The scandal isn’t that Wells Fargo’s John Stumpf has lost only US$41m of his US$249m in recent compensation after widespread fraud.
The scandal is that the compensation of Stumpf, and every other chief executive officer whose pay is option-based, is 90% generated by luck.
That’s right, we as a society and investors are lavishing executives with ever greater compensation based almost entirely on things over which they have very little influence.
A study from Moshe Levy at The Hebrew University, in Jerusalem, finds that luck rather than skill plays an overwhelming role in the value of management compensation.
Stumpf was grilled again by Congress on Thursday over his bank’s creation of millions of unauthorized accounts a day after he agreed to forfeit years of stock grants to make amends for the long-running fraud.
Much ink has been spilled over whether the amount Stumpf is losing is commensurate with what he has done, or left undone. That analysis takes for granted that the current system of handing out stock options to reward executives for improving company performance is itself fair. In this reading, Stumpf should lose out because he has underperformed, or been derelict.
Both of those adjectives are deserved, but the bigger issue is that the whole compensation system is largely unmoored from reality.
“Our findings support the view that managerial compensation is driven to a large extent by skimming, rather than being the result of an efficient competitive market for managerial talent,” Levy writes in the paper, released Sept. 11.
“We empirically estimate that approximately 90% of standard option-based compensation constitutes pay-for-luck. This value is very robust, and stems from the inherent fact that chance plays a dominant role in determining firm performance.”
What’s more, as a manager can do only very little to actually move the needle on the stock price, and hence on option value, the typical option-based award system fails at its most elemental task: motivating managers.
The broad idea that compensation and performance should be aligned is correct. Where the system fails utterly is in conflating the witterings of the stock market with an accurate short-term read on firm value. If markets were efficient, then perhaps handing out stock options would be fair. As they are not, it becomes nonsense.
The pedals don’t move the needle
To estimate how much luck is involved in executive stock option compensation, Levy performs a series of fairly simple calculations. The first is to look at how much a given executive can impact the net present value of projects to which they choose to dedicate time and resources. The better the manager, the higher the return on assets.
Using three different frameworks, Levy estimates that the average manager increases ROA by only 2.2%. That’s good and certainly worth paying for, but the question is, how does it relate to stock movements?
Look at the volatility of stock returns compared with the value added by managers and you can work out the ratio of performance-to-luck in stock option compensation. As you can probably guess, stock market volatility is far greater. The standard deviation of excess returns of all stocks is almost 40%. This figure falls if you regress for both market and industry to 33%, towering over the 2.2% manager contribution found above.
“A 90% pay-for-luck component implies that the manager can increase her expected compensation by only 11% by exerting effort. This is a rather bleak picture regarding the options’ power to incentivize managers,” Levy writes.
No wonder the system seems so unfair, and seems to give life to so many unfortunate events. For example, Stumpf boasted in quarterly earnings calls about Wells Fargo’s cross-selling success, a boast, as it turns out, in part based on fraudulent accounts created by frontline employees under targets set by higher management.
Levy makes recommendations for reforming the current system, such as indexing options to market or industry performance. That would mean that executives don’t get money simply because the Fed is cutting interest rates or the commodity their firm produces is rising in value. Another possibility is making option grants at levels much higher than prevailing equity prices, which does increase the proportion of reward due to effort.
It is hard not to feel that the whole system, which mistakes the voting machine of the short-term stock market with a weighing machine, is wrong-headed. More fundamental reforms of compensation are needed, with far longer-term measures and less pay for luck.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
