Executive Compensation Re: Executive Compensation

Executive Compensation

Re: Executive Compensation

Once again, executive compensation is making headlines. This time, it is the executives at banks that received TARP funds. Bonus pools at the nation's banks totaled $18.4 billion dollars, even as these same banks suffered record losses and laid off some 265,000 people as a result of their poor financial performance (Kopecki & Goldman, 2009). The banks have defended their actions, citing the need to retain top talent. Some industry observers have supported this claim (Oliphant, 2009).

They maintain that if the banking industry is restricted in terms of its bonuses, its top people will take jobs in other industries, or in other countries where they can earn more money. While there is some logic to that standpoint, it ultimately fails to demonstrate understanding of why we have bonuses in the first place.

When you understand the point of bonuses and other components of executive compensation, you can see that today's compensation packages make no sense. As a rule, executives are simply not worth the mammoth packages they receive.

To start from the beginning, a corporation is owned by its shareholders. As so famously put by Milton Friedman, the role of management is to build shareholder wealth (Friedman, 1970). The shareholders vote on the board and the board hires the executives. The board also decides on how to compensate those executives. In recent decades, boards have moved towards compensation schemes that are more incentive based. The idea behind this move is that boards wanted to motivate CEOs by tying their compensation to the performance of the company. The best way to do this, they felt, was to give the CEO an ownership stake in the company.

The trend towards equity-based compensation was supported by the rules governing its tax treatment. In particular, the rules made options-based compensation affordable. The company recorded as compensation expense the cost of the options, not the underlying asset. The leverage the options provided allowed firms to reward their executives to a much higher level than they would ultimately record on their books.

In 2005, the Financial Accounting Standards Board enacted Statement No. 123-R, which changed the way that equity-based compensation was accounted for. This dramatically increased the accounting cost of equity-based compensation, forcing many firms to move to alternative methods, such as restricted shares (Balsam, 2007)

Reducing the use of options in executive compensation packages is a starting point. The problem with options is that they are short-term in nature. This means that while they tied executive compensation to stock performance, they only did so for a short period of time. After the expiry date, options are worthless. So executives became focused on short-term results. This led to some of the accounting scandals in the earlier part of this decade, such as that at WorldCom (English, 2002). This scandal arose because WorldCom executives were compensated in large part with options. They capitalized expenses so that the firm would show a profit, thus leaving their options in the money.

Since the enactment of FASB Statement No. 123-R, companies have moved towards different forms of compensation. However, the period in which options became popular re-set the bar in terms of the size of executive compensation. Thus, we see that compensation today remains at very high levels. In 2007, the average salary for an S&P 500 CEO was $10.5 million (Pentilla, 2009). The question we need to answer is whether or not that is too much. In order to do that, we will set aside for a moment the issue of aligning executive and shareholder objectives and analyze the issue from a simple economic perspective.

In theory, executive compensation should be driven by supply and demand. Firms compete with one another to attract and retain top talent. This argument has been used by some of the banks to justify paying out bonuses this past year. One expert on the issue of executive leadership, however, has found that the market for CEOs does not adhere to this traditional economic principle. Rather, the CEO market more resembles a "closed ecosystem in which selection decisions (are) based on highly stylized criteria that often (have) little to do with the problems a firm (is) facing." (Khurana, 2002). In other words, the market for CEOs is characterized by irrational decision making. CEO selection was based on the desire to enhance short-term results, a result of a dramatic increase in institutional ownership (Ibid.).

Institutional ownership of stocks went from 5% to 60% starting in the 1980s, eventually owning so many shares that they could not liquidate a position easily, even if the company was starting to underperform. These investors began to exert influence over management. However, this created a market distortion, wherein an assumption was made by the Boards of Directors of troubled companies that internal candidates were generally incapable of making the necessary changes to right a troubled ship. Thus, abnormal emphasis was placed on finding external candidates. CEOs, in essence, have become brands, where a well-known name became more important than any tangible ability to fix the company. This created an artificial, distorted market in which top executive talent was perceived to be in short supply. This led to bidding wars for executives. The use of options allowed firms to offer substantial compensation packages with limited impact on their financial statements.

This goes a long way to explaining why, aside from the tax advantages, options became so popular. Ownership, once dominated by individuals, has become dominated by institutional investors. These investors set shorter time frames for success, and as such set executive compensation towards short-term goals. The goals of ownership and management are thus aligned. At least, this holds true if the company can avoid the sort of scandal that wipes a stock out.

Some institutional investors have a longer-term approach. In examining those investors, we can see that the companies they own do not make extensive use of options or other short-term motivators. For example, Berkshire Hathaway has strict limits on executive compensation in the companies it owns (Sioux City Journal, 2008).

The California Public Employee's Retirement Systems (CalPERS), one of the world's largest institutional investors, is also an outspoken opponent of modern CEO salaries, and has campaigned for legislation overhaul at the federal level to address the issue (Business Wire, 2004).

Berkshire and CalPERS, however, are among the most powerful institutional investors in the world. They have the buying power to exert influence over the compensation committees at the companies in which they are invested. The same cannot be said of most shareholders. This comes down to political will. It was only recently, in 2007, that individual shareholders were granted the right to a yearly non-binding advisory vote on executive compensation packages. This came as a result of HR 1257, which was passed despite numerous Republican attempts to neuter it. It was only in 2006 that the SEC changed its disclosure laws, now requiring companies to disclose to shareholders their executive compensation practices (Odell, 2007).

Shareholders, therefore, are only now being granted the ability to influence executive compensation schemes. As a result, more companies are being forced to move towards pay-for-performance schemes, wherein performance is not defined by the strike price of a call option (Pentilla, 2009). Firms are again setting pay and bonuses that are tied to profits, revenues and other measures that are more directly reflective of firm performance than its stock price.

This influx of common sense into the world of executive compensation is a welcome change. It reflects the understanding among some boards of directors that the CEO is hired to perform tasks and that success should therefore be measured a function of the outcomes of those tasks. If Khurana is correct, such thinking will begin to bring executive compensation back to normality by eliminating the distortions in the CEO market created by the so-called irrational quest for the charismatic CEO.

The executive compensation packages we see today are excessive. They are the product of an irrational, distorted view of the market for executive talent, combined with certain legal structures that allowed for executive compensation to get out of hand. FASB Statement No. 123-R has reduced the desirability of options as a compensation package component and HR 1257 has begun to put more power in the hands of shareholders with respect to compensation packages.