If the CEO is overpaid, blame the compensation committee – Robert Pozen & S.P. Kothari

MIT Sloan Senior Lecturer Robert Pozen

MIT Sloan Senior Lecturer Robert Pozen

MIT Sloan Professor SP Kothari

From The Wall Street Journal

Every year, shareholders of U.S. companies weigh in on executive pay by casting advisory votes on the reports of compensation committees. The committees are appointed by corporate boards to make recommendations about appropriate pay levels. Shareholders tend to take their reports at face value, voting to approve them in over 97% of cases. But their confidence is undermined by a lack of awareness about the often flawed methods compensation committees use to determine pay.

The trouble is that compensation committees frequently rely on faulty performance metrics that inflate executive pay. But the committee reports do not provide a sufficient explanation of these metrics to shareholders.

First, their reports routinely use “adjusted” earnings that are much higher than the figures calculated under Generally Accepted Accounting Principles. While many companies tout adjusted numbers in their press releases on earnings, regulations require these releases to give their GAAP figures equal prominence. By contrast, there is no similar rule for compensation reports, which may use only the adjusted numbers without quantifying their differences from GAAP.

Take Merck & Co., whose CEO had a bonus goal for 2015 of $3.40 in adjusted earnings per share. The compensation committee concluded that he had met that target, since the company’s adjusted earnings were $3.56 per share. But the committee’s report failed to mention that GAAP earnings were only $1.56 per share.

This example is not unique.

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