It’s easy to be angered when looking at some of the outrageous figures corporate executives are paid.
- Tim Cook, CEO of Apple Inc. (NASDAQ:AAPL): $4.2 million
- Michael Corbal, CEO of Citigroup Inc (NYSE:C): $11.5 million
- Indra Nooyi, CEO of PepsiCo, Inc. (NYSE:PEP): $12.6 million
But as shareholders, we should care less about how much managers are compensated – but rather how they’re paid.
Incentives matter
A good pay package should encourage managers to run companies correctly, to consider the long term and avoid taking excessive risks. But in many cases, compensation schemes not only fail to achieve that goal but actually encourage destructive behavior.
For example by linking pay to profits, managers can juice returns by writing risky sub-prime loans and leave before the defaults occur.
Or executives can increase profitability by scrimping on research and development spending.
This may benefit the share price in the short term, but only at the expense of the company’s long-term health.
Solutions
However, there are some possible solutions to this problem.
Pay them in debt: Many executive compensation plans are just stock and cash, but many would benefit by paying managers in debt as well. This structure will significantly reduce risk taking because managers have less upside from risky bets and are exposed to the downside.
Equity investors may wonder why they should consider the interests of debt holders. But paying CEOs in debt results in fewer restrictive covenants and lower interest rates on loans. Ultimately, that saves shareholders money.
Make them wait: Lengthen the time executives must wait to cash in their shares and options. Too many compensation packages only lock in pay for one to two years which encourages short-term thinking. Pay packages should be extended to encourage managers to consider the long-term implications of their decisions.
How long? That depends on the nature of the business. Industries that operate on long cycles, like pipelines and pharmaceuticals, should lengthen pay packages as far out as seven to 10 years.
Positive developments
Fortunately, shareholders are aware of this problem and are starting to make their voices heard in the boardroom.
Last February, Apple Inc. (NASDAQ:AAPL) shareholders pushed for major compensation reform.
Back by activists like David Einhorn and the California Public Employees Retirement System, shareholders passed an amendment that requires executives to hold a greater amount of stock. The amendment is an effort to get them to think less like employees and more like owners.
Executives are now required to hold three times their base salary in stock. CEO Tim Cook is required to hold 10 times his salary in shares.
In February, disgruntled Citigroup Inc (NYSE:C) shareholders pushed for major changes to the company’s executive compensation program.
In 2011, the bank was criticized for paying executives at the discretion of the board of directors. After the amendment, bonuses are calculated based on a formula that incorporates share price performance relative to peers and the company’s return on assets. While the formula isn’t perfect, it’s a major improvement to the scheme that was in place before.
Using returns on assets rather than returns on equity is also notable. Measuring profitability based on equity returns encourages banks to load up on debt to juice profitability, which in turn makes them vulnerable to unexpected losses.
Shareholders at PepsiCo, Inc. (NYSE:PEP) are also pushing for changes to executive compensation.
The company did away with outright stock option grants last year. Instead compensation is tied to a long-term incentive program based on the performance of the company’s share price and profitability.
In 2012, the PepsiCo, Inc. (NYSE:PEP)’s earnings fell to $6.18 billion, or $3.92 per share. That was down 4% from $6.44 billion, or $4.03 pershare, in the previous year. The company has struggled to turn around operations after losing market share to rival The Coca-Cola Company (NYSE:KO).
As a result, PepsiCo, Inc. (NYSE:PEP) cut CEO Indra Nooyi’s pay package 11% from the previous year.
These changes to executive compensation probably won’t have a material impact on financial results so why should shareholders care?
First, management efforts to address shareholder concerns reflects good corporate governance. That could become an important issue the next time a more important issue comes up like the company’s dividend policy.
Second, better aligning the interests of shareholders and management results in higher investor returns.
Foolish bottom line
While the recent developments are encouraging, shareholders need to continue to push for changes in management compensation. Only by aligning executive interests with shareholders can we ensure the long-term health of these businesses.
Robert Baillieul has no position in any stocks mentioned. The Motley Fool recommends Apple and PepsiCo. The Motley Fool owns shares of Apple Inc. (NASDAQ:AAPL), Citigroup Inc (NYSE:C), and PepsiCo, Inc. (NYSE:PEP).
The article Shareholders Unite! How We Can Fix Executive Compensation originally appeared on Fool.com.
Robert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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