Are CEOs really overpaid and mostly not worth it? Part 2

Posted by on Jan 16, 2012

Last week, in Part 1 of this topic, we introduced the following questions:

Are the highest paid CEOs really worth what they’re being paid?

And does paying top dollar for a CEO add to the bottom line, where it really matters?

The answers, supported by studies cited last week, are that the Fortune and FT 500 firms with the highest paid CEOs experienced negative abnormal returns over the subsequent 5 year period. (See details in Part 1 of this report.)

This week we’ll explore more data and review opinions from some of the top researchers in the field of executive pay.

We’ll answer 2 key questions:

1. What, exactly, is the problem, and how widespread is it?

2. What are the likely causes?

Finally, in next week’s article, we’ll conclude this three-part series by answering the question:

3. What should companies do about it?

1. What, exactly, is the problem, and how widespread is it?

Two issues stand out.

First, executive compensation has grown many times faster than employee pay. The data on this is clear and unchallenged, and the timing makes for terrible optics – the growing salary gap between CEOs and front line employees comes just when the middle class is falling behind and shrinking.

Second, most studies we found suggest that performance incentives for top level managers in Fortune or FT 500 firms do nothing to improve company performance, and may even make it worse.

These issues are connected. Some bonus structures clearly pose moral hazards. This has been particularly evident in the financial sector, where in-depth analysis following the 2008 financial crisis produced well-documented examples of CEOs, other executives, traders, risk managers, legislators and ratings agencies placing personal gain ahead of the interests of their employers or clients. (1)

Outside the financial sector there’s plenty of evidence that individual CEOs received bonuses while their companies were cutting the workforce, moving jobs offshore, and even in some cases when the companies were losing money. That doesn’t mean every decision that appears to hurt a company’s long-term interests is driven by a CEO putting his bonus ahead of the company’s success, but the evidence suggests it is likely that some such decisions are the result of this moral hazard. If the incentive to take risks is strong enough, then we should expect to see excessive risks being taken. The incentive to take big risks is exacerbated by the fact that performance bonuses skew CEOs’ personal financial risk - they stand to win big if the company wins big, yet they walk away with a generous severance package if the company is decimated. This makes claims that CEO bonuses represent a risk premium somewhat hollow.

We found a study(2) that concluded CEO salary growth is equivalent to the compensation that would be required to offset a moral hazard. It argues that without the carrot of big bonuses, CEOs would tend to adopt lower risk, lower return strategies that require less effort. However, this doesn’t invalidate the finding of negative abnormal returns seen among the firms with the highest paid CEOs as cited in Part 1.

In addition to the evidence that bonuses extend beyond the financial sector, studies also show that high rates of CEO salary growth extend to mid-size and smaller firms. While much of the research on this topic has focused on CEOs of the biggest companies in the USA and Britain, a 2005 study(3) of total compensation for CEOs and top 5 executives shows the same effect in US large, mid-cap and small-cap firms. The growth in executive pay levels in all three size ranges goes far beyond what could be explained by changes in market cap and industry mix.

There is anecdotal evidence(4) that this trend has reached into the not-for-profit sector in the USA. The Boys & Girls Clubs of America came under fire for paying its CEO nearly $1-million in 2008, while compensation for the President of United Way of Central Carolinas topped out at $1.2-million the same year. We’re not aware of any broad studies on not-for-profit executive compensation, but the practices for setting salaries are similar, and in many cases, involve private sector executives as Board members for these charities. We think it is likely that private sector practices will worm their way into the not-for-profit sector.

This trend has become evident even in the public service in BC, with plenty of consternation expressed about salaries at BC Crown Corporations, utilities, and even in the civil service. Taxpayers in BC got into a snit over compensation for the President of BC Ferries past year. And the Opposition party in BC had a field day with the news that executives of a social services agency, Community Living BC, received bonuses at a time when group home funding for developmentally challenged adults was being cut.

Excessive pay and incentives are clearly an issue for shareholders, taxpayers and employees. This stands as a threat to public and employee trust and perception of the legitimacy of corporate leadership. Coming as it does during the worst US recession in 75 years, it poses a threat that cannot be overlooked.

2. What are the likely causes?

Moral hazards are at the root of this discussion. Journalist Polly Curtis reviewed the findings of Britain’s recently concluded High Pay Commission. Writing in The Guardian on November 22, 2011, Curtis quoted Lord Newby, a member of the Commission:

It’s been in everybody’s interest around the table in the remuneration committee for pay to go up. It’s in the interest of the executives and the non-executives who are part of the same little clique. The more exec’s pay goes up, the more high pay goes up generally and it’s in the recruitment consultants interests to devise the most complicated deals, for which they are paid more.”

But why now, and not several decades ago?

David Bolchover (“Pay check: are top earners really worth it?”) was interviewed by Curtis for her Guardian Article. She quotes him as saying:

“Pay has gone up because of immeasurability of individual impact on corporate performance. . . . Because of the difficulty in measuring it, executives capitalise on that.”

“The second reason is dispersed ownership. 1960s large companies were owned by wealthy individuals, so the senior executive comes into a meeting of shareholders and says I want several millions because otherwise I’ll leave. They would laugh at him because there is no evidence for it. Because these companies are owned by us as shareholders through pension funds and insurance companies, the senior executives of these intermediaries also have vested interest in high pay.

We can’t help but conclude that the way in which many CEO salaries are set is corrupted indirectly by self-interest. It’s not much different from an unlikely scenario in which the Vancouver Canucks hire a committee including top players from other teams to set the Canucks’ player salaries.

Many feel that the salaries for top athletes are excessive, but the team owner who pays the salaries makes his own calculation and puts his own(5) money on the line. Certainly, superstar economics applies to sports figures, but the team owner stands to lose if his customers stop buying tickets. And unlike the case for CEOs salaries, the team owner has extensive statistics estimating the impact of each player on the team’s overall success.

In next week’s concluding article in this series, we’ll explore opinions from more luminaries to help answer the question, “What should companies do about it”.

What is your opinion on the issues raised in this series?

Do you feel CEO and Executive salaries are excessive?

Do you feel they are properly correlated with the companies’ success?

Have you seen evidence of moral hazards built into performance bonus systems?

Join in the discussion by submitting a comment below.

1. Moral Hazard and the Financial Crisis, Kevin Dowd, Cato Journal, Vol. 29, No. 1 (Winter 2009)

2. Has Moral Hazard Become a More Important Factor in Managerial Compensation?, George-Levi Gayle and Robert A. Miller, American Economic Review 2009, 99:5, 1740–17691.

3. The Growth of Executive Pay, Bebchuk and Grinstein, Oxford Review of Economic Policy, Vol .21, No. 2

4. Nonprofit CEOs Who Want For-Profit Salaries Should Work at For-Profit Companies. Rosetta Thurman, The Circle of Philanthropy, March 17, 2010.

5. The vast majority of professional sports franchises are owned by individuals and private equity firms.

© 2012 Knowlan Consulting Group Inc. All rights reserved. Unauthorized duplication or publication in any form, in whole or in part, is prohibited.

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