Executive Salaries: Are CEO Compensation Packages Too High?

Introduction: The Executive Compensation Debate

With the financial crisis and intense controversy over government bailouts of struggling companies, the question of executive compensation has again come to the fore of business discourse. The issue is complex. In part, the controversy arises from the poor optics created when executives earn hundreds or thousands of times what their employees make. The question of how valuable any single individual can be is a fair one in 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, and generous compensation packages must be offered in order to attract top talent. Without top talent, the argument goes, the company will not meet its objectives.

The Case That Executive Salaries Are Too High

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

A 2006 survey of board of directors members 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 structures were designed to do exactly this. The rise in equity-based compensation schemes was primarily driven by the belief that if management had an ownership stake in the firm, its actions would be aligned with the objectives of other owners — namely, shareholders. The tax structure at the time, FASB Statement No. 123, encouraged equity-based compensation by granting it 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 it. In many firms, executives have enough control over their own compensation to build in some distance between their performance and their pay (Bebchuk & Fried, 2003). Options and executive contracts are both finite, so it is in the best interests of the executive team to maximize value in the short run, up to the point of option expiry. As long as the options are in the money at the expiry date, the executive will receive the compensation. This creates a short-term orientation for executives. While any given shareholder may hold the security for the short run, shareholders as a group exist in perpetuity. Their interests are for long-term growth and profitability — a goal that is not congruent with the short-term orientation produced by options. Indeed, some of the major accounting scandals of the early 2000s were driven by this time-horizon 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 that call. Companies such as Berkshire Hathaway have long eschewed large executive payouts and kept equity-based compensation focused on the long term.

The reason why executive salaries rose so high — and a central argument made by 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 an assumption of rational markets. However, the market for CEOs and other high-level executives has been found to be irrational. This has been attributed to several factors. One is the rise of institutional investors, who demanded the removal of underperforming management. This made the executive talent pool shallower but also reinforced the belief among boards that hiring an executive with an extensive track record of success reduces risk. A myth has developed around the constricted nature of the CEO labor market. As a consequence, boards behave irrationally — believing that few talented people are available, they drive up the price (Khurana, 2002).

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

The final argument is based less on economics and more on moral relativism. It is not the large salaries themselves that are the central problem, but the disconnect they represent from the general population and from the company's own workers. Not only is this apparent lack of social justice a concern for labor unions and workers' groups, but there is credible evidence that it is bad for employee morale. Food giant Sysco, for example, cut executive salaries and simultaneously gave its workers a raise in order to keep the compensation differential within reason, especially given the firm's expected sluggish performance during the economic downturn (Novy, 2009). When employee morale is at stake, curtailing executive pay seems perfectly reasonable.

The Case That Executive Salaries Are Not Too High

Drawing on the philosophy of John Rawls, one might suggest that there are models that could bring greater social justice to executive compensation. If executives were kept unaware of the timing and strike price of their options, they would be more inclined to act in the company's best long-term interests. There would be no urgency to inflate earnings before an expiry date. With an unknown strike price and expiry date, executives would be compelled toward consistent, everyday excellence. They might ultimately receive millions, but it would be based strictly on performance, and the temptation to manipulate earnings would be removed (Desai & Margolis, 2006).

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 market participants who determine executive salary. The factors that go into calculating worth will vary depending on the firm. For some firms, the board may feel it is essential to have an experienced CEO. The money paid to that 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 reflects the relative worth of each participant to the organization. A mid-level worker is paid less because they contribute less and are more easily replaced. A skilled CEO can be worth millions to a company and cannot necessarily be replaced with ease. The free market argument also holds with respect to the Berkshire Hathaway example. It is market participants who determine what CEOs are paid. If one company does not feel compelled to pay millions to its executives, that is its prerogative — it is a fair competition. Even if one accepts that the market is irrational, it remains a fair market, and responsibility for executive salaries still falls to market participants.

Another argument is that executive talent must be well-compensated in order to be attracted and retained. Such individuals do consider non-financial factors when choosing their employment situation, but that is their prerogative. As rational actors, they should seek to extract the highest possible compensation package — financial and otherwise. In a competitive environment, this is precisely what allows them to command such salaries. The company, in turn, chooses to pay these salaries because the opportunity cost of not doing so is deemed too high. Boards must answer to shareholders, and in many cases — particularly with institutional investors — if shareholders do not receive a sufficient return, they begin replacing board members. The board therefore has a vested interest in attracting talent that will keep the company competitive. It has been shown that talent acquisition at top companies is not position-specific but rather systemic. The highest-performing companies build pools of talent from which they can draw as needed (Michaels et al., 2001). This means there will inevitably be talented people who are at times underutilized. Their higher-order needs are not being met during this period, so they must be generously compensated to remain. Otherwise, when the time comes to move someone into a key executive role, that talent will not be there.

CEO pay proponents also point out that the bulk of so-called "excessive" executive compensation comes in the form of stock or options — instruments brought into executive compensation packages specifically to align the interests of management with those of shareholders. It was shareholders and boards of directors who initiated this, as a means to protect shareholder wealth. There have been instances where executives abused this system, but those executives face prosecution. The argument is that a properly constructed executive compensation plan will yield the desired results. If a firm fails to design its plan well, it will fail — but that is an argument about design quality, not compensation levels. Many firms have sound structures, and high executive pay is matched by high performance. In most situations, there is little publicity or outcry. It is largely only when performance is poor that the issue of executive compensation is raised. If performance is poor and bonuses are paid, the optics are bad — but evidence has shown that reducing executive compensation sends a red flag to investors, causing rapid erosion of shareholder wealth as stock prices fall (Hume & Tokic, 2005). It is therefore unreasonable to regulate or dismantle the entire system of executive compensation simply because some firms do not design their plans effectively.

At the core of the pro and con arguments is a fundamental disagreement about regulation in industry. The free market philosophy underlies the position of those who believe executive compensation is not too high. Those who believe it is want the system to incorporate limits, or a sense of common justice. Even some free market advocates acknowledge that the market is irrational. Equity-based compensation was encouraged by favorable tax treatment, and by the time that treatment was changed, the concept had become standard practice. It is only recently that shareholders have begun to exercise their rights meaningfully. Even now, only a handful of major institutional investors — such as CalPERS — have strict policies governing 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 of most public objections to executive compensation levels. The social justice view stems from the notion of patterned principles — the idea that there is a social order more just than others, and that the role of government is to pull levers of power to bring reality closer to that ideal order (Epstein, 2008). Robert Nozick, however, argues that such intervention in pursuit of patterned principles is itself unjust, because it means the rules of the game are not the same for everyone and that needless barriers are erected. If the market wants CEOs to earn millions, so be it — the rules are the same for everyone.