Earnings reporting season often motivates investors to complain about unjustified or excessive pay for corporate executives. When a company reports quarterly earnings or revenue below analyst estimates, the stock price usually falls and investors frequently blame the chief executive officer (CEO) for the disappointing results.

According to research by executive data firm, Equilar, the average (arithmetic mean) 2015 compensation for CEOs of the 100 largest S&P 500 companies was $15.5 million. The median compensation for those 100 CEOs in 2015 was $14.5 million. This represented a 3% increase from 2014. The median 2014 compensation for those 100 CEOs rose 5% from the 2013 level.

Incentive-Based Compensation

Since the Great Recession, public pressure has brought increased efforts to align executive compensation with shareholder returns. This triggered attempts to use various performance metrics for determining incentive awards to CEOs and other named executive officers (NEOs). Research by Equilar indicated that the use of earnings per share (EPS) as the metric for determining CEO incentive awards at S&P 500 companies declined from 18.1% of those awards in 2012 to 11.1% in 2015. Use of revenue as the metric for determining CEO incentive awards of S&P 500 companies declined from 12.9% of those awards in 2012 to 9.7% in 2015.

Performance-contingent awards are disbursed through long-term incentive plans (LTIPs) to help motivate executives by emphasizing a company’s quality goals and long-term growth objectives. As of November 2014, performance-contingent awards were in use by 89% of the 250 largest companies in the S&P 500. Performance periods can range from one to 10 years. Equilar’s research indicated that since 2012, three- and four-year performance periods have become the most widely used time frames. In 2015, 70.8% of the LTIP incentive awards for S&P 500 CEOs concerned three-year performance periods. Only 1% of S&P 500 LTIP performance periods were longer than five years between 2012 and 2015.

The use of total shareholder return (TSR) has become the preferred measure of executive performance because of its popularity among investors. Relative total shareholder return (rTSR) typically involves measuring performance against a peer group or stock market index, such as the S&P 500. Equilar’s research indicated that the use of rTSR as the metric for determining CEO incentive awards at S&P 500 companies increased from 12.3% of those awards in 2012 to 25.2% in 2015.

Criticism of TSR

Much of the criticism of using TSR as a performance metric concerns the use of a time horizon of only three years. Basing incentives on three-year time frames can reward executives for positive stock price volatility over the short- to mid-term, rather than sustained long-term TSR performance. Beyond that, use of rTSR for any time period can punish companies delivering good performance on a sustained basis. This happens when companies with high measurements at the beginning of the period are compared to companies starting the period with weaker performance.

Another problem arises when poor performers are not included in the comparison group because they go bankrupt or are acquired as their low prices attract companies in search of acquisition targets.

A study conducted by the Institute for Compensation Studies at the Cornell University School of Industrial and Labor Relations concluded that the evidence from its statistical regression analysis indicated either no impact of TSR plans on firm performance or weak evidence of a negative relationship. In other words, TSR plans are ineffective as incentives. However, they may be useful in demonstrating that a CEO’s compensation is exorbitant when compared to shareholder returns.

Comparing Compensation to TSR

Equilar’s analysis of 2015 CEO compensation at the 100 largest S&P 500 companies included a comparison of compensation with TSR and each company’s annual change in revenue. One of the most extreme disconnects between compensation and TSR was the situation involving Kenneth Chenault, CEO of American Express Co. (NYSE: AXP). Chenault’s total 2015 compensation was $21.7 million, despite TSR of negative 24% and a 4% drop in annual revenue.

The total 2015 compensation for Alcoa Inc. (NYSE: AA) CEO Klaus Kleinfield was $14.2 million, just $300,000 below the median for CEOs of the 100 largest S&P 500 companies. However, Alcoa experienced TSR of negative 37% in 2015, with a 6% decline in annual revenue.

Gaming the System

Many commentators criticize utilization of a garbage in-garbage out system of measuring performance to justify lavish executive compensation. The use of pro forma earnings in assessing executive performance can skew the outcome in favor of an underperforming CEO by limiting the focus to EEBS (earnings excluding bad stuff). An increasing number of publicly held companies are using methods other than GAAP (generally accepted accounting principles) in preparing their quarterly earnings reports.