Executive Salaries With the Current

Executive Salaries

With the current financial crisis and intense controversy over government bailouts of floundering companies, the question of executive compensation has again come to the fore of business discourse. The issue is complex. In part, the controversy comes from the poor optics that arise when executives make hundreds or thousands of times what their employees make. The question of how valuable an individual person can be is a fair one is this context.

Yet, the defense is also reasonable. The market for executive talent is driven by supply and demand. There is limited supply and substantial demand. Generous compensation packages must be granted in order to attract top talent. Without top talent, the argument goes, the company will not meet its objectives.

The issue is also tied into the study of corporate governance. No matter how much compensation an executive receives, the structure of the compensation should align the objectives of the executive team with the objectives of the shareholders. Setting aside the question of why an executive should have such little moral fiber as to require being strongarmed into acting ethically, there is considerable discussion as to the degree that executive compensation can impact governance.

Yes, Executive Salaries Are Too High

A survey in 2006 of members of boards of directors revealed that 81% of them felt that CEO pay was too high. The underlying premise, they argued, was that executive pay should be linked to performance. In many cases the constructs were designed to do just this. The rise in equity-based compensation schemes was primarily because it was believed that if management had an ownership stake in the firm, its actions would be aligned with the objectives of other owners (shareholders). The tax structure at the time, FASB Statement No.123, encouraged the use of equity-based compensation by providing it with favorable tax status (FASB, 1995). This led to a proliferation of options-based compensation.

The problem with options-based compensation is that it does not satisfy its objectives. The intent is to resolve the agency problem but ultimately it only adds complexity to the agency problem. In many firms, executives have enough control over their compensation to build in some distance between their performance and their pay (Bebchuk & Fried, 2003). The objective is to align the interests of management with the interests of shareholders, but options and executive contracts are both finite. It is in the best interests, therefore, of the executive team to maximize value in the short-run, to the point of option expiry. As long as the options are in the money at expiry date, the executive will receive the compensation. This creates a short-term orientation for the executives. While any given shareholder may hold the security for the short-run, the shareholders as a group exist in perpetuity. Their interests are for long-term growth and profitability. This is not congruent with the short-term orientation created by the use of options. Indeed, some of the major accounting scandals of the early part of this decade were driven by this time orientation conflict. The FASB recognized the problem and amended the treatment of equity-based compensation with Statement 123R (2004). Other firms did not need the FASB to make the call for them. Companies such as Berkshire Hathaway have long eschewed giant executive payouts and kept equity-based compensation focused on the long-term.

The reason why executive salaries went so high -- and a main argument of those who feel they are not too high -- can be found in a statement from WorldCom. "Our executive compensation policy…is designed to provide a compensation program that will enable us to attract, motivate, reward and retain executives who have the skills, experiences and talents…" (NYU Stern, 2002).

This is essentially the supply and demand argument. Underlying the free market argument is the assumption of rational markets. The market for CEOs and other high level executives, however, has been found to be irrational. This has been attributed to a number of factors. One is the rise of institutional investors, who demanded that underperforming management be removed. This made the executive talent pool shallower, but also fed the belief among boards that it is better to hire an executive with an extensive track record of success, as it reduces risk. A myth has developed with respect to the constricted nature of the CEO labor market. As a consequence boards behave irrationally, and thinking that there are few talented people available, they drive up the price (Khurana, 2002).

There is also the question of motivation. The notion that CEOs should be motivated by money only runs counter to our understanding of human motivation. One motivation theory used in compensation planning in Abraham Maslow's Hierarchy of Needs. Financial compensation meets low level needs of security and comfort (The Economist, 2008). Executives should ideally be motivated by higher-order needs, having long since met their basic needs. It is not unreasonable to expect that individuals as successful as executives should be motivated by actualization needs rather than financial ones. Some companies already adopt this approach. Executives at Berkshire Hathaway's constituent companies, for example, do not receive high levels of compensation, but rather compensation tied directly to performance (Associated Press, 2008).

The last argument is based less on economics and more on moral relativism. It is not the huge salaries that are the problem, per se, but the disconnect they represent from the populace at large and the workers of the company. Not only is this apparent lack of social justice a problem for the usual union and workers' groups, but there is credible evidence to support the view that it is bad for employee morale. Food giant Sysco, for example, took the step last year of cutting executive salary and simultaneously giving its workers a raise in order to keep the compensation differential within reason, especially given the firm's expected sluggish performance in the economic downturn (Novy, 2009). When employee morale is at stake, curtailing executive pay seems perfectly reasonable.

Using the philosophies of John Rawls, it might be suggested that there are models out there that would bring more social justice into the issue of executive compensation. If executives were to be in the dark about the timing and strike price of their options, would be more inclined towards the best interests of the company. There would not be a sense of urgency with respect to pumping up earnings before an expiry date. With an unknown strike price and expiry date, the executives would be compelled towards everyday excellence. They may ultimately received millions, but it would be based strictly on performance and the temptation to "fix" earnings would be removed (Desai & Margolis, 2006).

No, Executive Salaries are not Too High

The first argument that executive salaries are not too high is the free market argument. The market for executive talent is a free market, subject to the laws of supply and demand. It is the market participants that determine executive salary. The factors that go into this calculation of worth will vary depending on the firm. For some firms, the board may feel that it is essential to have an experience CEO. The money that is paid to the CEO -- even if in the tens of millions -- is a small fraction of what the CEO is worth to the company's bottom line.

This argument can be used to refute the claims made by opponents. The gulf between workers' salaries and executive salaries is related to the relative worth of each participant to the organization. A mid-level worker is paid little because they contribute little and are easily replaced. A good CEO can be worth millions to the company and cannot necessarily be easily replaced. The free market argument holds true with respect to the Berkshire Hathaway argument. It is market participants who determine what CEOs are paid. If one company does not feel compelled to pay millions of dollar to its executives, it has that prerogative. It is a fair competition. Even if we accept that the market is irrational, it is still a fair market and responsibility for executive salaries still falls to the market participants.

Another argument is that executive talent must be well-compensated in order to be attracted and retained. Such talent does take non-financial factors into consideration when choosing their employment situation, but that is their prerogative. They should, as rational actors, extract the highest package of compensation -- financial and non-that they can. In a competitive environment, this allows them to receive their salaries. Again, the company chooses to pay these salaries because the opportunity cost of not paying them is deemed to be too high. Boards must answer to shareholders. In many cases, if the shareholders -- these days they are often institutional -- do not receive a good return then they start replacing board members. The board therefore has a vested interest in attracting the type of talent that will keep the company competitive. Should their compensation package not be competitive, they risk their jobs in addition to the company's profits. It has been shown that the acquisition of talent not an area specific to each individual position at top companies. The highest-performing companies build pools of talent from which they can draw as needed (Michaels et al., 2001). Thus, there will inevitably be talented people who are at times underutilized. Their higher-order needs are not being met and thus they must be generously compensated. Otherwise, when the time comes to move someone from the organization to a fulfilling, higher-order executive position, the talent will not be there.

CEO pay proponents also point out that the bulk of the "excessive" executive compensation comes in the form of stock or options. These instruments were brought into executive compensation packages specifically to align the interests of management with those of the shareholders. It was the shareholders and the boards of directors who initiated this, as a means to protect shareholder wealth. There have been some instances where executives have abused this system, but those executives find themselves prosecuted. The argument here is that a properly-constructed executive compensation plan will yield the desired results. If a firm does not design their plan well, it will fail. Thus, it is not the size of the compensation package that determines its level of effectiveness but its structure. Many firms have sound structures and the high level of executive pay is matched by high performance. In most situations, there is little publicity or outcry about the issue. Largely, it is only when performance is poor that the issue of executive compensation is raised. If performance is poor and bonuses are given out, this has bad optics but evidence has shown that reducing executive compensation sends a red flag to investors, causing rapid erosion of shareholder wealth as the stock price drops (Hume & Tokic, 2005). It is unreasonable, then, that the entire system of executive compensation be regulated or scrapped simply because some firms are not good at designing executive compensation plans.

At the core of the pro and con arguments is the fundamental belief regarding regulation in industry. The free market philosophy underlies the beliefs of those who believe that executive compensation is not too high. Those who believe it is want the system to build in limits, or a sense of common justice. Some of those who believe in the free market perspective feel that the market is irrational. The use of equity-based compensation was encouraged by favorable tax treatment. By the time the tax treatment was changed, the concept had become standard practice. It is only recently that shareholders have begun to exercise their rights in a meaningful way. Even now, there are only a handful of major institutional investors, such as CalPERS, that have strict policies regarding executive compensation (Business Wire, 2004).

While CalPERS and Warren Buffett oppose high executive compensation on financial grounds, it is social justice that forms the basis for most objections to executive compensation levels. The social justice view stems from the notion of patterned principles -- that there is a social order that is more just than others and that the role of government is to pull levers of power to bring reality closer to that just social order (Epstein, 2008). Nozick argues that such involvement in the pursuit of patterned principles is itself unjust, because the rules of the game are not the same for everybody and there are needless barriers erected. If the market wants CEOs to make millions, so be it. The rules are the same for everyone.

Current Crisis

The AIG bonus scandal has become the flashpoint for discussion about excessive executive compensation and the global economic crisis. AIG, of course, represents a special case in that the company is essentially owned by the American taxpayers. Thus, the bonuses paid to executives came directly from the taxes paid by American workers. It is interesting to note that among shareholders there is seldom this same outrage. The fundamental principle is the same, however. High levels of executive compensation, if not translated into improved performance, are a drain on shareholder wealth.

The current crisis exemplifies this well. The crisis has a number of different antecedents, from the government reaction to the savings & loan scandal to the Fed's interest rate policies after the dot-com bubble burst to the creation and subsequent lack of oversight of Fannie Mae and Freddie Mac (Knowledge @ Wharton, 2008). The wide range of factors that have contributed to the crisis makes it difficult to accurately gauge the impact of executive compensation. However, there was a role in the development of the crisis that was caused by executive compensation schemes.

Flush with cash as a result of the Fed's aggressive interest rate cutting following the bursting of the dot-com bubble, banks began to invest aggressively in consumer credit markets. The main manifestation of this was the dramatic increase in subprime lending. Bank executives were willing to take this risk because they believed it would result in increased profits. They were essentially making a gamble on the housing market. For a few years, the housing market paid off and banks recorded stellar profits. Executives cashed in hundreds of millions of dollars in bonuses, options and stock. To ensure that the profits were maximized, bank executives package up their mortgages in mortgage-backed securities. By doing this, they were able to reduce their risk. This was not the case, but bank executives felt at the time that they were offloading some of these subprime loans.

Ultimately, executive compensation only played a minor role in the current economic crisis. Bank executives, armed with options, sought to increase profits. In doing so, they lowered their lending standards too much. They are not entirely culpable, though. It was the Fed who gave them so much money to lend. A bank executive who sits on cash is a bank manager who is losing money, so they were inevitable going to find ways to invest, and the demand was in the mortgage market. It is reasonable to expect that bank executives would have pursued such tactics regardless of the structure of their compensation packages, especially since they were being guided in that direction by the Federal Reserve.