This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.
Last week’s blog on proposed changes to Wall Street pay got me thinking: while it’s easy to see in retrospect what was going wrong in executive pay leading up to the financial crisis, why didn’t shareholders spot these problems sooner, before the crisis hit? Perhaps it’s just hard to be critical when times are good. When shareholders are satisfied, it’s easy to overlook the distinction between proper pay-for-performance and simply egregiously high pay. Unfortunately, it took a major crisis for us to open our eyes and demand reform. While it’s better late than never, what can we learn from the major banks during the financial crisis that might help us identify and eliminate risky compensation practices before they cause systemic damage?
To help spot what did and what didn’t work in the pivotal years leading up to the crash, I pulled the Farient Alignment ReportsTM on some major US banks. The Alignment Reports clearly show whether or not the CEO pay of each bank was: (1) reasonable compared to the relevant market, and (2) sensitive to company performance, as indicated by Total Shareholder Return (TSR) over time. It was no surprise to me that, for the most part, the better aligned companies were more successful in getting through the crisis than those with poor alignment.
To illustrate the point, I have drawn lessons learned from two companies (Bear Stearns and Lehman Brothers) that were misaligned from a pay and performance perspective, and two companies (JP Morgan and Morgan Stanley) that were relatively aligned.
Bear Stearns: Bear Sterns’ Alignment Report shows that in every single year from 2001 through 2007, the total Performance-Adjusted CompensationTM of CEO James Cayne was unreasonably high, even compared to the lofty pay levels in investment banking. A study commissioned by the Council of Institutional Investors, entitled Wall Street Pay – Size, Structure, and Significance for Shareowners, found that the sheer magnitude of Wall Street pay, while seemingly aligned with shareholder interests through the heavy use of equity-based compensation, was actually misaligned with shareholder interests because the vast size of the pay acted as a kind of insurance for executives against failure. So, even though Bear Stearns’ chart shows good sensitivity between TSR performance and Performance-Adjusted Compensation, the fact that Cayne’s pay was unreasonably high cancelled any benefit of pay being sensitive to performance and failed to provide the disincentive needed to stave off excessive risk-taking.
Lesson learned: Pay sensitivity is not enough; the amount of pay must be reasonable relative to long-term industry norms for the performance delivered.
Lehman Brothers: While Lehman Brothers also had issues of unreasonable pay (as indicated by Dick Fuld’s pay being above the Alignment Zone in the years leading up to the crisis), a more alarming concern was that Lehman’s pay was overly sensitive to performance. Fuld had an enormous upside in pay for only moderate increases in performance relative to others in the industry. Moreover, the downside wasn’t as punitive as the upside was enriching. For example, Fuld’s restricted stock awards, while seemingly “performance-based,” vested one year after grant for achieving relatively low financial hurdles.
Lesson learned: High upside opportunity, with little to lose on the downside, is not a winning combination for shareholders.
JP Morgan: In stark contrast to Bear Stearns and Lehman, JP Morgan’s Alignment Report illustrates a very conservative approach to pay. In all years from 2005-2009, Jamie Dimon’s pay was actually slightly under the Alignment Zone, demonstrating a refreshing level of modesty in pay for one of the better-performing companies during the recession. Even in 2008 when JP Morgan was far ahead of its peers in terms of relative performance, aggregate incentive compensation for executives decreased by 72 percent from the prior year in response to the company’s absolute performance suffering in the recession. Despite a heavy use of discretion in determining bonuses, the Compensation Committee demonstrated an appropriate understanding of limiting the level and leverage of incentive pay, keeping any risk that may be induced by executive compensation plans in check.
Lesson learned: Successful companies manage risk as well as reward.
Morgan Stanley: In a way, I’ve saved the best until last. Morgan Stanley’s Alignment Report is a standout in the industry. From 2000-2009, pay was well-aligned with performance, and the leverage, or risk-orientation, of the program was balanced on both the upside and downside. In terms of reasonableness, the Performance-Adjusted Compensation for Morgan Stanley’s CEO, John Mack, is in the Alignment Zone, indicating a history of reasonable pay for the company’s size, industry, and performance delivered. It’s worth noting that is not a coincidence, as Morgan Stanley did a number of things differently from its banking peers. For example, while most banks used only absolute measures of performance in their incentive plans, Morgan Stanley used a combination of absolute and relative measures that compared the company’s performance to that of its peers. As a result, in using the relative stock price growth and other market measures, Morgan Stanley did not pay its CEO for the windfall gains that were realized during the boom years of 2005 to 2007. Also, Morgan Stanley was ahead of its peers by attaching long-term performance criteria to the vesting of stock options based on ROE, TSR, and Pre-tax Profit measures over three years.
Lesson learned: Set goals in a relative context and/or use relative measures in the pay program; unless there is a strong rationale otherwise, set target pay at median market levels, letting actual future performance drive actual pay to above or below market levels over time.
At this point, Dodd-Frank requires that banks report on their pay and performance alignment. My hope is that all banks will not only comply with the letter of the law, but also with the spirit of it as well, offering reasonable pay for performance, as well as pay that is appropriately sensitive, or leveraged, to performance. Doing so is bound to benefit the company, the industry, the economy and investors alike.
Special thanks to my Farient colleague Katherine Edwards who helped with the research for today’s blog.
Robin A. Ferracone is the Executive Chair of Farient Advisors LLC, an independent executive compensation and performance advisory firm that helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled Fair Pay, Fair Play: Aligning Executive Performance and Pay, which explores how companies can achieve better performance and pay alignment. Robin can be contacted at email@example.com.