After some rocky years following the financial crisis, top Wall Street bosses look like they will be pocketing fatter paychecks again, raising questions about whether executive pay is getting out of line as the economy recovers. Perhaps the most stunning of the Wall Street pay announcements in late January was JPMorgan Chase CEO Jamie Dimon’s 74% raise — from $11.5 million in 2012 to $20 million for 2013. Also in January, the Goldman Sachs Group board awarded CEO Lloyd C. Blankfein $23 million in salary and bonus for 2013, a 9.5% increase from the previous year. And Morgan Stanley CEO James Gorman is getting $1.5 million in base salary — double the previous year’s level — and an 86% increase in his bonus, which will total $4.9 million for 2013.
For the bottom 99% of U.S. workers, whose average family income rose only 0.4% post-crisis from 2009 to 2012, these raises may look grossly supersized. But for shareholders, concerned primarily that CEO pay reflects performance, it appears that corporate boards have made strides in bringing CEO compensation packages in closer concert with shareholder interests — though more work lies ahead, say experts from Wharton and elsewhere. “Ten to 20 years ago, pay was set in smoke-filled backrooms,” says Wharton accounting professor Daniel Taylor. “But now with the passage of the Dodd-Frank Act, there’s a lot of disclosure in terms of how the pay is set, and the board has to do due diligence.”
Dimon’s 2013 raise, in particular, is raising eyebrows because of the many recent legal and regulatory entanglements that have occurred under his watch. Last year, JPMorgan forked over to the U.S. Justice Department $13 billion to settle charges that the firm failed to disclose adequately the risks of mortgage securities it sold in the years leading up to the 2008 financial crisis. The firm also paid fines last year to U.S. and British authorities for violations of banking laws leading to a $6 billion loss in 2012 from derivatives trades by one of its London traders, known as the London Whale. Separately, JPMorgan paid settlements to U.S. regulators in response to charges of manipulating energy markets and also for failing to alert authorities to suspicious activities related to Bernie Madoff’s Ponzi scheme.
“If people now are trying to constrain [JPMorgan from giving Dimon] a pay raise, it may make boards think twice before making substantial pay cuts [for bad performance] — which is not what we want.” –Alex Edmans
Now, JPMorgan is under investigation again by the U.S. Justice Department for possible violations of the Foreign Corrupt Practices Act for hiring relatives of highly placed Chinese officials, allegedly to gain business with large Chinese firms.
Is a 74% Raise Too Much?
Given JPMorgan’s legal and regulatory troubles, is Dimon overcompensated? Some analysts point out that JPMorgan’s stock rose by 33% last year, so a hike in CEO pay is reasonable. What’s more, Dimon got a big pay cut in 2012 due to the London Whale fiasco. “You could arguably say he didn’t get a raise,” says Mark Borges, principal at Compensia, an executive compensation advisory firm in Washington, D.C. According to Wharton finance professor Alex Edmans, “It was absolutely correct for the board to cut Dimon’s pay in 2012.” However, “if people now are trying to constrain the firm from a pay raise, it may make boards think twice before making substantial pay cuts [for bad performance] — which is not what we want.”
“The board could have chosen to split the difference by raising Dimon’s pay to only $15 million — not a pay cut, but [also] not back to his 2011 level — to hold him accountable to some extent,” says Borges. “But that might send a signal that they have lost confidence in him, which ultimately may not serve the best interests of shareholders.”
For those who note that Dimon’s pay rose at a higher rate than JPMorgan’s 33% stock price increase, Edmans says: “It’s not clear his pay raise is egregious” when looking at it in dollar terms. “JPMorgan’s market capitalization is $200 billion, and a 33% rise is about $60 billion,” he notes. “Out of the 33% rise, say 30% is due to the rise in the broader market and 3% is due to Dimon. That means $6 billion is due to Dimon. If he gets $20 million of that, that’s not actually out of whack.”
In addition, Dimon’s compensation package shows improvement in Wall Street’s efforts to tie CEO pay more closely to performance, Taylor points out. In particular, $18.5 million of his $20 million bundle is in restricted stock, which does not vest immediately. “These are shares that cannot be sold in the next two years,” says Taylor. “If he screws up, he pays a price, and if he scores big, he gets a cut of the profit.”
Taylor applauds the growing trend among Wall Street banks to award top executives with restricted stock instead of stock options, which can encourage outsized risk-taking. “If an executive has an option to buy shares at $15, he or she doesn’t exercise the option if the stock is below $15, so there’s no downside risk,” he says. “Tech companies may still use stock options to give top executives the incentive to take the risk to come up with the next iPhone, whereas one can make the argument that banks should be taking less risk.”
While restricted shares are a step in the right direction, Brandon Rees, acting director of the office of investment at the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO), endorses performance-based vesting as a more effective tool. Restricted stock, which vests over time, “rewards the mere passage of time and is more directly aligned with tenure than performance,” he says. In contrast, performance vesting — where shares vest when the CEO reaches certain targets, such as return on equity — depends on the CEO’s future performance. “We prefer that vesting standards be forward-looking,” Rees notes.
“Tech companies may still use stock options to give top executives the incentive to take the risk to come up with the next big iPhone, whereas one can make the argument that banks should be taking less risk.” –Daniel Taylor
Performance vesting has been on the rise in the last five to six years, as companies look for ways to tie CEO pay to long-term performance, says Aaron Boyd, director of governance research at Equilar, a leading executive compensation research firm in Redwood City, Calif. In 2012, three-fourths of S&P 500 companies’ CEOs received performance-based equity, up 8% from the prior year, while the number of them receiving stock options has declined, according to Equilar. By using performance vesting, companies are looking to avoid awarding a CEO lavishly for one good year when those results come at the expense of long-term growth, according to Boyd. For example, a bank may profit from selling risky mortgage securities one year, only to have those assets come back to cause losses later.
The Lake Wobegon Effect
The Dodd-Frank Act has provided companies with more reasons to improve CEO pay practices. Public companies now must hold advisory shareholder votes on executive compensation regularly, notes Amy Borrus, deputy director of the Council of Institutional Investors in Washington, D.C. Known as “Say on Pay,” these votes have acted as a “catalyst for engagement between companies and shareholders and have helped weed out outlier practices,” such as some non-financial CEO perks and tax gross-ups, where corporations pay for their CEOs’ taxes, she says.
About 97% to 98% of companies pass their Say on Pay vote every year, according to Boyd. Nevertheless, companies do make changes to their executive compensation packages “right up to the annual meeting,” says Rees. After a leading Wall Street bank failed its Say on Pay vote, the AFL-CIO convinced the bank to institute performance-based vesting.
One persistent challenge contributing to upward spiraling CEO pay is the Lake Wobegon effect, say experts. Boards continue to target their CEOs’ compensation to that of industry peers. Not wanting to be outdone by competitors, many companies target their CEOs’ pay to the upper percentiles of industry benchmarks. Like the children of the fictional town Lake Wobegon, all CEOs end up being above average, leading to ever higher industry averages and ever higher CEO pay.
“Now that we’ve established the practice of specific performance standards, shareholders and companies are just beginning this richer conversation.” –Brandon Rees
Still, says Rees, “anyone targeting above the 75th percentile in their peer group is rapidly disappearing.” New Dodd-Frank rules expected this year, requiring companies to disclose the ratio of CEO pay to the median pay of their workers, may help spur a downward trend, he adds. “Rather than encourage companies to compare their CEO to other CEOs, it also encourages companies to describe how CEO pay relates to that of other employees at the company.” In 2012, CEOs for S&P 500 companies received 350 times their employees’ pay, according to AFL-CIO estimates.
Better Performance Measures?
Is the return to shareholders the only performance measure that should determine CEO pay? Today, to calculate CEO compensation, companies largely measure performance by total shareholder return, earnings per share or revenue, according to Equilar. To what extent should the board also take into account long-term performance based on increased productivity, innovation, sustainability, legal and regulatory compliance and other measures? “Now that we have established the practice of specific performance standards, shareholders and companies are just beginning this richer conversation,” Rees says. “It’s hard to have a quantitative metric for legal compliance, but it’s very important,” as illustrated by JPMorgan’s London Whale experience, he adds.
Wharton’s Taylor is currently conducting research related to such inquiries about how executive pay structures can provide incentives for better corporate performance and behavior. He and his colleagues are finding that banks with higher risk-taking incentives in executive pay plans ended up with bigger risks in off-balance sheet transactions during the financial crisis. “If you are a bank regulator, you need to be concerned about the CEO’s pay package,” says Taylor. “Since we find it difficult to know at the time what activities are risky, perhaps you can use risk-taking incentives [in executive compensation] as a proxy for hidden risk. To make the system less risky, we would want to give CEOs incentives to reduce risk. Absent incentives, I don’t see how anything is going to change. We all take actions in our best interest.”