A new study: How overpaid CEOs tank their firms
Economic inequality. The issue has preoccupied liberals and conservatives alike this winter, and while they frame the problem differently, the evidence is indisputable: the gap between the bottom and top of the income ladder is widening, and has been for decades.
Of course wages for some middle class earners have been stagnant; that’s an obvious part of the problem. But enlarging the gulf is the explosive growth of income at the tippy top.
Why are those Olympian earners, racking up hundreds of times their average employees’ compensation, bringing home whole sties’ full of bacon? Just what are they being compensated for?
The CEOs, or at least their PR departments, have now felt the skeptical scrutiny.
Last week, Virginia Rometty, CEO of IBM, became one of the latest chief executives to turn down compensation on top of her $1.5 million salary.
“In view of the company’s overall full-year results, my senior team and I have recommended that we forgo our personal annual incentive payments for 2013,” she announced.
Much of the ire has been provoked by CEOs earning more than their desk jobs would seem to merit. It’s been framed as a matter of fairness — how a top-heavy pay structure demeans the average worker.
While places like Switzerland have entertained capping compensation so that what the highest-paid workers take-home can’t exceed 12 times what the lowest-paid employees make (though a referendum to that effect was defeated at the polls), America’s business culture — indeed its national mythology — feeds on the possibility of ever greater rewards.
If you couldn’t offer CEOs higher pay, General Electric CEO Jack Welch told Paul Solman years ago, you’d have trouble luring the best talent.
Here’s an excerpt of Paul’s interview with Welch, where he makes that point:
JACK WELCH: I mean, General Electric had — I don’t know the number, whether it was 7,000 or 10,000 millionaires. That happened because stock ownership was spread throughout the company, and a lot of people benefited.
The CEO, yes, got excessive amounts or large amounts. Well, I can say…
PAUL SOLMAN: (Laughs) Is it excessive?
JACK WELCH: It was large. It was very much… you… I can’t justify the absolute number. All I know is that tomorrow morning, if you want to cap it, you’d be the dumbest guy in town because…
PAUL SOLMAN: The dumbest guy in the whole town?
JACK WELCH: The whole town. Because what you would do is you would challenge the free enterprise system.
And what you would say to people that own WorldCom shares tomorrow that are out trying to hire a CEO, “You can only pay that CEO so much.” Or Tyco, who just had to replace their CEO, “You’d only pay them so much.” How do you think they get people to go take those jobs, take those high risks?
PAUL SOLMAN: You don’t think you could get somebody to take the job at Tyco or WorldCom or perhaps a place that’s a little less besmirched?
JACK WELCH: No, I’m giving you troubled situations.
PAUL SOLMAN: Yes. The worst — the worst of the worst; but you don’t think you could get people to do that job for less money than…
JACK WELCH: You won’t get the best people, because the best people are being paid very well where they are.
That’s what free markets are all about.
But what if extraordinary, or “excess” compensation of CEOs, is actually correlated with lower future returns for their firms? Then the pay trend becomes a subversion of economic logic. And that’s just what a new academic study reports.
The study about pay for non-performance is catching the attention not just of Occupy types, but of industry insiders who look to CEO compensation as an indicator of firm performance.
Theoretically, the structure of corporate compensation should motivate CEOs to perform well for their firms, aligning CEO and shareholder incentives. And some previous research cited in the study’s literature review supposedly found as much. But using a much bigger data set (of S&P 1500 firms) over a longer time span (1994-2011), this study finds a negative association between high compensation and a firm’s future stock performance.
Looking at the CEOs whose compensation placed them in the top 10 percent, the authors were surprised to see that over the next one to three years, their firms underperformed the market — by 5 to 10 percent. That’s a huge loss of shareholder wealth, said one of its lead authors, Michael Cooper of the University of Utah.
It’s important to understand that not all compensation is created equal. Oracle’s CEO refused his performance bonus last year and only accepted $1 for his salary. But even if you’re tempted to cry for Argentina, don’t cry for him. He was still eligible for $77 million in stock-based compensation.
Executives receive what’s referred to as “cash pay.” That’s the boring stuff, like their salary and a regular bonus. But they also get incentive pay, and that’s where things get exciting. Incentive pay often consists of restricted stock option grants — meaning options that are above and beyond what’s available to lower-rung employees — and they’re “forward-vesting,” meaning that when they’re granted, you don’t know exactly what they’ll be worth.
Among that top 10 percent of CEOs, fully 86 percent of their pay comes from incentive pay.
Firms that offer this kind of pay tend to have the largest market value and have grown over the last three to five years — hence their ability to compensate their executives lushly. The authors controlled for industry and size variation of firms so that similar companies were compared to each other.
To help explain the correlation between high incentive compensation and poorer performance, Cooper and his co-authors were interested in the behavior of these highly-rewarded CEOs. First, they noticed that the CEOs that are paid more invest 10 to 20 percent more than their peers and engage in 30 percent more “empire building,” or M&A.
So maybe their aggressive investing makes them good CEOs, performing on behalf of their shareholders. But Cooper’s team looks to see how those mergers and acquisitions work out for them and find that the firms’ stock prices react negatively to news of empire construction.
This kind of value-destroying behavior, Cooper suggests, is the result of an overconfidence effect. CEOs getting higher incentive pay (which will be realized over the course of several years) start feeling a little too big for their britches and take risks that jeopardize the firm — with those effects playing out over the same one to three year span as the realization of their stock options.
Cooper, who previously ran a firm at Goldman Sachs, doesn’t go as far as to say that higher incentive pay causes overconfidence. Maybe executives who are overconfident just tend to demand higher remuneration. After all, the reason CEOs earn so much in the first place is largely a supply and demand effect, he says. Running a large firm requires a rare and specific skill set, and because so few people can do that, Cooper says, that bids up the price.
So maybe the pay for performance results found in this study are a correlation and nothing more. Cooper, however, has been presenting the study to hedge funds around the country. Executive incentive pay, he said, “looks like a good signal for investors to use to ferret out firms that will underperform in the future.”
If stock prices are falling, eventually, investors are going to want to know why so they can do something about it. “The message,” Cooper said, “is that maybe this should make us revisit how pay contracts are set up.”
The study looked at one regulatory effort and its effects on incentive pay and performance. The authors thought that the Sarbanes-Oxley Act of 2002, which attempted to regulate corporate accounting and improve financial disclosures, might change how pay affected returns. But there was little change after 2002. (Although Cooper notes that enough time might not have passed to really assess SOX’s effects).
What about other regulatory efforts? They’re out there, sure, but Cooper doesn’t see high compensation giving way anytime soon.
The real question is, should it?
“The U.S. leads the world in terms of high pay compensation,” Cooper said. We’re an outlier. “But,” he continued, “that’s the American way I guess.” And that certainly jibes with ex-GE CEO “Neutron Jack” Welch’s rationale, as he expressed it to us on the NewsHour.
“I grew up in a union family,” Welch said. “I didn’t have two nickels to rub together. I went to a state school for $50 a semester — got lucky; got a great team together and made a lot of money. I worked hard as hell. That’s what America is about. We ought to be cheering that. We ought to be hoping there’s lots of people that that’s happening to.”
Another explanation? That boards of directors are in the pockets of their CEOs. Yet another: the Lake Woebegone Effect — that all boards think their CEOs are above average and want to pay accordingly, thus steadily ratcheting up that average, irrespective of performance. See our story about this with CEO pay expert Graef Crystal.
In the end, reining in compensation may not happen because of a liberal or conservative initiative to address inequality; it very well could be shareholders — of both political stripes — who finally make the call.
Watch more of our series on “Executive Excess” below: