“The best bargain is an expensive CEO . . .. You cannot overpay a good CEO and you can’t underpay a bad one. The bargain CEO is one who is unbelievably well compensated because he’s creating wealth for the shareholders. If his compensation is not tied to the shareholders’ returns, everyone’s playing a fool’s game.” ~Al Dunlap
Executive pay is financial compensation received by an officer of a firm, often as a mixture of salary, bonuses, shares of and/or call options on the company stock, etc. Over the past three decades, executive pay has risen dramatically beyond the rising levels of an average worker’s wage. Executive pay is an important part of corporate governance, and is often determined by a company’s board of directors.
In a modern US corporation, the CEO and other top executives are paid salary plus short-term incentives or bonuses. This combination is referred to as Total Cash Compensation (TCC). Short-term incentives usually are formula-driven and have some performance criteria attached depending on the role of the executive.
For example, the Sales Director’s performance related bonus may be based on incremental sales growth; a CEO’s could be based on incremental profitability and revenue growth. Bonuses are after-the-fact (not formula driven) and often discretionary.
In a study of 20,000 U.S.companies from 1965 to date by Deloitte’s ‘Center for the Edge’ shows a disastrous decline in performance overall in this period:
- The rate of return on assets of firms has fallen by 75%.
- The life expectancy of firm has fallen from around 70 years to less than 15 years, and is heading towards 5 years, unless something changes.
While corporate performance has been on this sharp decline, executive compensation has been increasing astronomically. Whereas in 1965, executive compensation was 24 times what the typical worker made, studies show that today executive compensation is a staggering 275 times what the typical worker makes.
In a more detailed study of the growth of U.S. executive pay during the period 1993-2003 by Lucian Bebchuk and Yaniv Grinstein, pay grew much beyond the increase that could be explained by changes in firm size, performance and industry classification. Had the relationship of compensation to size, performance and industry classification remained the same in 2003 as it was in 1993, mean compensation in 2003 would have been only about half of its actual size. In other words, executives were receiving increases in compensation that were twice what would have been justified by performance.
Meanwhile, during the period, compensation for workers has remained basically unchanged. Studies show that real average hourly earnings (excluding fringe benefits) now stand roughly at 1974 levels. Since the cost of health and education has been increasing rapidly, the actual standard of living of most people has been on the decline… Many newspaper stories show people expressing concern that CEOs are paid too much for the services they provide.
In “Searching for a Corporate Savior: Irrational Quest for Charismatic CEOs” by Rakesh Khurana documents the problem of excessive CEO compensation, showing that the return on investment from these pay packages is very poor compared to other outlays of corporate resources. Defenders of high executive pay say that the global war for talent and the rise of private equity firms can explain much of the increase in executive pay. But, how should we view the disparity between executive compensation which has been soaring and workers’ pay which has been flat for some 45 years?
Here are a couple of viewpoints: CEO of a green tech firm said: “I can get workers anywhere in the world. It is a problem for America, but it is not necessarily a problem for American business… American businesses will adapt.” Nor was the CFO of an internet company particularly sympathetic to the plight of the American middle class. “If you’re going to demand 10 times the paycheck, you need to deliver 10 times the value. It sounds harsh, but maybe people in the middle class need to decide to take a pay cut”…
In the article “What Fueled Public Outrage Wasn’t How Much Execs Got But How Little the Rest of Us Did” by Camelia Kuhnen writes: We’ve seen the call for reform before: Back in the ’90s, there was a similar sort of public outrage [and that led to] changes in the law. Cash pay had to be capped at $1 million [because] after that the tax implications for the company were more severe. Companies invented other ways to pay CEOs that weren’t subject to this cap. That’s when you saw stock options take off as a form of CEO pay. …
The public outrage recently has been about bonuses—the total value of pay that executives receive, especially the banking execs. So the issue is, if you regulate the way execs are paid, will they just come up with new ways to pay executives that aren’t in violation of regulation?
In the blog “Executive Compensation” by Deborah DeMott writes: In the book the ‘Big Short’ by Michael Lewis observes that “What are the odds that people will make smart decisions about money if they can get rich making dumb decisions?” Put differently, what worries Lewis is the risk that the incentives that channel greed aren’t necessarily calibrated to encourage smart decisions. Pressing a bit further, decisions that are dumb may have negative effects for particular firms and their constituents, including shareholders.
But, as we know, the adverse consequences of some dumb decisions extend more broadly. Some reforms to executive compensation practices, i.e., say-on-pay (SOP), more disclosure, greater focus on the composition and independence of boards’ compensation committees – may help, but also better oversight on managerial decisions that create major systemic risks is essential…
In the article “Competition for Managers, Corporate Governance and Incentive Compensation” by Acharya, Gabarro and Volpin write: Pay-for-performance compensation is greater in firms with weaker governance, thus a reminder of the dangers of putting on blinders when evaluating and regulating corporate governance. Executive compensation depends not just on a firm’s own governance, but on the governance of the firm’s competitors of comparable size.
Managerial quality also depends on firm governance. The authors note that the offsetting effects of governance and managerial quality “may explain why it has proven so hard so far to find direct evidence that corporate governance increases firm performance.”
However, a notable exception is the link between governance and performance found in firms owned by private equity: Private equity ownership features strong corporate governance, high pay-for-performance but also significant CEO co-investment, and superior operating performance. Since private equity funds hold concentrated stakes in firms they own and manage, they internalize better (compared, for example, to dispersed shareholders) the benefits of investing in costly governance.
Our model and empirical results can be viewed as providing an explanation for why there exist governance inefficiencies in firms with dispersed shareholders whereas, concentrated private equity investors can “arbitrage” through their investments in active governance.
In a Bloomberg poll, more than 80% of Americans – evenly divided between the well-off and those making under $100,000-a-year agreed most CEOs are paid “too much.” However, the simple truth is that Americans don’t mind income inequality, as Harvard University’s Benjamin Friedman points out in his book, ‘The Moral Consequences of Economic Growth Throughout U.S. History’ writes; “the central question is not the poverty of the most disadvantaged, not the success of the most privileged. It is the economic well-being of the broad majority of the nation’s citizenry.”
So when all income levels prosper, as they did in the mid-to-late 1990s, few mind if the rich get richer. What’s at stake, in short, is nothing less than the public trust essential to a thriving free-market economy. “There’s a right amount for CEOs to get paid, and it could very well be lower than it is today,” says Jeff Immelt when asked about executive compensation. “I don’t know. I wish the debate would end, though, for one reason … it’s crowding out important debates on education, innovation, technology, globalization, competitiveness, that are really what you want this whole thing to be about.”
In the article “Absurdity of the Golden Parachute” by Carl Icahn writes: A golden parachute is a binding agreement between a company and an employee (most often a CEO but in some cases all the employees) detailing considerable benefits for the employee if the employee is terminated or retires. When executives retire, parachutes are sometimes known as ‘golden handshakes’.
Golden parachute or golden fetters payments may also benefit employees should there be a change in company ownership or control. More perplexing and just utterly illogical are “golden coffins.” As if golden parachutes were not enough, many executives will receive huge packages after they die, says the Wall Street Journal. Without an act of Congress, the only way these practices will change is if shareholders demand it…
The issue of executive compensation seems to revolve primarily around many of the Fortune 500 companies, which are mostly proceeding along the lines of ‘classic capitalism’ (i.e. maximizing value to shareholders…). These are the Walmarts and G.E.s of this world—companies which are doggedly tweaking their value chains and whose share price has struggled for at least the last decade.
The picture is dramatically different if we look at companies practicing ‘new age capitalism’ (i.e. maximizing value to customers…). These are firms like Apple and Amazon, with increments in share value of ten-to-fifteen times over the last decade. If firms were performing like Apple and Amazon, then there would be plenty of room—and justification—for substantial increases in both executive and worker compensation.
All of which underlines the need for organizations to move into ‘new age capitalism’ and begin to significantly reduce the enormous compensation disparity between executives and workers…