Big companies pay CEOs for good performance-and bad

The best performers got big pay and big raises last year, but the laggards didn't do much worse. Complex arrangements to tie compensation to company results keep coming up short

The mechanics of chief-executive pay have grown ever more complex, but the rules remain simple: Strong performers get a raise. So do most of the rest.
 
For the fourth year straight, the biggest U.S. companies set CEO pay records in 2018, a Wall Street Journal analysis found, even as a majority delivered negative stock-market returns to their shareholders—a sign of the often-weak relationship between pay and performance.Median compensation rose to $12.4 million for the bosses of S&P 500 companies last year, up 6.6% from 2017 and the highest since the 2008 recession, the Journal analysis found. Yet the median shareholder return for the companies was minus 5.8%, the worst showing since the financial crisis.For 97 CEOs, last year’s pay was a high-water mark even while their shareholder returns were in the bottom half of the group. Among them: dialysis chain DaVita Inc., which doubled Kent Thiry’s pay to $32 million and recorded a negative 29% return, and Gap Inc., which paid Art Peck $20.8 million, the most of his four-year tenure, when it logged a negative 21% return.

 
Such mismatches highlight lingering questions about how successfully corporate boards have tied executive pay to company performance. Urged on by investors and governance advocates, companies have spent years crafting mechanisms to do this. In many cases, new research suggests, the fault lies with the execution and complexity.
 

“The more complicated the scheme is, it’s less transparent to consumers and society,” said Alex Edmans, a professor of finance at London Business School who has studied executive-compensation trends on both sides of the Atlantic.
 
DaVita declined to comment. Its proxy statement notes that $14 million of the increase in Mr. Thiry’s reported pay came from a new retirement benefit that lets executives keep restricted stock they otherwise would forfeit on retirement if they meet certain age and tenure thresholds. Absent that change, Mr. Thiry’s pay would have risen 13% to $17.3 million. Mr. Thiry is stepping down as CEO June 1.

 
Gap said that since Mr. Peck’s appointment to CEO in February 2015, stock-price changes and other factors mean he ultimately received cash and equity averaging about $4.75 million a year—considerably less than the $12.9 million average reported in securities filings. In 2018, Mr. Peck also gave up his bonus “in light of business performance.”
 
For its annual ranking, the Journal examined 442 companies with fiscal years ending after June 30, 2018, and disclosing pay data through May 1. Companies that changed CEOs during the year were omitted, leaving 400 CEOs. The analysis includes salary, bonus and stock awards as they are valued in securities filings.

 
The highest-paid executive was Discovery Inc.’s David Zaslav, whose pay tripled to $129 million thanks to an equity grant tied to a new five-year contract. Discovery posted a 10.5% shareholder return for the year.
 
The television-channel owner said Mr. Zaslav’s pay increase is largely the result of stock-option awards tied to his new contract running through 2023, with exercise prices that escalate each year. Future pay will approximate earlier years, it said. Mr. Zaslav has averaged $41 million in pay in most recent years.
 
There are almost as many ways of measuring corporate performance as there are ways to compensate a CEO. None of them are perfect, pay experts caution. But one widely used measure—total shareholder return, which tracks stock performance and assumes dividends are reinvested—illustrates the challenge.

 
Only two of the 25 highest-paid CEOs in the Journal analysis led companies that ranked in the top 25 for 2018 shareholder return: Netflix Inc.’s Reed Hastings and Adobe Inc.’s Shantanu Narayen.
 
More broadly, sorting CEOs into groups by company performance shows the 20% with the highest shareholder return claimed the biggest paychecks, with a median of about $14 million. But the 10% of companies with the worst returns also gave big packages, with a median of $12.6 million for those CEOs.
 
One-year performance can be skewed by bad luck and long-term plans that take time to bear fruit. Over longer time periods, pay and performance correlate better—but still far from robustly, analysts and many consultants say. Comparing CEO pay growth against shareholder returns over five years shows pay growing faster at about 28% of S&P 500 companies, sometimes sharply so, according to data from proxy advisory firm Institutional Shareholder Services.

 
“There are lots of individual cases where things aren’t working great yet,” said John Roe, head of ISS Analytics.
 
At Fluor Corp. , David Seaton led the engineering and construction company starting in 2011. His reported pay rose 24% last year, even as the company posted a negative 37% return in 2018—and annual returns trailed those of most other S&P 500 capital-goods companies in the Journal analysis for each of the past five years.
 
Mr. Seaton’s total pay rose in three of those five years, and overall he was paid $56 million, much of it in stock, during that time. In the most recent year, 2018, restricted stock made up $9.6 million of the total, compared with a $5.6 million award in 2017. Fluor said much of that increase stemmed from a change in the way the company structured its equity awards beginning in 2016, leaving the reported value of stock grants that year and in 2017 smaller than they otherwise would have been.

 
Yet cost overruns on some projects and other issues forced the company to take more than $1 billion in write-offs over the three years, hitting its shares and leading to several earnings misses in recent quarters. On May 1, Mr. Seaton stepped down just before the company reported a first-quarter loss that sent the stock tumbling 28% in a day.
 
Fluor’s proxy notes that the pay Mr. Seaton could actually realize from the last three years was about 60% of his target compensation, thanks to stock-price declines and other factors.
 
“What you’re granted is not what you receive,” Dawn Stout, Fluor’s vice president of law, said. “We feel pretty strongly we have a performance-based plan, and 90% of his compensation is variable, tracking performance.”

 
Indeed, companies and pay consultants often complain that the figures reported in securities filings can be misleading. Equity is valued at the time options and restricted stock are awarded, even though CEOs might not get full title to it for years.
 
Measuring the pay CEOs ultimately receive—including stock-price appreciation or declines—shows much better correlation with performance, said Ira Kay, managing partner at consulting firm Pay Governance. “We measure whether there’s after-the-fact alignment.”
 
When pay fails to track performance, it generally isn’t for lack of mechanisms to link CEO pay to the fortunes of the companies and their shareholders. In 2018, half of compensation awarded to S&P 500 CEOs consisted of restricted stock. Including stock options, two-thirds of CEO pay last year was equity.

 
Increasingly, those awards consist of performance shares and options, meaning the executives get more of the securities when the company meets key targets—and fewer when they fall short.
 
So why—with formulas yoking CEOs’ pay to the success of the companies they manage, and to the performance of the companies’ shares—are pay and performance still so misaligned?
 
A recent study by researchers at Cornell University and the Massachusetts Institute of Technology suggests part of the problem may lie in the operating and stock-market goals that corporate boards set to measure company performance—and thereby determine executive pay. Many such goals use financial or other measures that don’t meet generally accepted accounting principles, and instead substitute metrics that exclude some costs or financial benefits that the company deems outside management’s control or not reflective of core performance.

 
The problem: Companies that make big adjustments to measures of profit tend to pay their CEOs more—by an average of 16%—than other companies, the researchers found. The difference averaged $1.9 million a year above and beyond what the CEOs would otherwise be expected to earn. The solution, one of the authors argues, is more clarity about how performance is measured.
 
“If we’re going to ever come to pay for performance, we have to have a better compensation committee report that tells us what exactly these measures are,” said MIT senior lecturer Robert Pozen, a co-author of the paper and former executive at Fidelity Investments and MFS Investment Management.

 
Mr. Kay, the pay consultant, said directors are careful in picking performance targets. “I see that the boards definitely agonize over whether these adjustments are appropriate to make,” he said. “In the final analysis, we do think they add the right things back and take the right things out.”
 
Celgene Corp. relied on non-GAAP metrics last year to determine pay for CEO Mark Alles. The drugmaker’s shares fell nearly 40% over the course of 2018, battered particularly after Celgene hit setbacks in the development of several potential drugs. Still, Mr. Alles’s compensation rose 24% to $16.2 million.
 

Despite its drug-development stumbles, the company said, just under half of Mr. Alles’s annual bonus was based on meeting selected objectives in expanding Celgene’s product pipeline.
 
While Celgene posted GAAP earnings of $5.65 per share for 2018, the adjusted earnings the company reported to investors came in at $8.87, once the company stripped out the cost of acquiring research assets and other items. For the purposes of its management incentive plan, Celgene tweaked its EPS figure further to adjust for an acquisition and share buybacks. That revised figure: $9.06, surpassing the $8.70 to $8.90 target range it had set for its top executives to hit. Pay consultants generally say boards take into account adjustments from standard accounting measures when setting targets for executive compensation.

 
Ultimately, Mr. Alles could get an even bigger payout: Celgene crafted new change-in-control provisions for him and other senior executives in December, as the company negotiated a $74 billion sale of the company to Bristol-Myers Squibb Co. He would receive an exit package of $28 million if he departs after the acquisition closes.
 
A Celgene spokesman noted that 2018 results exceeded the company’s forecasts and that by GAAP standards, earnings rose more steeply than on an adjusted basis, climbing 51% per share from 2017. The spokesman also said Mr. Alles took on the duties of board chairman last year, in addition to serving as CEO. The company’s securities filing indicates his salary rose about $265,000 a year and his bonus target rose about $670,000 at the time of the promotion.

 
The growing complexity of CEO compensation packages and the performance mismatches have spurred some investors to call for revamping executive pay in a radically simple way: Pay CEOs in cash and give them shares they must hold for, say, at least five years.
 
The idea of compensating CEOs primarily by making them long-term shareholders in their companies has been recently endorsed by Norway’s $1 trillion sovereign-wealth fund and recommended by a House of Commons committee in the U.K. examining corporate governance. Removing the specific, but often arbitrary, performance targets would free CEOs from trying to hit them and instead let them focus on creating long-term value, said Mr. Edmans of London Business School.

 
Often, when it comes to CEO pay, he said, “the simple things are better than the sophisticated ones.”