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YahooU: Executive compensation explained

Yahoo Finance’s Brian Cheung breaks down executive compensation.

Video Transcript

JULIE HYMAN: We know that CEOs in this country make a lot of money, but the way they collect that money can be awfully confusing. Here to help us sort that out is Brian Cheung in this week's Yahoo U. Professor, take it away.

BRIAN CHEUNG: Well, class is in session, and here's a stat for you. Among the largest 350 companies in the country, the average CEO compensation was about $14 million in 2018. That's an over 29% increase from executive pay in 2009. That's according to the Economic Policy Institute. That's not bad at all. But CEO compensation is a confusing mix of all of this stuff, so let's unpack the many different ways that the big wigs in this country get paid.

So what you're looking at here-- let me pull this up really quickly-- is a breakdown of executive compensation. So ISS Analytics has this breakdown. This is aggregate S&P 500 CEO pay, and it shows that the largest share of compensation is performance-based. That's the light blue bit here, about 40%, and that's stock. Then there's also performance-based equity, 18%, the orange bit here. This is all awarded to the CEO conditional on the achievement of certain business goals. We'll walk through that a little bit later.

The other remainder of compensation is time-based, so think of cash, the purple, 27%, or stock, 14%, the red bit here. These are things that have vesting conditions, so you might accumulate 25% of that cash or stock bonus every year over the next four years. Now, this is all obviously a very different pay structure than for most employees.

And after the financial crisis, lawmakers sought to make the difference in pay a little bit more transparent with what they call the CEO Pay Ratio. This is measured as CEO compensation divided by the median employees' pay. And the idea here is that higher pay ratios signal either high CEO pay or low median employee pay.

Now, a fair argument to look at this equation here is to say, OK, well, the CEOs that get paid a lot should be paid a lot if their companies do well, right? Well, let's consider that as of 2018, the average CEO pay ratio was 144:1. That meant that the average CEO was getting paid 144 times more than the median employee at that company. But shouldn't those companies be doing better?

Here's a metric that shows you the breakdown of CEO pay ratio data from 2018, as broken down by Pearl Meyer, and it shows you that really wasn't the case. So companies where CEOs got paid more, again, a higher CEO pay ratio of above 150:1, which was higher than the average, showed that three-year average shareholder returns were actually similar to those with the lowest pay ratios of less than 35:1.

Now, one fair criticism of the data that I'm showing you here is that there are plenty of other metrics beyond total shareholder return that weigh on a company's performance, which, as we know, is the majority determining factor in CEO pay, which I showed you at the top. And ISS data confirms this. So this is a look at what percentage of Russell 3000 companies, a slightly different universe, that tie their specific performance metrics to CEO incentives.

And what you'll see is that only 3% of companies, which is the purple bit here for short-term, long-term is in light blue, really tie total shareholder returns to the amount that they pay their CEOs. Instead, it's really earnings over the short term, revenue, and other, which would be company-specific metrics that are more commonly tied to these types of metrics.

Now, you'll notice that, of course, this changes over long term. In the long term, there might be total shareholder returns that are more closely tied to those types of things. Now, the question here is obviously either whether this framework is serving employees or total shareholders. Well, you can see that the linkages really show a higher priority on earnings and revenue when paying out to CEOs.

Now, return to shareholders isn't as emphasized, and neither is the treatment of employees. But you got to consider that with the rise of ESG and more public scrutiny on CEO pay through things like the CEO Pay Ratio, which, by the way, is an SEC requirement, it could be something that really puts the system due for change here with so much scrutiny on the likes of Tim Cook and others making a lot of money right now.