The Mismeasure of Mammon: Uses and Abuses of Executive Pay Data

Abstract

Times mismeasured the actual take-home pay of each and every one of these CEOs in 2014 and 2015. The reason for this mismeasure is that both articles relied on "fair value" estimates of the stock-based pay of these CEOs as reported in the Summary Compensation Table of the definitive proxy statement (Form DEF 14A) that each publicly listed company files annually with the U.S. Securities and Exchange Commission (SEC). Yet the very same proxy statements also report the actual realized gains of these CEOs in the Option Exercises and Stock Vested Table. It is the realized gains on stock-based pay, not fair-value estimates, that enter into the total compensation that a CEO actually takes home and reports as income in his or her income-tax return. Moreover, including actual realized gains instead of estimated fair value of stockbased pay in the measure of total executive compensation can make a big difference. In 2014 average total compensation of the 500 highest-paid executives named on corporate proxy statements based on actual realized gains was $34.3 million, with 81 percent coming from stock-based pay. But average total compensation of the 500 highest paid based on estimated fair value was $19.3 million, with 62 percent attributable to stockbased pay. The excess of total actual realized-gains compensation over total estimated fair-value compensation was greatest in those years when the stock market was booming. Why would the Wall Street Journal and the New York Times report estimates of executive pay when they could be reporting the CEOs' actual pay? In this paper, we answer this question by explaining the origins of the "fair value" estimates of stock-based pay and how the obsession with these estimates by the SEC, relying on the business-run Financial Accounting Standards Board (FASB), has relegated to statistical obscurity executives' readily available, accurate, and actual realized gains from stock-based pay. We use Standard & Poor's ExecuComp database to document that a) stock-based pay, in the forms of realized gains from stock options and stock awards, dominates both the size of and the changes over time in the total compensation of the highest-paid senior executives; and b) the fair-value estimates of stock-based pay tend to understate, often substantially, the realized gains from stock-based pay that these executives actually receive. An irony is that even critics of excessive executive pay, most notably the AFL-CIO on its Executive Paywatch website, use the fair-value estimates when the actual CEO compensation numbers would reveal a much larger ratio of CEO pay to the earnings of the average worker. Indeed, as we discuss in the conclusion to this paper, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, this mismeasure of executive pay has become institutionalized in U.S. government policy in the SEC's Pay Ratio Disclosure Rule, which beginning in 2017 requires every company to publish the ratio of CEO to median-worker pay. Under this rule, the SEC requires companies to ...

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“…Compensation of executives includes salaries, social security contributions, post-employment benefits, non-monetary benefits, bonuses and deferred compensation, as well as stock-based payments. For the U.S. case, Hopkins and Lazonick (2016) have shown that executive compensation has been systematically mismeasured. When it comes to recording stock-based pay, the two bodies that determine how remuneration is being reported for the U.S. listed firms -the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC)promote the use of "fair value" estimates of what stock-based pay might be worth in advance of being realized as distinct from the gains that executives actually realize from stock-based pay.…”

“…Actual realized gains measure stock-based pay when stock options are exercised and stock awards vest, using the market price of the stock. Hopkins and Lazonick (2016), analyzing the 500 highest-paid corporate executives of U.S. companies from 1992 to 2014, show that a) stock-based pay, in the forms of realized gains from stock options and stock awards, dominates both the size of and the changes over time in the total compensation of the highestpaid senior executives; and b) the fair-value estimates of stock-based pay tend to understate, often substantially, the realized gains from stock-based pay that these executives actually receive, especially (for reasons having to do with the systematic implementation of expensing of stock options on financial statements) since 2003. Since it is the actual realized gains from stock-based pay that are relevant as incentives for the executives, it is the realized-gains measure, and not estimated fair value, that is relevant for analyzing the implications of stock-based executive pay for corporate resource allocation.…”