Abstract
With the semester coming to its logical conclusion it brings me upon completing another SMAC paper. After completing ten of them in the last semesters I have grown to develop a better sense for what is a meaningful topic that a student can write about throughout the course of the semester. In this class, we discuss the issues of workforce, careers and development, variable pay and executive compensation. The latter became a wildly debated subject around the United States and has created great division among public opinion.
As a result, during the last presidential election both Democratic and Republican candidates campaigned on this issue. Consequently, it has become a favorable issue to win the nation’s approval.
In the U.S., the Republican candidate Donald Trump “has called high CEO pay “a total and complete joke” and “disgraceful,” arguing that CEOs stack boards with their buddies who rubber-stamp excessive pay. Hillary Clinton has lamented that “There’s something wrong when the average American CEO makes 300 times more than the typical American worker.” Even in the United Kingdom, Theresa May launched her ultimately successful campaign to become Prime Minister with a speech that proposed to curb executive pay.”
While we certainly can be skeptical that the politicians might use executive compensation as a talking point to win them votes, the fact remains that the issue is real for many Americans. Management guru Peter Drucker believed the proper ratio between a chief executive’s pay and that of the average worker should be around 20-to-1 as it was in 1965. The Economic Policy Institute (EPI), in a report last summer by Lawrence Mishel and Jessica Schieder, shows that CEO pay is and continues to be dramatically higher now. CEO pay in the US peaked in 2000 at $20.7 million (in 2016 dollars), 376 times the pay of the typical worker. In 1995, the CEO-to-worker pay ratio was 123-to-1; in 1989, it was 59-to-1; in 1978, it was 30-to-1; and in 1965, it was, as Drucker’s ratio would have it, 20-to-1.
“CEO pay continues to be very, very high and has grown far faster in recent decades than typical worker pay,” the EPI authors wrote. “CEO compensation has risen by 807 or 937 percent (depending on how it is measured—using stock options granted or stock options realized, respectively) from 1978 to 2016. At 937 percent, that rise is more than 70 percent faster than the rise in the stock market.” A typical worker’s annual compensation over the same period rose at the rate of 11.2%.
However, there are many who look at this situation from a different perspective. It is shareholders who bear the costs of paying the CEO, and so it is unclear whether the government should intervene. A common argument is that high pay has indirect costs — in particular, it incents CEOs to take actions that hurt society. However, there is no evidence that the level of pay indeed has these effects. While it’s the level of pay that captures politicians’ (and the public’s) attention, it’s the structure of pay which matters more for firm value – for example, whether it vests in the short-term or long-term. Vivian Fang, Katharina Lewellen, and I find that, in quarters in which significant equity vests, CEOs cut R&D and capital expenditure in quarters in which significant equity vests. The electorate will be more impressed by a politician who proposes a headline-grabbing law to halve a CEO’s salary than a politician who extends the vesting horizon from three years to seven years, even though the latter will have a far greater impact on long-term value creation. Moreover, even if shareholders didn’t take into account the effect of poorly-designed contracts on CEO actions, it’s not clear why the government should regulate pay rather than these actions themselves – surely the most direct route to curtailing them.
In this paper I will attempt to analyze issues and problems in executive compensation and attempt to look at it from both perspectives.
Body
To begin with let us analyze the definition of executive compensation. The CEO and top executives in the company are responsible for the organization’s strategy and operations. The compensation committee of the board of directors usually designs compensation packages for CEOs. The amount is usually determined at a minimum that is required to attract a qualified candidate. The compensation package must serve as a motivational tool for the executive to perform in line with company’s beliefs and objectives. Executive compensation is usually a combination of short-term incentives ( salary, bonuses, benefits) and long-term incentives ( stock options and shares). Also pension could be included and other guarantees such as severance agreements.
Next, lets break down the CEO Compensation Data. As of 2016, a general level of CEO pay at a S&P 500 company is on average $10 million. According to Equilar CEO Pay Trends the median value of CEO pay in 1995 was 3.6$ million. The median value in 2015 was 10.4$ million. That shows almost a 3x raise in CEO pay over the period of 20 years for S&P 500 companies. Generally the compensation levels for the CEO vary by the size of the company. Analyzing the data compiled by Equilar for the fiscal years ending June 13 to May 14, a Top 100 company average figure of total expected compensation is $13,713,000 with the market value of $104,413,000 ($ in thousands). A Top 101-500 company average figure of expected compensation is $10,656,000 with the market value of $21,710,000 ($ in thousands). A Top 501-1000 company average figure of expected compensation is $6,458,000 with the market value of $6,086,000 ($ in thousands). It is a fact, that the executive compensation levels have risen significantly in the last fifty years and it is mostly caused by equity-based awards. For instance, between 1936 and 1959 Inflation adjusted CEO pay was around $1 million. As the Stock<ip and Options became a bigger part of the compensation package, they have increased from about $1.2 million in 1970 to about $9.2 million in 2005. With all these figures in mind, how do US CEO compensation values compare to those of other countries? Even after controlling for organization size and industry based on 2006 research estimated total CEO pay of a company with 1$billion in sales in US is far greater then such in other countries. U.S figure is $2.6 million and U.K comes second with $2.0 million, followed by Ireland at $1.8 million and Switzerland at $1.6 million. Again, with the research by Matos and Murphy we can conclude that the premium pay in the United States is caused by equity based awards. Another curious ratio is CEO pay versus other executives in the organization. In recent years, according to Equilar the ratio has been stable and the CEO’s make about three times as much. The ratio that is used wildly in debates around the country is that CEOs earn dramatically more pay than the regular U.S worker. While the calculation of this ratio depends heavily on methodology it is anywhere between 178 and 248 times difference. Accroding to “Say on Pay”It is essential to point out that shareholders generally vote favorably to CEO compensation plans as part of the annual non-binding “say on pay process”. According to Equilar’s “CEO Pay Trends” CEO compensation is largly dependent on the incentives such as bonuses, options and stocks. A sample of a S&P Top 500 Company breaks down the ratio as
• Salary 14%
• Bonus 22%
• Stock 47%
• Options 15%
• Other 3%
These equity awards connect CEO compensation to the stock price of the company. As a recent Stanford university study on CEO compensation points out “Stock awards change 1-for-1 with stock price. Options add “convexity” by magnifying both upside and downside value”
According to Equilar, in the past yeards. Stock-based performance awards substituted stock options as the most used form of equity based pay. The value of such awards heavily relies on a mixture of stock price and performance numbers such as earnings per share, return on capital, revenue and operating margin. CEO’s usually hold company stock. As stock prices tend to fluctuate, the value of CEO wealth can alter greatly due to this function. Consider this, a Top 100 organization’s CEO earns $104,912,000. A 1% stock change is over $1.5 million. Many top executives hedge a portion of these holdings in order to protect themselves from fluctuations in the market.
Furthermore, there are many milestones impacting CEO compensation. A summary from Stanford’s Graduate School of Business Research includes the following:
• Securities Exchange Act 1934
This Act required companies to report on compensation of chief executives. In addition, it required executives to own shares from exercised options and performance plans six month before sale. Another important aspect of this act is that executive compensation among public trading organizations became public records.
• Revenue Act 1950, 1954, 1964
In 1950 the Revenue Act created “restricted stock options” that were taxable when sold at a capital gains rate. Also, stock option plans became more prevalent. In 1954, the organizations were allowed to lower exercise price of previously granted restricted options. The exercise term was limited to 10 years and further contributes to attractiveness of stock options as part of compensation. In 1964, the Revenue Act created qualified stock options that were to replace restricted options. Exercise term was now lowered to five years and income tax rate lowered. Executives were required to hold qualified stock options for at least three years to qualify for capital gains rate. Furthermore, the Act prevented organizations from lowering exercise price of previously granted options.
• Price controls 1970s
President Nixon limited executive pay increases to 5.5%. However, these limits did not include performance-based bonuses and non-qualified stock option plans. Furthermore, these limits did not apply to benefits and perquisites such as luxury items (planes, cars, yachts). This increases the popularity of performance based plans and non-qualified stock options and perquisites.
• Budget Reconciliation Act 1993
The Omnibus Reconciliation Act of 1993 limited tax deductibility of executive compensation above $1 million. This limit does not apply to performance-based compensation, including stock options. This further increases popularity of stock options.
• Sarbanes Oxley Act 2002
Sarbanes Oxley Act of 2002 required executives to disclose new equity grants within 48 hours of origin. Importantly, it required organizations to take back incentive compensation in the case of financial restatement coming from fraud or financial misconduct. In addition, the practices of stock option backdating and practice of cashless exercise of stock options were eliminated.
• Dodd Frank Act 2010
Dodd Frank Act of 2010 granted shareholders a vote on executive compensation. It required disclosure of ratio between CEO/Average worker pay. It also required disclosure of executive hedging policy and required more stringent claw back policies.
Using this information, it is clear that CEO compensation plans are an extremely complex issue. Without a doubt change must happen, yet the question remains whether some of the measurements suggested (Tax rate increases, legal pay caps) have provided the economic results. Without a shadow of a doubt, the fact that during 2009 the majority of public trading companies have not altered their compensation programs has angered the public and resulted in the Dodd Frank Act. I believe that the companies must make the right changes to their compensation programs.
Next, lets look at some organizations and their ratio between CEO/ Average worker.
As you can see, some of the results of the ratio’s are quite stunning. Before jumping to conclusions, lets take a close look at the results. Mattel, operates factories overseas and thus, employs numerous low-wage employees in Asia and elsewhere. Ms. Mattel was hired to turn around the company disrupted by online shopping but it did not work well and the former Google executive left the company within a year. Even after forgoing most of the performance-based awards, Ms Mattel took home over $10 million. While the ratio in this case is the largest, it is highly driven by the low wages in outsourced countries. The next highest pay ratio is in the company called First Data, which processes credit card transactions. Frank Bisignano, was the highest paid executive in the country last year. The median salary is about $50.5 thousand, which results in one of the highest pay ratios. However, the company rewards each of the employees with stock shares as a performance-enhancing tool. If you perform better your rewards become greater.
The company that has faced great scrutiny for its low wages is Walmart. Walmart is the largest private employer in the country employing over $1.6 million people. It has responded to the critics by raising the minimum wage to $11 dollars/hour. However, the median employee at Walmart has made $19,177. Mr. McMilon , the CEO, has made over $22 million. Unfortunately, many employees at Walmart are still looking for public assistance programs and are living close to poverty line. Public pressure on Walmart is helping to create a change for the low-income workers.
While there are certainly many companies where the average workers are not paid much, while the CEO receives large sums of money the solutions aren’t so simple.
What are the solutions?
Well, you have many examples in history today where the principle of “greed” has caused a tremendous amount of suffering and loss for the society. Take 2008 Financial Crisis for instance, indeed when the dust settled, it was clear that it was largely motivated by greed. However, while every person understands why greed could be problematic the issue of jealousy is quite real as well. I do believe that a lot of the regulations considered by the government do not bring positive change. In fact, while there was a significant amount of government regulation it has not worked, but accelerated CEO pay hikes. So in order to provide manageable solutions I belive that focusing on how should the CEOs be paid is more important then how much.
Indeed, the CEO compensation has to be structured in a way to be rewarding for the talented executives and incentivize them to achieve great performance by the companies. In fact, there are many organizations that perform poorly while the CEO collects a large salary and equity. Thus, this excessive executive compensation in this case is not tied to performance and that needs reform.
What is prevalent in the marketplace is that executive compensation is based largly on short-term financial return for shareholders. Long term financial results are consistent with a company’s strategy development and implementation. Optimal incentives for executives ought to focus on sufficient organizational learning and development, development of processes and customer-related data and achievements. Moreover, the compensation packages must attract the right people. If the salaries are below market, but the individual performance incentives are generous, they will still attract intrinsically motivated competent candidates. I believe that better job security is also essential. If the executive is afraid of being let go, they will only focus on shareholder returns and not developing the vision of the company. The board of directors must appreciate efforts to developing strategy and meeting strategy milestones, creating pathways to long-term success even if at the beginning the financial upside is low. Careful succession planning must be present as well, as in the time of crisis the highest compensation packages are negotiated. According to Harvard researcher V.G. Narayanan, “should get rid of egregious practices such as over the top severance packages (more than two times annual compensation), grossing up taxes, defined-benefits plans, guaranteed returns on deferred compensation, accelerated vesting in the event of change in control, and time-based vesting of restricted stock. On the stock question, companies should require that equity pay vest on the basis of company performance relative to their peer group over five to ten years”
Furthemore, the government regulation and intervention are an answer for many to solve the problem of executive compensation. Such measures include: ceilings on CEO/Worker ratios, caps on pay and federal commission oversee as most prominent examples. Unfortunately, those measures have not until now proven successful in reducing excessive CEO compensation. What excessive regulation could create is environment where new approaches are few and organizations do not adjust their packages to organizations strategies. Certainly, we have learned from our studies that same regulation cannot fit every company as their strategies differ and so do their compensation practices. What can make matters worse is that regulation may include unintended consequences. For instance, if the cap on ratios were introduced the lowest workers in the organization might be outsourced and the CEO pay will remain the same.
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