Obermatt CEO: 'Pay Will Spiral Until It Hits The Fan'

Dr. Hermann Stern, CEO of Obermatt Inc., an international financial research firm based in Switzerland, is one of the foremost authorities on CEO pay-for-performance.

Stern, who has pioneered a methodology aimed at creating "more reliable and sustainable" executive compensation models, collaborated with CRN on a three-year analysis of CRN Solution Provider 500 CEO compensation aimed at determining which CEOs in the technology services market delivered the best and worst pay-for-performance.

Among his recent papers on the topic of pay-for-performance available at Social Science Research Network are "Making Bonus Systems Fair and Crisis Proof," "Pay For Performance Tests Will Change The U.S. Game," "3 Year Pay-for-Performance Analysis of the Largest 100 US Companies" and "Say No To Pay For Performance."

[Related: 10 VAR Executives Who Aren't Paid Enough ]

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Below are excerpts from a question-and-answer session CRN conducted with Dr. Stern.

CRN: How do you measure pay-for-performance?

Stern: The most common way to measure pay-for-performance is to look at stock prices. But this gives a distorted view of performance because of market sentiment and business cycles, which is why pay is often also distorted. We measure pay-for-performance by measuring both performance and pay as percentile ranks. For pay to be based on performance, your performance percentile rank should match your pay percentile rank. If a CEO achieves a performance percentile rank of 60 percent -- better than 60 percent of peers -- the pay should be in the 60th percentile as well, that is, higher than 60 percent of the peers but not more. If there is a difference, we call it excess pay.

CRN: What is your reaction to the specific results from the Obermatt/CRN Index charting pay-for-performance in the technology services sector?

Stern: There is hardly any correlation between pay and performance in the technology services sector. While this may be surprising for many, it isn't a surprise for me. Pay-for-performance is against the interest of boards and shareholders. It would imply that half of all executives are paid below average. Why should boards and shareholders want that? Paying a CEO below average would be demotivating and would result in higher retention risk. This is not in the interest of boards and shareholders. If CEOs underperform, they are replaced. This is motivation enough.

CRN: What characteristics are prevalent for company CEOs that are overpaid?

Stern: The 'overpaid' CEOs are usually those steering companies through a difficult phase. These are the most challenging situations for CEOs, which is often why they are paid so much then. If CEOs would be paid below the average, they would simply leave -- often the worst case for boards and shareholders.

NEXT: CEO Compensation In The Tech Sector CRN :

Are there more overpaid CEOs in the technology/technology services market given the competitive nature of the industry?

Stern: The more competitive an industry, the more important it is to pay above average. In addition, you need a compensation cushion in very volatile industries to prepare for unexpected events. Therefore, you would expect that there is a higher likelihood of pay excesses in the technology market because competition is more intense and volatility is higher than in other industries.

CRN: In a past study using Obermatt data, the top two underpaid executives [former Apple CEO Steve Jobs and former Google CEO Eric Schmidt] and No. 7 on the list [Microsoft CEO Steve Ballmer] are all technology industry executives. Why is that and what does it say about the technology sector?

Stern: These executives own large chunks of their companies. They don't need high salaries anymore. An exception is [Oracle CEO] Larry Ellison, who can't get enough. If executives are not large owners, the situation turns. When Tim Cook accepted the position of CEO at Apple last year, he received Apple shares worth $376 million USD; now worth half a billion. Apple and Tim Cook will soon be at the bottom of the pay-for-performance-league table because Apple's performance can never match the level of CEO pay. No wonder that Tim Cook turned down $75 million in dividends [recently]. This way, he can postpone the reputation damage of his pay package for some time.

CRN: Have you gathered any data comparing pay-for-performance in privately held companies vs. publicly held companies?

Stern: Privately held companies pay lower salaries except, of course, if they are held by private equity, which is often financed with other people's money. Even family-run public companies pay lower salaries than companies with diluted ownership. If there is personal ownership present in the board, salaries tend to be more reasonable.

CRN: Is there less pay-for-performance in publicly held companies because CEOs and boards of directors are dealing with 'public' shareholder funds?

Stern: Maybe. But this is just my personal opinion. I have no hard facts to support this statement.

CRN: Talk about the role of boards of directors and why they are not stepping up to guarantee pay-for-performance.

Stern: Pay-for-performance is against their interest. If they would pay for performance, half of them would need to pay below average. That would be demotivating and destroy retention. Executive retention is far more important for boards than performance. This is why they pay so much, and not because they think that CEOs need to be motivated. CEOs are already sufficiently motivated to perform because they are very public figures. If they screw up, they suffer much more than just a financial loss. No CEO can work harder than how he or she already does. This is why boards and shareholders want to pay their executives above average. The costs of paying above average are much smaller than the damages and risks that true pay-for-performance entails.

NEXT: Revenue Size And Performance CRN :

You say you have learned that in the technology services sector, pay mainly depends on size -- not performance. Talk about why that surprised you and whether that is the case with other industries.

Stern: It's actually not that big of a surprise to me. In many industries, size is the most important factor in pay. It's much more important than performance. This is justified up to a certain degree, but most likely not to the degree that we see today.

CRN: How big an impact does revenue size have on technology services performance?

Stern: In the last three years, size has had no impact on performance in the technology sector. Small companies did just as well as big companies and vice versa.

CRN: What advice would you give to technology services companies that want to reward their CEOs based on recurring revenue rather than revenue growth?

Stern: Don't tie it to absolute numbers. Otherwise, your compensation bill increases with your top line. It's better to link compensation to recurring revenue growth compared to peers. We call this the Bonus Index. This is a highly stable mechanism that doesn't need target-setting or ad hoc adjustments.

CRN: Talk about the role of compensation consultants and the comparable measures they use to justify executive compensation.

Stern: There are at least half a dozen well-respected performance metrics that compensation experts use. And there is a myriad of excuses for paying more. The New York Stock Exchange justified a salary double the peer average with the argument that they are a branded technology company now. They also said that stock returns are less important for them. If a stock exchange doesn't believe in stock prices anymore, you know that leaving performance measurement to companies will never work. It's like asking Roger Federer to decide if he has won the match instead of counting the games and sets.

CRN: What do you think of compensation consultants?

Stern: The consultants aren't the ones to blame. They do what they are paid to do. It is the system that is broken. Ever since pay became public, companies were forced to keep increasing pay to retain and motivate their staff. Consultants can't advise against the flow or they'll simply go under.

CRN: Are compensation consultants doing trusted third-party analysis?

Stern: Consultants are hired by boards to represent their interests. They are trusted, but they are not really an independent third party.

CRN: Give some examples of the 'faulty logic' used by compensation consultants.

Stern: There is no faulty logic. Compensation consultants need to advise on how to retain and motivate executives. This means paying above average in far more than half of all companies. The faulty logic is at the regulatory level. Making pay transparent actually hinders rather than helps in finding the solution.

NEXT: The Importance Of A Third Party CRN :

Talk about the need for a trusted third party like Obermatt to step up as performance rating agencies rather than compensation consultants.

Stern: You can't ask the board or its compensation consultants to evaluate performance because they will never provide a balanced assessment. Nor will shareholders, by the way. Just think of the half of all companies who would need to state that their performance is below average and the half of all CEOs who would get paid below average for that reason. Wouldn't this massively hurt the interests of boards and shareholders? No compensation consultant would do this. If pay should fluctuate with performance, you need public performance standards and a referee, just like in sports. This is the role of Obermatt for its clients.

CRN: In the technology services market right now, the drive is toward measuring based on recurring revenue vs. revenue growth. Do you think that will have a big impact on pay-for-performance?

Stern: That will probably make it more stable, which is a good thing. Too much pay variability leads to excessive risk taking.

CRN: Are the technology services sector compensation results in line with other industries or public companies as a whole?

Stern: They are maybe a little more extreme in the technology sector, but the picture is similar in other industries.

CRN: If everyone is looking to pay above average to keep their top talent based on retention, then aren't we effectively in a vicious cycle that guarantees we will never get pay-for-performance?

Stern: Yes. Pay will spiral until it hits the fan. I wonder when.

CRN: Talk about any successful consulting engagements you have had in the technology services industry where you revamped executive pay based on performance.

Stern: Two solar technology companies, Phoenix Solar and Meyer Burger, are using our Bonus Index. Both of them are owner-run, which is probably the reason why they opted for a reliable compensation method.

There are also two chemical conglomerates, Sika and Symrise; Toyota Textile Machinery; and Zumtobel lighting equipment, which have excessive cycles and need indexed performance measurement for reliable bonus results. In addition, we have Beiersdorf, the Nivea company, and two world-leading automotive manufacturers that I can't name. All these companies turn to indexed compensation because the unindexed alternative -- prevalent today -- rewards managers for the ups and downs of the economy. Why would you want to pay an incentive for the economic cycle? That just doesn't make sense. But this is exactly what stock options and shares do.

CRN: Any final advice for technology services boards and executives based on these results?

Stern: My advice is twofold. Firstly, to truly honor pay-for-performance, use relative measures rather than absolute figures. Only by comparing a company against its peers can we identify true performance. This also eliminates much of the massive swings in compensation and will help end the spiraling executive pay.

Secondly, pay more in fixed salaries and less in performance-based pay. Executives are as risk-averse as anyone else, as recently published by PricewaterhouseCoopers in a global study. Risky compensation structures just lead to risky behavior, and that is not a sound strategy for the long term. 'A steady salary may be an invitation to mediocrity' but 'slow and steady wins the race.' I learned this once from a stock trader -- not really a risk-averse bunch.