Why has academic research had so little impact on US executive pay practice?

• Published date: 01 March 2023
• Author: Stephen F. O'Byrne
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/jacf.12564

DOI: 10.1111/jacf.12564

ORIGINAL ARTICLE

Why has academic research had so little impact on US executive pay

practice?

Stephen F. O’Byrne

Shareholder ValueAdvisors

Correspondence

Stephen F.O’Byrne, Shareholder Value Advisors.

Email: sobyrne@valueadvisors.com

INTRODUCTION

The now voluminous academic literature on executive pay shows

surprisingly little awareness of the history of US public company

pay practices. There is today a nearly universal misconception,

even among finance and accounting scholars, that there was lit-

tle incentive pay at US public companies until stock option use

exploded in the 1980s. What’s more, there has been virtually no

recognition of the widespread use of incentive plan fixed-sharing

formulas by US public companies in the first half of the 20th cen-

tury. General Motors,as the most famous example, had a pay plan

that made the bonus shared by the entire senior management team

(nearly 3000 managers in 1929) equal to 10% of GM’s total after-

tax profit in excess of a 7% return on capital. GM continued to

use this formula, with only slight variations, from its start in 1918

until 1982, when the company’s drop in profitability reduced the

bonus pool to zero.

Also conspicuously absent in the academic literature on exec-

utive pay is recognition of the reduction in effective CEO

pay-for-performance that has been accomplished (presumably

unintentionally and unknowingly) by the adoption of so-called

“competitive pay” practices starting in the late 1960s. The

post-World War II development of modern human resource

management, with its reliance on private compensation surveys

designed to establish the “going rate” for each “benchmark” job,

has led to the replacement of the fixed-sharing practices, often

based on EVA-like formulas (like GM’s above), that were in fact

the rule among large public companies before World War II. The

competitive pay policies that began to take hold in the 60s and

70s aimed to establish targeted levels of pay (measured in dollars)

as opposed to fixed sharing percentages, which had the effect of

making (cumulative) pay over longer periods of time largely inde-

pendent of company performance. What corporate boards and

HR departments came to care about most was that their top execs

had pay plans that promised to provide, at the start of each new

year, total pay equal to at least 50th percentile pay for the job.

Both the near-complete replacement of GM-type sharing for-

mulas in public companies by such targeted dollar pay and the

resulting reduction in pay for performance (which I have long

tracked using a measure called “managerial wealth leverage”)

have gone largely unnoticed by both academics and practition-

ers. Stated as briefly as possible, “wealth leverage” is the ratio of

the percentage change in an executive’s total wealth—stock and

options holdings plus the present value of expected future pay—to

the percentage change in shareholder wealth.1

To see the difference between old-fashioned (pre-WW II) fixed

sharing and today’s competitive pay practices, let’s consider the

effect of a 5% increase in a company’s profitability and value.

For a CEO paid with a fixed percentage (or “share”) of current

and future EVA, such an improvement would increase the CEO’s

expected future pay by the same 5%. But for the CEO of a

company run according to competitive pay practices, that same

5% improvement would be associated with a significantly smaller

change in expected future pay. Why? Because of the annual recal-

ibration built into competitive pay policy that effectively penalizes

superior performance (by raising performance targets and reduc-

ing equity grant shares) and rewards substandard performance (by

reducing targets and increasing equity grant shares).

So, for example, if a company’s return on capital increases

by 200 basis points (and is maintained at the higher level), an

executive’s bonus under the old GM bonus formula would have

increased not only in the current year, but in all future years.

But in the case of competitive pay policy, the executive’s bonus

increases only in the current year. In the years that follow, the

company raises its EVA target, reducing the management team’s

share of EVA, to bring the expected bonus back down to the

level of the target bonus. And so, whereas under the GM shar-

ing formula a large component of an executive’s lifetime expected

wealth—in fact, the entire present value of his or her expected

future pay—was highly sensitive to current performance, under

the competitive pay practices that prevail in most large US com-

panies today that large future expected wealth is largely unaffected

by current performance.

1See O’Byrne, Stephen F., and S. David Young,“Top Management Incentives and Corporate

Performance.” Journalof Applied Corporate Finance 17(4), Fall 2005.

58 © 2023 Cantillon & Mann. J. Appl. Corp. Finance. 2023;35:58–65.wileyonlinelibrary.com/journal/jacf