Watson Wyatt study finds Strong link between CEO pay and performance

Executives at financially high-performing companies are realizing greater compensation than their counterparts at underperforming companies, suggesting that corporate Americaís executive pay-for-performance model is working for most companies, according to a new study by Watson Wyatt Worldwide, a leading global consulting firm.

In its study, Watson Wyatt found that CEOs at higher-performing companies have significantly greater ìrealizableî pay, especially from long-term incentive (LTI) awards. Realizable pay calculates the current value of outstanding LTI awards (typically, in-the-money stock options and performance share payouts) granted over a specific time frame (in this case, 2003-2005) using the ending stock price.

This method contrasts with pay opportunity, a more traditional analysis that calculates the value of the new LTIs as of the grant date, using the Black-Scholes value of stock options. Between 2003 and 2005, the median realizable LTI for CEOs at higher-performing companies was $4.4 million, compared with just $1.5 million for CEOs at lower-performing companies.

The study, based on public data from 793 companies in the SandP Composite 1500, a stock index that includes companies of various sizes in all sectors of the U.S. economy, found similar results for realizable total pay, which includes realizable pay from stock incentives as well as cash compensation and annual bonuses, which tend to be less sensitive to shareholder returns.

Companies
Median TotalReturns to Shareholders
Median 3-Year Cumulative Realizable LTI
3-Year Cumulative Realizable Total Pay

High Performer
32.3%
$4.4 million
$8.0 million

Low Performer
9.8%
$1.5 million
$5.0 million

All
19.8%
$2.8 million
$6.4 million

ìExamining how much pay an executive can realize is an important step forward in measuring the sensitivity between actual pay and performance,î said Ira Kay, global director of executive compensation consulting at Watson Wyatt. ìAnd directors and shareholders will be pleased that the results show that companies with a well-designed incentive program are only paying for the performance they get.î

A critical element in this design is properly setting the range of potential compensation opportunity. The Watson Wyatt study also found that some companies may be setting their pay opportunities higher than optimal from a shareholder perspective. Companies that offer executives above-market LTI pay opportunities but have only average stock price performance may still deliver above-market pay ó not a shareholder-friendly outcome. In contrast, companies that offer average incentive opportunities are delivering average pay for average performance and high pay only for high performance, a much more shareholder-friendly result.