Is CEO Pay Excessive?

Tyler Cowen discusses a paper supporting a controversial position on CEO pay:

A Contrarian Look at Whether U.S. Chief Executives Are Overpaid, by Tyler Cowen, Economic Scene, NY Times: ...Not surprisingly, many people think ... American executives are overpaid. Their salaries are set by corporate boards, often filled with insiders or friends. Salaries for the top executive are far from transparent, especially when stock options and complex compensation plans are used. Nor is pay always linked to performance...

But in a new paper "Why Has C.E.O. Pay Increased So Much?," the economists Xavier Gabaix of the Massachusetts Institute of Technology and Augustin Landier of the Stern School of Business at New York University ... suggest that the higher salaries for chief executives can largely be explained by increases in the value of the stock market. Viewed as a whole, these salaries are a result of competitive pressures rather than the exploitation of shareholders.

Their core argument is simple. If we look at recent history, compensation for executives has risen with the market capitalization of the largest companies. For instance, from 1980 to 2003, the average value of the top 500 companies rose by a factor of six. Two commonly used indexes of chief executive compensation show close to a proportional sixfold matching increase (the correlation coefficients are 0.93 and 0.97, respectively; 1.0 would be a perfect match). ...

As Professors Gabaix and Landier predict, chief executives' salaries in different sectors are higher when the capitalization of that sector is higher. A stronger sector means more bidders for a chief executive of a particular kind; an executive who has run one car company can go run another. Chief executives in large industries, therefore, receive more, even after adjusting for the size of their current companies. Business services, computers and banking turn up as exceptions for this comparison; their top executives are overpaid relative to ... market capitalization... Perhaps chief executives can add more value in more dynamic sectors.

The authors are still working on their international comparisons... But the preliminary results suggest that the total value of the companies in the sector helps predict how chief executives' salaries vary from country to country... The two also find that the best chief executives do not seem to have much more talent than other chief executives in ... the top 250. By their calculations, replacing the No. 250 chief executive with the No. 1 will increase the value of the company by only 0.014 percent. The No. 1 chief executive receives much more compensation, but that is mostly because he manages a larger company...

The Gabaix-Landier argument does not cover all objections. We do not have adequate data for longer stretches of American history. There are important cultural differences across countries. Lucian A. Bebchuk of Harvard Law School, a leading critic of chief executives' pay, argues in response to the paper that pay remains insensitive to performance, that high executive pay is correlated with bad corporate governance and that chief executives take great care to hide their true compensation. For those reasons, he does not believe that executive pay is driven by productivity.

In any case, the debate over chief executives' salaries has moved a step forward. Yes, there are numerous examples of corporate malfeasance. But it is not obvious that the American system of executive pay — taken as a whole — is excessive or broken. ... [T]he rate of productivity growth in the United States has been the envy of the world. Chief executives must be doing something right.

The growth in executive compensation reflects how much more is at stake in American companies. Is not the real question which policies and institutions have led to this explosion of value?

There is evidence on the other side as well (some of it is cited in the paper), and there are other explnations for the correlations in the data, so I can't say I'm convinced.

Comments

[reason]

So it doesn't make much difference who does the job, but whoever happens to get it is paid a fortune. And there isn't market failure? Huh?

I want to see their underlying model. Essentially, they are saying that the pay of chief executives is related to the market value of the company they lead (so the GM Boss is getting a big pay cut?). But they don't explain why? In every other market it is just supply and demand. Find the cheapest guy that can do the job satisfactorily.

Now I happen to think that it is fairly irrelevant who has the job because the job is done according to the current fad from the leading MBA schools. They could give me the job and I would just outsource it to McKinsey because that is essentially what the board wants. The board is risk averse in a big firm because big money is involved. Paying somebody with experience a fortune is just an exercise in arse covering - "we did the best we could".

[anne]

Yes, yes, I know, American chief executives are underpaid and those who work for them are overpaid, I know. Stock market this, and stock market that. Let's pay the chief executives, poor dears, more, and the rest, the heck with them, less. But, as I have repeatedly shown the American stock market has badly lagged European markets for years and European chief executives are paid nowhere like American and European chief executives are not starving or are they?

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Dollars]
4/28/96 - 4/28/06

Australia 11.9
Canada 14.8
Finland 21.0
France 11.4
Germany 9.5
Hong Kong 5.5
Japan 0.3
Netherlands 8.9
Norway 14.2
Sweden 13.9
Switzerland 10.2
UK 9.8
USA 8.9

National Index Returns [Domestic Currency]
4/28/96 - 4/28/06

Australia 12.3
Canada 12.5
Finland 20.6
France 11.5
Germany 9.7
Hong Kong 5.5
Japan 1.2
Netherlands 9.1
Norway 13.5
Sweden 15.8
Switzerland 10.2
UK 7.7
USA 8.9

EAFE 6.944 7.027
Dollar Value Loss = 1.2%

E 10.4 11.0
P 2.2 1.7

[anne]

When the Chief Executive of UnitedHealth is given a bonus of $1.6 billion on top of an insane salary, there is something dreadfully wrong and the idea of justification is comically bizarre.

[spencer]

See my comments at Marginal Revolution.

But in short, why should CEO pay be related to market capitalization when they do not influence the PE side of the equation. They only influence the EPS side of the equation and there is no evidence that there has been a shift in the long term growth rate of EPS.

Stock owners have an agent problem.

[Nicholas Weaver]

Also see Warren Buffet's letter to shareholders for this year. He has a good explanation as well. Note, in the years he has been on board of directors, he has only ONCE been on a compensation committee.

[anne]

Spencer is clever :)

There has remarkably enough been no significant shift in earnings per share over the last 30 years. What has happened however is that management has gained ascendency over owners and workers.

[Robert]

When the market tanks, we'll see precisely how "sticky" Exec comp is on the way down. I have a premonition that proscribed relationships will, in the event, prove less than robust.

[anne]

Ah, but there has been no lessening in executive gains since the fierce bear market of 2000 to 2002, but who's accounting :)

[me]

"They only influence the EPS side of the equation"

I guess you are saying that Palmisanno at IBM is a great CEO becuase he has bought back $17 Billion is stock in 5 years to maintain a stock price of $82.

To the original question - you decide.

Bob Nardelli - Home Depot

Pay package 5 years $200 million
Stock performance 5 years - down 14%

I fail to see how this man is anything but grossly over paid.

[Stormy]

Oh my...and these are economists from esteemed institutions. If you think that study is off-kilter, try the next one...slavery is but a step away.

I read the other day an argument that very poor countries are not ready for labor regulations. The learned economist set the history of labor regulations in the U.S. along with the history of U.S. income levels against those of poor countries. Until a country reaches a certain income level, it is not ready for labor regulations-based on our history. Oh my. Some African countries are still ready only for slavery. But our wise economist did not press that point. He didn't have to. I hear it everyday as we congratulate ourselves on how much we are helping those poor peasants in those sweatshops.

The esteemed study is:

Good for the Goose, Bad for the Gander: International Labor Standards and Comparative Development

--Joshua C. Hall Economics Department at West Virginia University
--Pete T. Leeson, West Virginia University

It's a pdf file; you can find the link here:

http://austrianeconomists.typepad.com/weblog/2006/05/sweatshopintens.html

a pdf

[billy]

Most of the company shares are held by institutional funds. The funds have no accountability for their actions to the shareholders of the funds.

The fund shares are really products of the fund company. Hence fund shareholders dont have any say over how the fund influences corporate decisions in the companies they invest in.

They cannot fire the fund management, they can only bail out of the fund.

This is a key problem today - mutual funds acting as intermediaries break the chain of accountabilty from the CEO to the real shareholder (the mutual fund investor)

The very purpose of the mutual fund is to releive the fund investor from making these kind of decisions and delegate them to the fund management. But there has to be some amount of accountability for this delegated responsibilty. Otherwise it just degenerates into a cabal of CEOs and fund management.

Especially when mutual funds own a majority of the company.

The only way to stop this kind of abuse is to have an active shareholding community for the company.

[Alejandro]

Mark,

I think that this paper will help people understand the Gabaix paper better.

The Economics of Superstars
Sherwin Rosen
American Economic Review, Vol. 71, No. 5 (Dec., 1981) , pp. 845-858

[save_the_rustbelt]

We don't know for certain the totality of CEO pay, which makes an evaluation even more difficult.

[Holly W.]

So if it makes sense for the value of CEOs to rise with the value of the stock market ... shouldn't the value of the regular workers at these companies also rise? And yet the median wage has been stagnant during the same period that CEO pay has been soaring. I'm not sure this argument makes ME feel any better.

[Richard]

Suppose one lives in an economy where certain agents have great power and a very affluent background. Their children go to the best schools, prosper, and hired into the most elite of management classes. They are drawn to the industries and companies experiencing the greatest growth and, naturally, request - nay, require - the highest of salaries.

Such a country would have executive compensation correlated with large companies experiencing great growth. But as every budding statistician knows, correlation does not imply causation, and the authors of the study may have the order wrong, or both factors may be spuriously related to another factor not considered.

If I were to shoot from the hip, I'd guess that "Growing companies have more money to pay economic rents to the elite" is more likely an explanation than "talented managers from elite schools create levels of value unparalleled in the rest of the world". But, honestly, my biases are showing yet once again . . . .

[Robert]

here's a few more wild stabs :

"As long as share prices and co profits are going up (irrespective of relative comparisons or benchmarks), investors don't care";

"With the average institutional holding periods decidedly short, most investors couldn't be bothered rattling the cage - they vote with their feet"

"Large shareholders/investors who might promote change "pay" Co. mgmt for material non-public information or disclosure by rubber-stamping or not opposing even the silliest exec comp. since their relative information advantage is worth more than the impact of excessive comp upon the co's profits"

You could also combine the two of Richard's hypotheses together and you'd end up with a less-than-benign form of Philip Burch's "Elite Theory"

[tom s]

I think what I like in particular about the post is the idea that it is a "Contrarian" look at the topic. Notwithstanding the posts here, it is far fetched to think that the conventional wisdom is that CEO's are paid too much. And to be able to pose as "contrarian" while supporting those poor underpaid CEO's, as anne calls them, is absurd.

It reminds me of another article I saw. It claimed that the election of an old Etonian as leader of the tory party is evidence of Britain's new classless nature -- that in the past his privilege would have counted against him, but in the new classless world we are generous enough to allow the privileged to take their place at the top of the heap. Remarkable!

[anne]

Tom, that is terrific :)

[Emmanuel]

Their method is questionable. I can illustrate any number of spurious correlations too if they want. For instance, I once ran a correlation between the number of registered cars in California and the suicide rate in Japan and came up with a correlation coefficient of 0.80 or better.

It's fun to play with numbers, but whether they tell you anything meaningful is another matter.

[Robert]

If you were sensibly trying to create a CEO incentive plan that maximized "long-term shareholder value" ALONE (not opening the can of worms as whether this should be the goal), it is doubtful that a wise board would design plans anything like what comp consultants & sychophantic boards agree to. That they are extraordinarily generous is not in question, but what precisely they incent, (since there is little symmetry or risk-sharing) is unclear. The result, where "the moons align", is in the least "double-dipping" since most will have made off with enormous cash, AND cash bonuses, separation payments, golden parachutes, gross-ups, consultants fees, etc., in addition to stock & option award grants that is the gargantuan cherry on top. At worst, when they fail, (and many do by any sensible metric), the compensation package (ex-gains on shares & options) is merely obscene for quite obviously a monkey, or the mailroom clerk could have botched things equally-well (with no disrespect to the clerk intended).

My kids get these inane politically-correct ribbons (Everyone's A Winner!!) for merely participating in school sports day, which makes me think of CEO Pay: Is there no culpability any more? What about maxims like "No pain, no gain" or "It takes enormous risk to make or lose a fortune", or something that suggests anything but a free-ride in risk terms?

[Martin P.]

The correlation between company capitalization and CEO compensation package seems to fit perfectly with the "outrage constraint" hypothesis from Paul Krugman based on the work of Bebchuk et al. At the extremes this is obvious. Suppose a 50 bn company. It can readily afford a 10 mln CEO-compensation without serious outrage. Rationalizations for such compensation can easily be found on a lot of company size dependant variables such as capitalization, revenues, absolute results, added value, shareholder value, turnover, manpower etc. A 50 mln company cannot bear an annual 10 mln extraction for the CEO without massive outrage from all sides fully blocking such compensation. The outrage constraint hypothesis does logically imply a strong correlation. On a first glance the data from Gabaix and Landier in fact seem to provide strong evidence for this hypothesis.

[Joseph Brierly]

CEOs are normally not inventors of major industries. They are basically hired hands who have politicked their way into corporate power. They are just another worker unless they created the industry like Martha Stewart did, for example. True entrepeneurs like Warren Buffet, Martha Stewart, Al Taubman, and more deserve to profit from their risk-taking. CEOs who have not been the primary force behind creating an industry do not deserve more that 10 to 15 times what an average worker makes in the corporation. They can be replaced just like any other worker. They have done nothing to make jobs and a better economy. In many cases greedy executives give themselves raises and bonuses when their company is going bankrupt. Witness the greed in Enron for example. Enron was only the tip of the CEO greed. Adelphia, Global Crossing, Ford Motors, GM,...and a host of other corporations have CEOs that are given outlandish salaries despite their corporations losing money.

Basically, it is greed that comes with power to name one's own salary that causes the Exxon mobil CEO to give himself a 400 million dollar retirement package. Simply put, he is not worth any thing more than a retirement package like government chiefs get. Government executives are allowed 80 percent of their regular salary which is controlled by law so as not to be unduly exorbitant. There is no control over the greed of CEOs in the USA. Some nations have restrictions on how much compensation a CEO can be paid.

says...

Rich, I want to be rich...

[Jack]

Directly link the pay of the CEO's to the pay of the average workers salary. Say 40 times. The average worker makes 40,000/yr then the CEO makes 400,000/yr. Seems fair and links the working classes in a way that shoudl eliminat ethe tendancy of CEO's and management to drive down the average wage of the middle class worker.

[Jack]

Sorry for the bad math. $1,600,000.

[BJ Feng]

When management can set their own pay, abuse is bound to happen sooner or later. Not all Boards are abusive, but all it takes is a few bad Compensation Boards to drastically increase executive salaries across the marketplace. Why? Because managers are often paid RELATIVE to what their peers make. I've read annual reports of several companies, and most companies don't want to appear "cheap" and pay their executives less than average salaries.

So when a few bad apples get ridiculous bonuses, everyone else automatically raises executive compensation in order to stay "average" or at least within the ballpark. One or two companies in each sector giving ridiculous bonuses eventually cause a domino effect.

Furthermore, not everyone can be average if there are people getting above average bonuses to begin with. Those who are near the bottom of the compensation scale will try to raise bonuses in order to achieve average compensation. However all this accomplishes is to raise the average even higher and higher, it's an endless spiral of increases.

Stockholders who become alarmed are powerless to stop the raises without engaging in long and costly proxy fights. Basically the entire Board or much of the Board has to be replaced, but golden parachutes, staggered elections, and other management tricks make it difficult. There's no guarantee either that the replacement won't become corrupted by the money and potential for bonuses either.

I wonder why any and all attempts to give more power to shareholders over compensation seem to go nowhere. Yet ridiculous legislation to give government power to set executive pay goes very far before failing. There are some laws that align interests and are good for society, not to mention fair.

Management should not be allowed to institute poison pills and golden parachutes. Management should not be allowed to use their power to entrench themselves and reward themselves, this is an abuse of power. Executives that leave due to poor performance should not receive bonuses just for leaving. All the bonuses they received in the past are more than enough. Executives that are no longer needed thanks to a merger could still receive a departure bonus, but shareholders should have a say on the amount.

And executives that retire should never receive lifetime benefits outside of their pension if any. They should never be allowed to use the corporate jet or have the company rent a penthouse for them for life. Retired executives aren't working for stockholders anymore and don't deserve to be compensated anymore. A nice gold watch, even diamond encrusted, to show appreciation, or perhaps an one time gift, is more than enough.

[hari]

CEO pay is an *obscene* moral issue that state's and their parliaments must consider and decide after this global financial meltdown.

It's interesting Merkel (of Germany) has done exactly that and made it a *moral* issue of society to decide.
However her own views are crystal clear. CEO pay even in Germany today is obscene compared to those who work under those CEO/s - relative compensation valuation.

Anne is right to illustrate the dicotomy between CEO pay in EU-27 and US - relative compensation valuation has creeped-up inside EU - ever since *free market* concepts replaced state intervention policy.