Evaluating Executive Compensation

Executive compensation can be an important factor to consider when evaluating a company. Executive pay that is aligned with a company’s strategy can boost performance, but other compensation structures that are managed poorly may result in an unmotivated workforce, the loss of employees, and weaker shareholder returns.

While new laws and regulations have made executive compensation much clearer in company filings, many investors remain clueless as to how to find and read these critical reports. This article will take a look at the different types of executive compensation and how investors can find and evaluate compensation information.

Key Takeaways

• Executive compensation can take various forms, including cash compensation, option grants, long-term incentive plans, and retirement packages.
• Information on executive pay can be found on public filings, including the 8-K and 10-K, among others.
• A common way to evaluate executive performance is by comparing executive pay to the firm’s stock performance, typically over a year.
• Comparing executive pay to industry peers is another method of evaluating executive performance.

Types of Executive Compensation

There are many different forms of executive compensation, offering a variety of tax benefits and performance incentives. Here are the most common forms:

1. Cash compensation: This is the sum of all standard cash compensation an executive receives for the year. In the proxy statement, the company will list the base salary for each key member of the management team, such as the chief executive officer (CEO), chief financial officer (CFO), legal counsel, director of sales, and other divisional heads.
2. Option grants: This is a list of all options granted to the executive; the information includes strike prices and expiration dates. Stock options, if used correctly, are a terrific way to inspire management to maximize shareholder value. However, there is a downside to options compensation. For example, management may be awarded a significant options grant that is barely out of the money, meaning if the stock price goes up a little, management will be able to exercise options, convert them to common stock, and sell the shares to reap a quick windfall. 
3. Deferred compensation: This compensation is deferred until a later date, typically for tax purposes. However, changes in regulations have reduced the popularity of this type of compensation.
4. Long-term incentive plans (LTIPs): Long-term incentive plans encompass all compensation tied to performance for tax purposes. Current tax laws favor pay-for-performance compensation.
5. Retirement packages: These are packages given to executives after they retire from the company. It is customary for some executives to receive health benefits upon retirement for years of service, or other reasonable perks. These are important to watch because they can contain so-called golden parachutes for corrupt executives or be payable regardless of whether the company meets its financial objectives or is even profitable. 
6. Executive perks: These are various other perks given to executives, including the use of a private jet, travel reimbursements, and other rewards. These are found in the footnotes. Perks paid out to executives at small companies should be subject to even greater scrutiny because this type of greed is more likely to bankrupt smaller companies or contribute to annual deficits.

Finding Executive Compensation

All executive compensation information can be found in public filings with the Securities and Exchange Commission (SEC). The SEC mandates all public companies to disclose how much they are paying their executives, how this amount is derived, and who is involved in determining pay. The information itself is disclosed in several locations, including:

• Form 8-K: The current event filing can be used to disclose compensation information if the event is related to changes in compensation policies and procedures.
• Form 10-K: The annual report filing is always used to disclose yearly compensation information.
• Form 10-Q: The quarterly report filing also contains quarterly compensation information.
• S-1/S-3 Forms: New issues contain executive compensation information relevant for future investors to consider.

Evaluating Executive Compensation

Evaluating executive compensation can be a difficult task for the individual investor. Luckily, there are many tools available to make the process easier. These tools automatically parse SEC filings to pull the numbers and make comparisons designed to give meaning to raw information.

Pay vs. Performance

One of the most popular ways to evaluate executive compensation is by comparing pay and performance. Unfortunately, many executives are given raises and bonuses even when their companies are faltering. Comparing pay to stock performance can help you determine whether executives are overpaid.

The specific metric used most often is comparing the change year over year in executive pay increases to the change year in stock price. If the change in the stock price outpaces the change in pay, the executive is not overpaid. Trends showing that executives are receiving a higher rate than stock performance can mean overcompensation for underperformance, which can hurt investors both in dollars paid out and incentive to perform.

Source: Pay Governance

Peer Comparison

Another popular way to evaluate executive compensation is to compare one executive to other industry peers. While market leaders typically have CEOs who are paid slightly more than their industries, the majority of executives should be paid on par with their peers. Here is the same example as above, except this time, it’s a peer comparison instead of pay vs. performance:

Here we can see the relative pay of CEOs among telecom companies in 2020. Mike Sievert of T-Mobile received the highest relative pay, and most CEOs earned a majority of their income from stock compensation.

Executive Compensation Laws

There have been many new laws passed to help satisfy investor concerns over executive compensation. Changes in SEC reporting requirements have forced companies to include an “Executive Compensation Discussion and Analysis” section to accompany future pay documentation in all SEC forms. This section requires a “readable” explanation of how the compensation was determined and what it encompasses.

Other laws have been more direct in curbing practices the companies themselves use. One prime example of this was the removal of the deferred compensation tax shelter that helped many executives avoid millions in taxes. Moreover, improvements in other tax loopholes have made it much harder for boards to justify large payouts and hide these payouts from investors.

How Do You Assess Executive Compensation?

Across publicly-traded companies, executive compensation can be evaluated by comparing the change in CEO pay to the change in share price. If the change in CEO pay increases significantly while the company’s share price falls, it may reflect that the CEO is being overcompensated for lacklustre performance.

Another common way to assess executive pay is by comparing it to industry peers.

What Is a Typical Executive Compensation Package?

Among S&P 500 companies, stock awards make up the vast majority of total compensation. Meanwhile, cash and retirement packages will typically make up a smaller share overall. In addition to these components, an executive compensation package may include a long-term incentive plan, which ties a CEO’s compensation with stock performance or other strategic goals.

How Much Do C-Level Executives Make?

Often, CEOs will receive $1 million or more in base packages, while the highest-paid chief executives in America can make upwards of $162 million in total compensation. In 2023, the median total compensation of S&P 500 CEOs was $15.7 million, more than doubling over the past decade.

The Bottom Line

Executive compensation is a critical aspect for investors to consider when making investment decisions. An improperly compensated executive can cost shareholders money and can produce an executive who lacks the incentive to increase profits and boost the share price. The good news is that the government is working to curb the problem with new laws that close loopholes and make the process more transparent. Combined with new analysis tools, investors can now be much more informed.