What CEOs Really Make: Breaking Down Executive Compensation
Salary conversations may be taboo in polite company, but investors curious about the paychecks of corporate executives need not skirt social mores to find out.
Every year, publicly-traded companies include compensation tables detailing the pay for their highest-ranking executives in their proxy statements, which are released ahead of annual shareholder meetings.
For the average investor, understanding the nuts and bolts of executive compensation can be challenging as pay packages for CEOs and other high-ranking executives tend to be considerably more complicated than those offered to the average American worker. In addition to a salary and a bonus, a compensation package may include stock awards and stock options. Companies also typically provide executives with either traditional bonuses, non-equity incentive compensation — a type of cash bonus tied to specific performance goals — or both.
"At a high level, compensation is essentially broken down between what is fixed and what is variable," said Matthew Goforth, a research and content specialist at the executive compensation research firm, Equilar.
Salary, Goforth explained, is fixed, and so too are some types of stock awards. But stock awards and bonuses can also be variable and tied to different metrics.
Let's take a closer look at these compensation categories. (It should be noted that employees who are not executives may also receive such compensation but, in light of the information available in proxy statements, we're concentrating on executives.)
One example in the fixed category of stock awards is time-vesting equities, which are tied to the amount of time an executive spends with the company. Such awards are considered fixed because, while the price of shares may fluctuate over time, the number of shares an executive receives will not vary as long as he or she remains with the company for a minimum period.
Time-vesting equity, Goforth said, is used to encourage executive retention.
"Companies want their executive talent to stick around and do the job they were hired to do," he said.
On the variable side of the equation are stock awards that are intended to encourage executive performance. Such awards, known as performance-based equity, are typically tied to specific company performance measures, such as revenue or earnings per share growth, over a period of at least two years or longer. An executive may be eligible to receive a certain number of shares once the company meets a specific target within the given amount of time.
Meanwhile, restricted stock units (RSUs) have become an increasingly popular type of stock award in recent years that can be structured either as a time-vesting equity or a performance-based equity.
Here's how they work: When executives are awarded stocks in the form of RSUs, they possess some rights and benefits in relation to the stock, but do not have full ownership of the stock until a certain period of time has passed (in the case of time-vesting equity) or until a certain performance goals are met (in the case of performance-based equity.)
For instance, during the so-called restricted period, an executive may receive dividends on RSUs but will not be allowed to sell the shares. In another case, an executive may be allowed to vote his or her shares during shareholder referendums, but may be prohibited from using the shares as collateral. RSU conditions vary from company to company.
An employee stock option is a contract that grants an employee the right to buy shares in his or her employer at a specific, fixed price, known as the exercise price after a designated date.
An executive awarded stock options by his or her company may choose to buy stock from the company once his or her options have vested — that is they have become eligible to exercise — and if the stock's market price exceeds its exercise price. If the company’s stock price doesn’t exceed the exercise price at the time of vesting, it wouldn’t make financial sense for the executive to exercise his or her option.
Stock options have fallen out of favor in recent years for a number of reasons. During the 2008-2009 financial crisis many became wary of options as falling stock prices led to "underwater options" — contracts that specified an exercise price above the stock’s market value, in effect making the options worthless since it would be cheaper to buy the stock on the market than through the option.
In 2010, when the Dodd-Frank Wall Street Reform and Consumer Protection Act allowed non-binding shareholder votes to approve executive compensation, proxy firms — firms that advise institutional investors on shareholder votes — began calling for voters to favor performance-based awards, such as RSUs, over options.
Some also prefer RSUs to options because RSUs lead to less shareholder dilution — the decrease in what percentage of the company each share represents resulting from an increase in the total number of shares — than options.
In the case of an option, an executive has to spend his or her own money to buy the stock (even if they ultimately sell it), while an RSU is granted to an executive without any investment on his or her part. As such, an RSU generally holds more value than a single stock option for the executive receiving it (unless the company's stock price plummets to zero in which case both an RSU and a stock option are worthless.) Therefore, a company must issue more stock options to equal the same value of fewer RSUs, so if a company goes the RSU route it can issue fewer shares than it would through options, resulting in less shareholder dilution.
Cash Bonuses and Non-Equity Incentive Compensation
Companies may choose to provide executives cash bonuses, non-equity incentive compensation or both.
Traditional cash bonuses are usually structured as a percentage of an executive's salary and are tied to a company's performance in a given year. Traditional bonuses tend to be discretionary, meaning that an executive may be awarded a bonus if a company had a good year irrespective of any specific performance targets.
Non-equity incentive compensation bears some similarity to traditional bonuses, but such compensation may be based on a company's performance over a multi-year period and may be contingent on the company meeting certain performance goals, much like performance-based equity awards.
Some corporations prefer non-equity incentive compensation because, under IRS rules instituted in the 1990s, non-equity incentive compensation may make companies eligible for higher corporate tax deductions than traditional bonuses.
Learning More About Executive Compensation at Specific Companies
Under SEC rules, corporations are required to provide "Compensation Discussion and Analysis" sections in their proxy statements. These sections — often called CD&As, for short — provide information on companies' compensation practices and explain how compensation committees make their decisions.
To find a CD&A in a proxy statement, refer to the statement's Table of Contents. Proxy statements for publicly-traded companies are available on the SEC's EDGAR database.