,415,159 1,894,097 1,577,976 1,200,413

241 1,190,955 1,411,867 1,226,952 976,996

lowest 149 858,204 1,045,605 865,041 794,706