How many S&P 500 CEOs are overpaid? Which CEOs are underpaid? Should executive compensation be capped? Do financial incentives improve performance? I recently asked Robin Ferracone, author of Fair Pay, Fair Play: Aligning Executive Performance and Pay, and I began by asking her to define fair pay.

Robin Ferracone: Fair pay, which I also call alignment, is something that, when total compensation after performance has been factored in, is (1) sensitive to company performance over time, and is (2) reasonable relative to the relevant market for executive talent and for the performance delivered.

Mac Greer: You write that the most important indicator of executive performance and, ultimately, long-term performance is total shareholder return, which you define as stock price appreciation plus dividends reinvested in the stock. What’s the appropriate time horizon for investors to measure total shareholder return?

Ferracone: When I wrote Fair Pay, Fair Pay: Aligning Executive Performance and Pay, I used companies in the S&P 1500 over a 15 year period to study whether or not pay and performance were aligned. I measured the relationship of performance and pay in one-year, three-year, and five-year rolling increments. I took CEOs out of the database if they had not been in that position during the entire period. As you can imagine, many CEOs were dropped out of the database for the five-year look. We found that three-year increments provided just as much insight and validity as five-year increments. Moreover, the three-year increments had a lot more data points and robustness. As a result, we concluded that measuring total shareholder return over three years is sufficient. The key, however, is to measure total shareholder return over rolling three-year increments in order to see a long-term pattern in total shareholder return (TSR). To see this pattern, we like to see eight to 10 years of three year rolling total shareholder-return data. This provides an excellent gauge of whether CEOs and their companies are really performing or just riding the market.

Greer: What are some CEOs who score well if total shareholder return is used as the primary metric?

Ferracone: Based on the methodology (referenced above) I used to write Fair Pay, Fair Play, CEOs who score well if TSR is used as the primary metric include David E. Pyott, Allergan (NYSE: AGN); Andrea Jung, Avon Products (NYSE: AVP); and, Theodore M. Soslo, Cummins.

Greer: When you look at S&P 500 companies, what percentage of CEOs do you think are overpaid?

Ferracone: Fewer than we would all think. One of the myths around CEO pay that I expose in Fair Pay, Fair Play, is that only a small percentage (around 5% of CEOs) are actually overpaid based on their company size, industry, and performance. In fact, inflation- and company size-adjusted pay has been relatively consistent over the last 15 years and generally below $10 million of total compensation a year in 2008 dollars. But it is the Dennis Kozlowski, the Larry Ellison, and the Ray Irani types who get all of the media attention, which leads people to draw the false conclusion that CEOs in general are overpaid.

Greer: Who are some CEOs who you think are underpaid?

Ferracone: CEOs who also are founders of their companies, like Jim Sinegal of Costco (Nasdaq: COST) or Steve Ballmer of Microsoft (Nasdaq: MSFT), often are underpaid according to our Alignment methodology. However, I would argue that these CEOs are very aligned with shareholders because they are significant shareholders. These are the people who are looking to be compensated through stock-price performance more than anything else. Having said this, this isn't always the case. Larry Ellison, for example, who owns over 20% of Oracle (NYSE: ORCL), the company he founded, is always one of the highest outliers when it comes to compensation.

Greer: There is a lot of debate about the effectiveness of financial incentives. We've interviewed behavioral economist Dan Ariely, who wrote Predictably Irrational, and Dan Pink, author of Drive, and both talk about some of the limitations of incentives as motivators. When do financial incentives work and when don't they work?

Ferracone: I interviewed Dan Ariely for Fair Pay, Fair Play, and we are both in agreement that incentives implicitly say we want executives to do well. They also say we are willing to pay a higher price for a high-performing executive than for one who is not performing. As for motivation, I believe, as Dan does, that good executives are motivated regardless of incentives. But I also believe that what incentives do is help deliver a message about what's important and what managers should focus on. Where Dan and I differ is that Dan believes, based on studies on incentives that are not directly analogous to executive incentives, that executive incentives don't make a difference and, in fact, could have a negative effect upon outcomes. In contrast, what I believe is that executive incentives do make a difference and you need to be very thoughtful about what you're incentivizing management to do, because you're going to get a lot of it. What I also believe is that at a minimum, incentives, if properly structured, will ensure alignment of investor and executive interests.

Greer: What do you think of Whole Foods Market's(Nasdaq: WFMI) policy, where the highest-paid executive cannot make more than 19 times the wage of the average hourly worker? 

Ferracone: These are social issues masquerading as compensation issues. Generally, I am not in favor of establishing pay-ratio guidelines, as they ultimately make the company's compensation less relevant to the outside market. Because we have a free-market system for talent (and practically all of our other goods and services, for that matter), companies ultimately will put themselves at a disadvantage if they pay certain jobs considerably less than the market, and will be misallocating scarce resources if they pay other jobs considerably more than the market.

Greer: Berkshire Hathaway (NYSE: BRK-B) Chairman Warren Buffett has said that the best tool in fixing executive pay was embarrassment: Investors, the media, and the public should go after overpaid CEOs and boards of directors. Do you agree with Buffett that embarrassment is an effective tool in controlling executive pay?

Ferracone: I think embarrassment is generally effective in exposing excessive executive pay and puts the board on notice that they need to address excessive compensation on behalf of their shareholders. However, there are some companies, like Oracle, where the embarrassment factor doesn't work. So embarrassment, while directionally effective, is a blunt instrument at best.

Greer: To what extent do you think misaligned incentives and bonuses played a role in the financial crisis and Wall Street meltdown?

Ferracone: I think that incentives were a factor in the financial meltdown, but not the seminal factor. Essentially, companies were deploying strategies to bring in revenue and take on risks that had a low probability of producing sustainable profits. Incentives were put in place to drive behavior accordingly. (Who says incentives don't motivate?) This was short-termism at its finest -- bringing in revenue that wasn't going to result in long-term profit, and taking on risks that were hidden, unknown, or ignored -- and was misalignment at its finest. In response to this situation, the SEC now requires companies to identify anything in their compensation packages that may contribute to excessive risk-taking.

Greer: What's the biggest misconception about executive compensation?

Ferracone: The biggest misconception is the definition of the problem. Most people identify the problem as being that executive pay is too high. But the real problem is that executive pay often is not aligned with total shareholder return. This is counterintuitive, as most executive-compensation packages are delivered in the form of equity. But there are a lot of forces that work against alignment, even with an equity-laden compensation package. Without getting into detail, one category of forces that work against alignment is the program design -- for example, measures or goals that don't lead to value creation. The other category of forces that work against alignment is decision-making. Certain decisions by the compensation committee can lead to executives being paid handsomely when performance is down, thus creating misalignment.

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Mac Greer owns shares of Costco. Berkshire Hathaway, Costco, and Microsoft are Motley Fool Inside Value selections. Motley Fool Options has recommended diagonal call positions on Microsoft. Berkshire Hathaway, Costco, and Whole Foods are Motley Fool Stock Advisor picks. The Fool owns shares of Berkshire Hathaway, Costco, and Microsoft.

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