NEW YORK, NY – Following the U.S. Securities and Exchange Commission's (SEC) recent adoption of rules that require executive pay to be tied to a company’s financial performance, new research explores a better way to calculate a CEO’s pay that could improve outcomes for companies, and therefore investors. The SEC developed its rules to give investors in public companies a line of sight into executive compensation policies. However, Columbia Business School Professor Shivaram Rajgopal finds that many businesses continue to use an initiative known as “competitive pay policy” – awarding stock to CEOs at a fixed price, which can lead to windfalls even when companies underperform.

New research by Rajgopal and co-authors University of Modena and Reggio Emilia Professor Mascia Ferrari, University of Zurich Professor Francesco Reggiani and Stephen O’Byrne of Shareholder Value Advisors Inc. calls on companies to improve their formula for compensating executives with stock grants. The researchers built a combined dataset from the Center for Research in Security Prices and Execucomp spanning 1992 to 2018, leading to 21,614 instances of publicly-traded companies with records of CEO compensation. They analyzed companies that grant stock to executives at a fixed price, compared to those that award stock as a fixed number of total shares. Traditionally, researchers calculated performance-based pay by running a regression on the pay the CEO received and stock returns compared to earnings in a similar period. The research by Rajgopol and his co-authors provides evidence that a competitive pay policy creates an inherent performance penalty – poor performance is rewarded with larger share grants, while superior performance is penalized with fewer shares.

“If corporate boards want to match their chief executives’ compensation to company performance, then it really doesn’t make sense that companies would continue to use a pay policy that backfires,” said Professor Shivaram Rajgopal, the Kester and Byrnes Professor of Accounting and Auditing. “The SEC’s latest rules demonstrate that they are willing to create more transparency for investors on the issue, but the rules don’t go far enough to address the heart of the problem – that CEOs often are inaccurately paid performance-based compensation based on the growth of the company’s value year over year.”

To better align executive compensation and a company’s financial performance, Rajgopal recommends that businesses evaluate company performance from the perspective of the average stockholder, measuring the return a stockholder would receive in a given period compared to a comparable benchmark in the financial market (like the overall market index). In cases where the investor was better off investing in the company than an alternative, the CEO is rewarded; but if they were worse off for investing in the company over an alternative, the CEO also feels the loss.

The full report, Competitive Target Pay Practices for CEO Compensation, is available online here.

To learn more about the cutting-edge research being conducted at Columbia Business School, please visit www.gsb.columbia.edu.

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