Are CEOs overpaid?
Henri Proglio’s appointment at the head of EDF, the French utility company, in late November, and his asking for a salary equal to his previous salary at Veolia (2m €) spurred the debate on CEO pay in France. “I don’t like high salaries” stated Martin Hirsch, to whom government’s representative Eric Woerth (Budget Minister) responded “CEOs of large companies have high salaries because they have high responsibilities. What I do not like is a high salary for small responsibilities, and here, it’s not the case”
On that very last point, one can only agree with Mr. Woerth: EDF is one of the largest utility companies in the world, with $95.5 billion in revenues in 2008, and one of the top French industrial companies (where the government has a core shareholding and a substantial say in management).
One can also understand that being sought after, Mr. Proglio asks to keep his level of compensation, should he accept this new position. Moreover, a 2 million € salary would be close to the CAC40 CEO’s median salary.
However, the salary he had at Veolia, that is of 2 million €, is higher by 45% to that of EDF’s former CEO, Pierre Gadonneix. One could reasonably wonder: is Mr. Proglio better and more competent by that much? Have the responsibilities at the head of EDF increased by that much? Or is it simply a premium the state is willing to pay, in order to attract such assets in strategic companies?
The discussion around Mr. Proglio’s case is a punctual illustration of a more global debate regarding CEO’s pay. Substantial responsibilities, size or the strategic relevance of the company are often brought up by some to justify a certain level of CEO pay, while others argue that despite all these parameters, salaries often strike indecent levels. All these interrogations eventually come down to one question: Are CEOs overpaid?
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Going back over the CEO’s role can be helpful, so as to reframe our reflection and have a better overview of the functions and responsibilities of a CEO.
The CEO (Chief Executive Officer) is one of the highest-ranking persons in the management of an organization. Various roles and responsibilities incumbent on the CEO can be identified (among many others): advising and supporting the board, ensuring that staff and board have sufficient up-to-date information, being the interface between the board and employees, formulating policies, deciding courses of action, overseeing operations, implementing plans, managing the firm’s resources, etc… Most of the CEO’s duties, such as setting the company’s strategy and vision, creating culture, or building the senior management team, are responsibilities he/she cannot delegate.
Hence, the subject of the debate is whether the amount CEOs are paid is linked, proportionate and coherent with the role they actually play, the responsibilities they are liable for, and subsequently the impact and result of their actions.
Two major theses are in conflict.
On the one hand, Kaplan (2008) claims that CEO pay is largely determined by market force, and that the CEO turnover is more closely tied to stock performance than it has ever been. More regulation as so the compensation structure and level of CEOs is time consuming and costly, and would affect the effectiveness of the company more than it would foster it.
On the other hand, Bebchuk and Fried (2006) believe that there is a decoupling of CEO pays from performance. Relationships between CEO and the boards, non-equity compensations, and substantial goodbye payments, among many others, account for this distortion.
In this paper, we will first of all present the current situation regarding CEO compensation (basis, structure and current trends).
EXECUTIVE COMPENSATION SHOULD NOT BE CAPPED Stock market investors in America and Europe agree that top managers get tremendously huge salaries. This became an issue three decades ago when their salaries skyrocketed especially during the turn of the millennium. Yet, looking at the issue deeply, one sees that these highly-salaried top executives hold jobs that need not be envied at all. Most people ...
In a second part, we will analyse and look through the various issues raised by this current situation, namely the possible decoupling from performance. Finally we will tackle the potential solutions and ideas to fix the problems evoked in the previous section.
Part 1: Executive compensation: theory and facts
A. The Principal-Agent View
Almost everything in a corporation can be related to corporate governance. executive compensation is a typical response to an agency problem. What is an agency problem? We can describe an agency situation as a relationship between to parties when one party called “the principle” delegate decision-making authority to another party: “the agent”. The action of the agent has an influence on the welfare of the principal. In this respect, it clearly appears that there is an agency problem between the CEO and the shareholders. Indeed, shareholders and CEOs can have divergent goals. Shareholder’s welfare depends positively on the effort expended by CEOs. And CEOs welfare is reduced by expending more efforts since effort is onerous. Of course there is a moral hazard: shareholders cannot observe at zero cost effort expended by CEOs. Executive compensation is precisely this cost. It aims at shrinking sub-optimal effort, self-dealing or empire buildings. To sum it up, compensation plans exists to align the interests of risk-averse and self-interested executives with those of shareholders. As Kevin J. Murphy (1999) puts it, “the fundamental shareholder-manager agency problem is not getting the CEO to work harder, but rather getting him to choose actions that increase rather than decrease shareholder value.”
B. A typical Executive compensation
Executive compensation can be defined as the total remuneration or financial compensation a top executive receives within a corporation. As Kevin J. Murphy (1999) points it out, a typical executive compensation package is made of a salary, a bonus plan, stock options and restricted stocks.
A salary is a periodic payment which may be specified in an employment contract. It is contrasted with piece wages, where each job, hour or other unit is paid separately, rather than on a periodic basis. It can also be viewed as the cost of acquiring human the CEO for running operations. Salaries have no link with the performance contrary to bonuses.
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A bonus is a supplemental payment which is not considered as a regular part of an employee’s salary. Bonus payments are triggered when specific performance levels are reached. Those criteria are based on accounting features (Sales, EBITDA, EBIT, Earnings, ROI, and ROE).
The compensation is constant until a minimum is reached. Usually it represents 80% of budget target. When this threshold is reached, the manager receives a bonus. Then, the bonus is linearly linked to performance. But this linear correlation ends when a maximum is reached (Usually, 120% of budget target).
Stock options is a form of compensation which can be described as a contract giving right to purchase an asset at a pre-determined price (strike or exercise price).
Both privately and publicly held companies make options available. Stock options are interesting only when they are in the money: the price of the underlying share is higher than the strike price and the intrinsic value is positive. Since their interest lies in the gap between the strike price and the market price of the underlying share, the wider the gap is, the bigger the profit is.
Restricted stock, also known as letter stock or restricted securities, refers to stock of a company that is not fully transferable until certain conditions have been met. Upon satisfaction of those conditions, the stock becomes transferable by the CEO holding the award. The conditions that allow the shares to be transferred are a period of time, when they vest. However, those restrictions can also be some sort of performance condition, such as the company reaching earnings per share goals or financial targets.
C. The current trends in CEO pay
From a methodological point of view, it is not easy to collect long time series. Indeed, the SEC imposed disclosure on executive compensation at publicly traded companies in the 30s. Frydman and Saks (2007) have collected such information and offer us long term perspective on executive compensation trends.
Extracted from Frydman and Saks’ article the graph shows the trend: the real pay of the median top officer declined up to the 1950s. Between the 1950s and the 1970s, the growth was quite slow, but since the mid 1970s, executive compensation has skyrocketed until 2005. This movement can be probably linked with the spread of stock options and financial markets deregulation. In the 1990s, the growth rate was more than 10%.
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As shown in the figure below, Jensen, Murphy and Wruck (2004) also prove that stock options have played a key role in the dramatic increase underlined by Friedman and Saks. Indeed, in 1992, stock option plan represents only 24% of the total pay. But in 2002, it represents 47%.
Part 2: Executive compensation: main issues
A. Incentives focused on short-term rather than on long-term performance
As explained above, executive compensation aims to solve an agency problem. CEOs’ compensation is used to align CEOs’ interests with shareholders’ ones. But what are shareholders’ interests? Generally speaking, shareholders seek a sustainable increase of the organisation’s value, in order to benefit from higher dividends or capital gains. Such sustainable increase of value results in an increase of the firm performance, in the long-term. But executive compensation schemes appear to reward short-term performances.
This issue is particularly sensitive regarding the stock-options component of executive compensation schemes, as Lucian A. Bebchuk and Jesse. M. Fried (2006) point out: “Option plans have been designed, and largely continue to be designed, in ways that enable executives to make considerable gains from temporary spikes in the firm stock price, even when long-term stock performance is poor.” Indeed, “as everybody knows, there are occasional spikes in stock prices” (), recalls Ralph V. Witworth, president of the United Shareholders Association.
This academic point of view is clearly confirmed by facts, especially by the General Dynamics experience. Compensation program of this firm comprised a Gain/Sharing Plan. Under this program, top executives would receive a certain amount of money if General Dynamics’ stock price closed at or above a pre-determined price, and stayed at or above this level for ten consecutive trading days. According to Howard Sherman, vice president of the Institutional Shareholders Services, “a 10-day plateau is nowhere near a measure of long-term success” ().
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The same absence of long-term perspective can be observed as to bonuses. As explained above, a bonus payment is triggered as soon as a minimum budget target is reached; the compensation level then rises linearly until an upper budget target is reached. Michael C. Jensen (2001) shows that those two kinks in the bonus plan favour managers’ behaviours based on short-term perspective. First, when a manager feels that he/she will have trouble to reach the first performance level, he/she will be naturally tempted to increase his/her performance by all means, even illegitimate ones. He/she will have a strong incentive to increase the current year’s earnings at the expense of next year’s for example. On the contrary, when the managers realizes he/she will never reach the lower performance level, he will have no more interest in increasing his/her performance. Therefore he/she will have an incentive to move profits from the present to the future, in order to be sure to have a bonus the following year. The same behaviour is observed when the manager approaches the upper performance level: Since he/she has no more interest in increasing his/her performance for the current year, he/she will push profits into the future.
In that way, CEOs are more encouraged to favour their own short-term interests than the shareholders’ long-term ones. Thus the main goal of executive compensation is not reached. Such absence of correlation between executive compensation and long-term performance of the organisation is one of the main issues affecting executive compensation schemes.
B. Influences on Boards
Executive compensation is usually decided by the board. But in this task, directors are subjected to many influences, especially regarding global amount and composition of compensation packages. CEOs have indeed great power over directors, even independent ones. In the end, it creates a situation of major conflict of interests between CEOs and directors, as shown by the following examples.
First, CEOs have power over directors’ re-election. As Lucian A. Bebchuk and Jesse. M. Fried (2006) point out, “the director slate offered by management is the only one offered. The key to a board position is thus being placed on the company’s slate. And because the CEO has significant influence over the nomination process, displeasing the CEO has been likely to hurt one’s chances of being put on the company slate”. That’s why many directors seem to be reluctant to minimise CEOs compensation.
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CEOs can also influence Boards thanks to their power over directors’ compensation. A kind of reciprocity is created: if directors grant the CEO a high compensation level, the latter will accept in exchange a great remuneration for directors. Once again, many directors do not want to break this balance.
Such conflict of interest is highlighted by Benjamin E. Hermalin and Michael S. Weisbach (2003): “CEO pay at a given company increases when the given company’s board contains directors who are CEOs of firms on whose boards the CEO of the given company sits (that is when boards are “interlocking”).”
But beyond this conflict of interests, we can also observe a deep issue of fraternity and collegiality amongst CEOs and directors. CEOs and directors belong to the same social circles and they all share positions of direction. It creates a kind of collegiality, which prevents directors to financially harm their peers, through a minimisation of their compensation.
C. Misuse of market values as references for executive compensation
Executive compensation is usually determined as regards to market references. But such market references seem to be inadequate, because of the absence of correlation between the actual performance of a given CEO and his/her compensation. When a firm wants to attract a given CEO, it will have to propose him/her a given compensation, even though it does not know yet the performance of that CEO regarding the firm.
Executive compensation is also linked to another market reference: the evolution of the stock price. Once again, such indexation appears to be irrelevant, since the evolution of a stock price can have many other causes than CEO’s action. For example, a CEO could get a huge compensation because of a great increase of the stock price on a given period, even though such increase would be only due to the market general situation.
The latter shows that using market references also disconnects executive compensation from real value creation in an organisation. The top management is not alone in the chain of value creation. But top executives are much more rewarded than other participants in this value creation. Sandra Waddock (2008) recalls that “CEO compensation soars well above anything comparable happening to worker wages; one recent estimate pegged CEO compensation in 2006 at 364 times that of the average worker in the US (AFL-CIO, 2007).” Such gap becomes a real issue for corporate social responsibility.
According to market standards, a special compensation has to be granted to the CEO if he/she is fired by the Board. Such provision is supposed to compensate the risk taken by the potential CEO when he/she accepts a non stable job. But this rule leads to a “pay for failure” system: a CEO will be highly rewarded even when he/she has a record of extremely poor performance. Such behaviours clearly show that, on the one hand, market references favour decoupling pay from performance and, on the other hand, influence is exerted by CEOs over boards.
Part 3: Solutions to tackle the current issues
A. Improving the link between CEO compensation and performance.
One way to pressure the CEO and the board to choose a compensation structure in ad equation with performance is to improve transparency and therefore, enhance disclosure of the elements of executive pay and of their exact dollar value, and of the rationale directors followed when building the pay package. Since the last decade, one can observe a general international movement toward more disclosure. In 2002, the U.K. Parliament passed the Directors’ Remuneration Report Regulations, which required that companies issue an annual report on the compensation of each member of the board of directors.
However, one can wonder whether too many rules and regulations with high requirements in disclosure would not deter companies from being listed and reduce their chances of raising capital.
Moreover, according to Bebchuk and Fried (2006), confusion between transparency and disclosure is often made by the public. The two authors recognize that disclosure already exists thanks to some regulations (SEC requirements in the USA for example), but they believe that only an improved transparency would manage to link better pay and performance. They especially insist on the “total dollar value” of the pay, in order to eliminate particular forms of compensation, such as pensions, post-retirement perks, deferred compensation…, which usually are chosen for their camouflage quality rather than for their link to performance.
Finally, measures could be taken considering the structure of compensation itself. For example, according to Jensen (2001), the kinks in the pay-for-performance line of a typical bonus plan induce gaming behaviour from the managers. That is why Jensen (2001), and later Jensen and Murphy (2004), advocate to “stop using budgets or targets in the compensation formulas and promotion systems for employees and managers”, and this could be possible by first, “taking all kinks, discontinuities and non-linearities out of the pay-for-performance profile”, and second, “committing not to change the pay-for-performance profile from year to year based on budgets, prior-year performance, or any other metric influenced by managers in the current or prior years.” They conclude that “as long as the pay-performance relation is linear with no kinks or discontinuities, a manager’s bonus does not depend on what his or her target is”, hence, won’t be encouraged to lie and cheat anymore.
B. Improving Board Independence
As explained earlier, the CEO can influence the board of directors to raise the level of his pay. This process is described by Marianne Bertrand (2000).
She describes two competing views of CEO pay. She opposes the contracting view, in which pay is used to solve the agency problem, to the skimming view, or the rent extraction view where CEO and managers exercise an influence on the board of directors and the pay process.
In the contracting view, compensation plans do succeed in aligning the interests of the executives with those of shareholders -as Bertrand puts it: “the compensation committee optimally chooses pay contracts which give the CEO incentives to maximize shareholder wealth”.
But in the skimming view, pay becomes the result of an agency problem: the CEO has managed to capture the board of directors and the pay process so that he sets his own pay.
One way to avoid captured boards is to ensure its independence. Jensen and Murphy (2004) make several recommendations on this matter, aimed at making the board members understand that they are not working for the CEO, and therefore not support the CEO but actually monitor him.
– The board should not be chaired by the CEO, or a former CEO or a potential next CEO, because “The critical job of the Chair is to run the process that evaluates, compensates, hires and fires the CEO and top management team.” The Chair should have neither personal interests at stake, nor a glimpse of compassion for the current CEO.
– Contrary to a received idea, Jensen and Murphy don’t advocate a high number of outsiders in the board, as they may be friends with the CEO, as the CEO may have suggested their name for election or simply because they lack hindsight on the business and the culture of the company and could rely too much on the CEO’s words without challenging them.
– But at the same time, Jensen and Murphy recommend that “The CEO should be the only member of the management team with board membership.” They admit that members of the management team can add much value to board discussions as they can bring very precise and up-to-date pieces of information. But they don’t see why they should be formal voting members, as they fear that the management will always support the CEO, and not monitor him. That’s why, Jensen and Murphy advocate an “ex-officio” membership for the management team.
The two last recommendations certainly leave us a bit confused, as we don’t understand how one board can reduce the amount of outsiders without accepting any insiders except the CEO…
Jensen and Murphy’s second recommendation is opposed to the vision Bebchuk and Fried (2006) have of an independent board. The latter believe that a board should be composed of a majority of independent directors, that is to say, directors who have no business interests with the firm. Bebchuk and Fried recommend the compensation and the nominating committees to be entirely filled with outsiders in order to reduce the managers’ power. But according to the authors, no matter what the level of independence of the board is, nothing will ensure that it will defend the shareholders’ interests. That’s why Bebchuk and Fried recommend creating a dependence of the board on the shareholders. This particular point will be addressed in the following section.
C. Role of the shareholders: can they personally defend their interests?
Because shareholders are the residual claimants of a firm, they are often considered as the owners and the principal goal of the firm is to maximize the shareholders’ value. Critics of the level of CEO compensation often consider that, in the process of building the CEO compensation plan, shareholders are not playing a role in line with their risk-taking as owners. They benefit from a limited right to speak and therefore, their ability to counterbalance a capture board is restricted.
On those grounds, opponents advocate a deeper shareholder activism in order to rein in pay. Several proposals are made by different authors to improve the board accountability to the shareholders, and by this mean, reduce the risk of its capture by the CEO. Below are listed three of those proposals.
– We previously dealt with the first proposal of improving transparency. A bigger disclosure allows investors to be better informed of the Board’s decisions and react accordingly.
– The second proposal, by Bebchuk and Fried (2006), is that the alleged power of the shareholders to replace a director should become a reality. The authors suggest that in addition to becoming more independent, the board should become more dependent on shareholders. They assert that, even when bad governance is proven by facts, directors face small risk of replacement. They want all kind of impediments to director removal to be reduced. That is why they also recommend that all staggered boards should be eliminated so that all directors would stand for re-election each year.
– The third proposal, usually called “say on pay”, wants to give shareholders a direct vote on CEO compensation, using the proxy voting procedures. The pros and cons of the “say on pay” are described in the case “Say on Pay: Does the Buck Stop Here?”, prepared by Pr David F. Larcker and Brian Tayan. Say on pay allows shareholders to give directors a feedback on whether they approve their job of designing the compensation package. The vote can be advisory: directors can ignore its outcome and implement the policy anyway; or precatory: if the new policy is rejected, the existing policy automatically remains. Advocates of the say on pay believe that such process improves the dialogue between the board and the shareholders, reduces the risk of public outcry when the annual compensation plan is revealed, and forces the directors to better assess the consequences of their decision concerning the amount and the structure of the CEO pay.
Despite all those benefits, we would like to question the efficiency of the Say on Pay process. Organizing a vote within the shareholders is a time-consuming and expensive process (and the money used is out of the shareholders’ pockets), whose issue isn’t necessarily taken into account in case of an advisory vote. So why bother?
Furthermore, say on pay is duplicative with existing control as shareholders can already express their dissatisfaction by voting against the re-election of directors who approved excessive pay practices, as long as such right to vote isn’t only a myth, as implied by Bebchuk and Fried (2006).
Finally, say on pay casts discredit on the work carried out by directors and affect the credibility of their decisions in general. If the compensation committee and the rest of the board have voted in favour of that plan, it musts certainly be a valuable plan. They have already spent much time structuring it. By adding a new monitoring structure, to make sure that the board whose mission already is to defend the shareholders’ interests actually is defending these interests, we then may fall into the “who monitors the monitors?” loop and who knows where this will end?
The research we conducted, based on the current trends, figures and facts lead us to the assumption that indeed, CEOs are overpaid. However, the analysis we carried out from these observations is that this excess in CEO pay is neither a general nor absolute reality.
It is in the way that the compensation is determined that the kink lies. Several defaults in the mechanism were identified as responsible for this discrepancy, such as a too frequent focus on the short term, the too big influence of CEOs on boards, and the poor use of market references, to name a few.
Improving this mechanism would enable to determine more unbiased, legitimate and accurate compensations. Key trails were identified in the search for solutions to this issue: clarify the structure of the compensations by upgrading the disclosure globally, with an emphasis on the bonus part and increase the independence of boards. Other trails are worth to be considered, such as “say on pay”. However, we believe that they may not be real solutions, given their drawbacks (time and energy consuming, discrediting for the board, etc…).
Finding solutions and implementing them would not necessarily lead to substantially lower pays.
It is indeed rather the quality than the quantity of the CEO compensations that we reckon disproportionate and not fair. The issue as to the CEO pay would therefore not be that they are overpaid, but that they are “ill-paid”. Hence, rather than wanting at all cost to reduce CEOs’ compensations, one should focus on rethinking how they are to be legitimately defined and assessed.
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 « A Most Unusual Executive Bonus Plan », Washington Post, October 9, 1991, p. A1