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Sunday, December 17, 2006

Is CEO Pay Too High?

CEO pay again. This article from the Minneapolis Fed looks at efforts to establish that CEO pay is excessive, how pay might be better aligned with the interests of shareholders, and other issues:

Goldilocks in the Corner Office, Ronald A. Wirtz, The Region, Minneapolis Fed December 2006: ...The group: chief executive officers. Their crime: getting paychecks that are simply too big. In the court of public opinion, it's a slam-dunk case: guilty. A thousand—no, make that several million—times, guilty.

The anecdotes of seemingly ludicrous CEO pay almost never stop; every year produces a fresh batch of fat cats to parade as examples of capitalism run amok. But the matter of CEO compensation is more complicated than some normative sense of what the public considers fair. Even if cool-headed economists might agree that CEO pay appears out of whack, they can step back and search for reasons why current compensation levels may be perfectly logical in a market sense.

What comes out in the end is something of a hung jury: Anecdotes aside, a multitude of factors make it difficult to see if CEO compensation is systemically biased and inefficient, and for whom or to what consequence. Indeed, if the matter were so straightforward, there would be no controversy.

Recent research has made some strong theoretical arguments that CEO pay is above what efficient markets would confer. But some fundamental unknowns cast doubt on whether that theory holds up in practice, none of them more critical than the fact that there has been no solid evidence of systematic overpayment—only anecdotes, even if numerous.

Some evidence even suggests—put down those tomatoes—that current CEO pay levels are fair, or at least reasonably so. ...

Critics of CEO compensation point to steep differences between head-office pay in the United States and in other countries as prima facie evidence of off-kilter U.S. CEO compensation. For example, CEOs here make 35 percent to 80 percent more (depending on study) than their British counterparts. ...

The contrast might be even starker than rankings suggest. Researchers like Lucian Bebchuk of Harvard University have uncovered ballooning retirement packages, which are not typically included in annual compensation surveys...

As in the case of someone caught after a crime spree, the evidence of soaring CEO pay just keeps piling up. ...

Even pro-business magazines like Fortune and Forbes have been openly critical of the trend in CEO pay. Says one Forbes article, “What's at stake, in short, is nothing less than the public trust essential to a thriving free-market economy.”

Regardless of whether CEO pay offends people's sense of fairness, even to the point of outrage, that doesn't mean it automatically violates any rules of market efficiency. But at these stratospheric levels, could current CEO pay possibly be efficient? ...

[A]t its core, research on CEO compensation is rooted in principal-agent theory, which examines how a manager (the agent) operates a firm on behalf of the owner (the principal). In the case of CEOs, the common dilemma is getting the CEO to act in the best interests of the shareholders when he or she has inherently different interests and motivation, and holds a significant advantage in information and leverage over shareholders.

CEO compensation should therefore be designed to mitigate this principal-agent problem, providing both incentives and a monitoring effect to better align a CEO's self-interest with that of shareholders...

Whether CEO compensation actually accomplishes that goal is a hotly debated question. Virtually no one is arguing that CEOs are underpaid. The controversy revolves around whether they are appropriately or overly compensated. Answering this question typically involves uncovering whether shareholders have prospered as much as CEOs. In decades past, CEOs were often compensated largely through cash salaries. But over time, added focus on this principal-agent problem slowly shifted compensation schemes toward a greater use of incentives, whereby the CEO would profit when—and hypothetically, only when—shareholders did.

Compensation schemes veered hard toward pay-for-performance in the 1980s... The matter received a further boost in 1993 when President Bill Clinton signed into law a tax-deductibility cap of $1 million in compensation for a firm's top five executives in an effort to slow down what was perceived at the time to be flagrant pay. Prior to this, all CEO compensation was tax deductible, like any other employee salary. With a leash on cash compensation, firms saw noncash incentives as a perfect fill-in.

What's not quite clear, however, is the degree to which rising CEO pay is actually linked to greater firm performance. Chamu Sundaramurthy, Dawna Rhoades and Paula Rechner, in a 2005 Journal of Managerial Issues article, say empirical evidence regarding executive compensation and firm performance “is quite mixed.” Their own results indicate that there is “no substantive relationship between ownership and firm performance.” ...

Bebchuk, from Harvard, has been the general in a small army poking holes in the notion that CEO compensation is truly based on performance. In the past several years, he has published a sizable list of papers on the subject with a variety of cohorts, along with one well-received book ... with Jesse Fried of the University of California, Berkeley.

The thrust of their argument is that CEOs hold managerial power—simply put, leverage—over the boards that set their compensation. The leverage starts at the board nomination process—typically controlled by the CEO—and is reinforced by the information advantage the CEO has over the board in terms of the company's performance and his or her role in it. It persists because board members are generally reluctant to rock the boat and are somewhat toothless to do much given their limited time commitments as directors.

As a result, company boards cannot negotiate CEO pay at arm's length, a critical factor in aligning a CEO's interest with that of shareholders. What happens in its place is a pseudo-negotiation in which the CEO holds most of the cards. ... By playing their hand well, CEOs can extract pay that exceeds fair market value (what economists call “rent”).

In some cases, the design of the compensation process makes matters worse. Boards tend to benchmark pay in terms of what the competition offers. When this happens, boards inevitably approve above-average pay packages because they don't want to send the message that their CEO is average, or worse. Call it the Lake Wobegon mentality, because all CEOs become above average. That's where Bebchuk and others scream foul, because no such arrangement would come from an arm's-length negotiation.

In a 2005 discussion paper, Bebchuk and Yaniv Grinstein, from Cornell University, show that executive pay from 1993 to 2003 “has grown much beyond the increase that could be explained by firm size performance and industry classification.” ... 

Bebchuk and his various co-authors have no particular gripe about the nominal level of CEO pay. But they chafe over the pay-padding they believe results from managerial manipulation of board compensation decisions. They also object to what they call “windfall compensation”—big executive payouts from stock appreciation that stem more from an industry or marketwide surge than from judicious moves by the CEO.

Oil and other energy firms are a good example: Rising stock prices in that industry have been due as much to political conflict, natural disasters and even serendipity than to the particular activities or visions of the CEO. Rising energy prices have lifted virtually all stocks in this sector, which creates windfall compensation for CEOs despite the fact that their company's stock performance was not unique within the sector.

Bebchuk and Fried suggest that performance benchmarks use indexed options that compare a company's stock price appreciation to a basket of competitors, and offer compensation to the degree that the company beats the competition in stock price appreciation and is the result of firm-specific performance. ... The idea has reportedly been slowly winning some board converts.

Bebchuk and others have also zeroed in on other, growing forms of compensation—golden hellos, goodbyes, perks and especially retirement packages—that typically have little to do with company performance.

Bebchuk calls such pay “stealth compensation,” because it is rarely disclosed, or obscurely so when required, and so flies under the radar of investors, the public, even boards themselves. ...

To a certain degree, both sides are swinging at shadows. That is, neither has the weight of hard evidence on its side. The critics of current CEO compensation levels point mostly to theory and to seemingly obvious design flaws, and the weight of anecdote can be pretty compelling. But they typically fail to demonstrate the “so what” factor: namely, that high CEO pay has had a systematically detrimental effect on shareholder value.

Indeed, if CEOs are overpaid, then it would seem logical that the crush of recent research might have calculated, even hypothesized about, the amount of rent being extracted by CEOs. But you'll find no such estimates in the literature. Despite their extensive—and widely heralded—critique of executive pay, Bebchuk and Fried make no estimates of the booty seized by way of managerial power, despite insisting repeatedly that it exists and making numerous reform proposals to constrain its growth.

In an e-mail response to questions from the Region, Bebchuk said the focus of his research “is on the structure of compensation, not on the level.” He added that it's hard to determine exactly what CEO pay would look like with arm's-length contracting. “The absence of arm's-length contracting is likely to lead to pay exceeding the arm's-length benchmark,” Bebchuk said. So, while their argument is intuitive, logical, even seductive, it adds up to something of a “trust us.”

A lengthy review of Pay Without Performance in last year's Michigan Law Review by John Core and Wayne Guay, both from the University of Pennsylvania, and Randall Thomas of Vanderbilt, puts it this way: “It is correct that U.S. CEO incentives and pay are large both by recent historical standards and relative to other countries, and that they have grown during the 1990s. However, there is very little if any empirical evidence that shows that U.S. CEO pay, or its growth, is suboptimal. ... [Bebchuk and Fried] have provided some interesting examples of bad apples, but have not offered evidence to show that the entire barrel is bad.” ...

On the other side, defenders of CEO pay might want to simply plead the Fifth. Though some studies have found correlations between CEO pay and firm performance (specifically stock prices), there is little evidence to suggest a cause and effect—that is, that high stock market returns are the direct result of CEO performance (and related CEO pay).

There are plenty of examples of highly paid CEOs running poorly performing companies, as well as modestly paid CEOs at the helm of high-performing companies. ...

So too are there plenty of examples of pay-for-performance incentives going awry, where CEOs either fudge the books or focus exclusively on enhancing short-term stock prices to the long-term detriment of the company. ...

The shenanigans don't stop there... [C]ompanies nationwide [are] being investigated ... by the federal government or internal auditors for back-dating and other questionable stock-option practices.

So if there is no clear link between CEO pay and firm performance, but also no real firm notion of what a “rentless” CEO market might command in pay, might there be other market-based explanations for why CEO pay continues to rise? Possibly, but none of them extends much beyond speculation.

For example, economic theory would suggest that the passage of Sarbanes-Oxley has helped raise CEO pay, if only to a small degree. The law—mostly derided by Corporate America—makes CEOs liable for erroneous financial statements, which represents a risk factor that would logically lead to higher insurance-based payments for any prospective CEO.

Supply and demand idiosyncrasies also influence CEO pay. For example, there is a growing trend toward hiring CEOs from outside the firm, rather than the more traditional method of promoting from within. In a 2004 paper, Kevin J. Murphy and Ján Zábojník, both from USC, find that outside hires accounted for 15 percent of CEO replacements in the 1970s; by the 1990s, it was 26 percent. Anecdotal evidence suggests it is higher still today and that firms tend to pay more to attract CEOs from outside the firm.

Rakesh Khurana at Harvard has expressed this as the “Super CEO” syndrome—the desire for a charismatic CEO savior. Such a standard artificially narrows the candidate field to existing CEOs or recently retired ones, eliminating many otherwise-qualified candidates.

At the same time, CEO turnover has been accelerating—evidence, some argue, of greater board independence and stricter pay-for-performance demands by these boards. ...

With CEOs having shorter expected tenure, more demands for performance, greater demand for their services and higher personal liability for a firm's financial statements, economic theory suggests that reservation wages—the level at which a person chooses work over leisure—for CEOs should also be going up.

Ultimately, any change in the trend of CEO pay likely will have to come through a changing mindset among boards, which feeds back to much of Bebchuk's arguments. Some research has begun to recast the principal-agent problem farther upstream between shareholders and a firm's board, looking at whether incentives are in place for boards to properly govern and lead firms, including the setting of CEO pay at proper levels.

As one might hope, there appears to be a solid correlation between good governance and shareholder return, though research to date is limited. ...

Better governance doesn't come free, however, and like CEO pay, incentives matter for directors as well. Director compensation has been on the rise, according to separate surveys by the Conference Board, Korn-Ferry and Aon Consulting. Annual compensation runs between $50,000 and $100,000, depending on the sector and firm, with annual increases of late running up to 20 percent or more.

A 2005 study by Paula Silva in the Journal of Managerial Issues finds that boards compensated with equity ownership tend to use a more quantified, verifiable approach to CEO performance. Those boards without stock ownership tend to use more qualitative approaches to CEO evaluation. She also finds that poorly performing firms have boards that use qualitative evaluations of CEOs.

The moral of the story is that current CEO pay levels, whether deemed too low, too high or just right, haven't happened by chance, but by design. And in the future, better design is likely to come about through better corporate governance. That might or might not lead to changes in CEO pay levels, but it would better ensure that CEO pay—whatever its level—is more surely attached to performance.

    Posted by on Sunday, December 17, 2006 at 08:38 PM in Economics, Market Failure | Permalink  TrackBack (0)  Comments (25)

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