The New Critics of Executive Comp
Forget the usual gaggle of gadflies who have long admonished corporate America for paying what they say are unconscionably high compensation rates to top executives. They are no longer the most influential critics of CEO compensation practices. Today, the most serious critiques come from mainstream pundits and, often, from within the business community itself. The result is growing talk of reform efforts, some of which could ultimately affect not just compensation plans but also corporate governance.
“About half of American industry has grossly unfair compensation systems where the top executives are paid too much,” said Charlie Munger, Warren Buffett’s partner at the famed diversified holding company of Berkshire Hathaway (Kirkland, 2006). Munger isn’t the only investor to think so. A Watson Wyatt survey (2005) found that 90% of institutional investors believe the current compensation system has overpaid execs and 85% think it has hurt America’s image. And the founder of the investment management firm Vanguard, John C. Bogle (2005), has concluded, “The bottom line is that our system of executive compensation is broken.”
Even many directors see a problem. A PricewaterhouseCoopers survey conducted in conjunction with Corporate Board Member magazine found that 70% of U.S. directors considered executive compensation levels too high (Marshall, 2006). Adding scholarly rigor to such opinions is the influential book Pay Without Performance: The Unfilled Promise of Executive Compensation. It argues that it’s a myth that executive pay arrangements are the result of a free-market, arms-length bargaining between executives and boards (Vogl, 2005).
Adding to the cynicism over executive compensation is the recent “backdating” scandal. Based on a comprehensive analysis of stock option grants between 1992 and 2002, University of Iowa Erik Lie’s work suggests that some organizations were “backdating their stock options to dates when the stock was low for the year or the quarter, tilting the odds of profiting on those options heavily in their favors,” according to Fortune (Colvin, 2006). Another factor that may play into the perceived unfairness of executive compensation is that overall, U.S. real median wages have been stagnant since the start of the decade, and real median family incomes have actually been falling in recent years (Kirkland, 2006).
The criticism of executive compensation comes at a time when, historically speaking, at least one study indicates executive pay increases are climbing at relatively modest rates (“CEO,” 2006). In 2005, the pay for CEOs rose 7.1% to an average of $2.4 million, according to Mercer HR Consulting’s CEO compensation survey. But a survey conducted by Pearl Meyer and Partners put median pay increases at 10.3%, and The Corporate Library put median increases at 11.3%. “All three studies,” reports IOMA’s Report on Salary Increases, “found no steady pattern matching pay with their companies’ performances. In some cases, the link was strong; in others, CEOs took home huge sums while their organizations faltered.” The Corporate Library study indicates that the biggest gaps between pay and performance over the previous five years occurred at 11 of the largest U.S. companies (“Executive,” 2006).
So, assuming that the link between executive pay and performance really is broken at some firms, what can or should organizations be doing? First, it should be noted that some important reforms have already occurred or are in the works. Sarbanes-Oxley, for example, requires option grants to be reported within two business days, which may well have put an end to the backdating phenomenon (Colvin, 2006). And the Securities and Exchange Commission (SEC) has already proposed new rules that could result in the biggest changes to executive compensation disclosure laws since 1992. The rules, which would take effect with 2007 proxy filings, may require companies to clearly report compensation for their top five executives and all directors (Pomeroy, 2006). Meanwhile, companies have already reduced their use of stock option grants and are using more restricted stock grants, probably in response to new accounting rules.
But some experts argue that such changes won’t adequately address the pay and performance gap. Prof. Lucian Bebchuk of Harvard University, coauthor of Pay Without Performance, argues the performance gap could be narrowed by changing aspects of corporate governance. He states that there aren’t enough good incentives for today’s directors to keep shareholders’ best interests in mind when negotiating compensation with CEOs. He suggests, “Directors should be paid much of their fees in the form of restricted stock grants. Holding a significant stock position that cannot be unloaded for a reasonable period of time helps focus directors on shareholder interests.” He also thinks that it should become easier for shareholders to replace board members.
In addition, Bebchuk is in favor of greater transparency in the compensation system and advocates specific practices for tying performance to pay more rigorously. For example, he supports “filtering out gains that are connected to marketwide or sectorwide movement of options” (Vogl, 2005).
The bottom line is that corporations are likely to come under growing pressure to justify their executive compensation rates. The link between performance and pay will be even more closely scrutinized, especially given the increased transparency that’s likely to be demanded by the SEC. It’s possible that, down the line, such pressure will affect not only compensation plans but also the roles and allegiances of corporate directors.
For a Fortune article titled “The Real CEO Pay Problem,” click here.
For an Across the Board interview with Prof. Lucian Bebchuk, click here.
For a Watson Wyatt Worldwide item on institutional investors’ dissatisfaction with executive pay systems, click here.
For more on the SEC’s proposal to change disclosure requirements, click here.
For an article on the backdating story, click here.
Documents used in the preparation of this TrendWatcher include the following:
Bogle, John C. “The Executive Compensation System Is Broken.” Journal of Corporation Law. ProQuest. Summer 2005.
“CEO Pay and Corporate Performance Closely Aligned.” Workspan. ProQuest. June 2006.
Colvin, Geoffrey. “A Study in CEO Greed.” Fortune. ProQuest. June 12, 2006.
“Executive Pay Increase Is Modest; Pay for Performance Remains Mixed.” IOMA’s Report on Salary Surveys. ABI/INFORM Trade and Industry. June 2006.
Kirkland, Rik. “The Real CEO Pay Problem.” Fortune, June 2006.
Marshall, Jeffrey. “Looking Hard at Executive Pay.” Financial Executive. ProQuest. May 2006.
Pomeroy, Ann. “Few Executive Pay Changes Expected.” HR Magazine. ProQuest. May 2006.
Vogl, A.J. “Out of Control?” Across the Board. ProQuest. March/April 2005.
Watson Wyatt Worldwide. “Institutional Investors Dissatisfied with U.S. Executive Pay System, Watson Wyatt Study Finds.” Press release. December 13, 2005.
Below are some other informative articles on the subject of executive compensation:
Hymowitz, Carol. “Sky-High Payouts to Top Executives Prove Hard to Curb.” Wall Street Journal. ProQuest. June 26, 2006.
Lashinsky, Adam. “Options Gone Wild.” Fortune. ProQuest. July 10, 2006.
“Leaders: Looking for Alternatives; Stock Options.” The Economist. ProQuest. June 3, 2006.
O’Byrne, Stephen and S. David Young. “Why Executive Pay Is Failing.” Harvard Business Review, p. 28.
“Q&A: Getting a Grip on CEO Pay Levels.” Directorship. ProQuest. June 2006.
“About half of American industry has grossly unfair compensation systems where the top executives are paid too much,” said Charlie Munger, Warren Buffett’s partner at the famed diversified holding company of Berkshire Hathaway (Kirkland, 2006). Munger isn’t the only investor to think so. A Watson Wyatt survey (2005) found that 90% of institutional investors believe the current compensation system has overpaid execs and 85% think it has hurt America’s image. And the founder of the investment management firm Vanguard, John C. Bogle (2005), has concluded, “The bottom line is that our system of executive compensation is broken.”
Even many directors see a problem. A PricewaterhouseCoopers survey conducted in conjunction with Corporate Board Member magazine found that 70% of U.S. directors considered executive compensation levels too high (Marshall, 2006). Adding scholarly rigor to such opinions is the influential book Pay Without Performance: The Unfilled Promise of Executive Compensation. It argues that it’s a myth that executive pay arrangements are the result of a free-market, arms-length bargaining between executives and boards (Vogl, 2005).
Adding to the cynicism over executive compensation is the recent “backdating” scandal. Based on a comprehensive analysis of stock option grants between 1992 and 2002, University of Iowa Erik Lie’s work suggests that some organizations were “backdating their stock options to dates when the stock was low for the year or the quarter, tilting the odds of profiting on those options heavily in their favors,” according to Fortune (Colvin, 2006). Another factor that may play into the perceived unfairness of executive compensation is that overall, U.S. real median wages have been stagnant since the start of the decade, and real median family incomes have actually been falling in recent years (Kirkland, 2006).
The criticism of executive compensation comes at a time when, historically speaking, at least one study indicates executive pay increases are climbing at relatively modest rates (“CEO,” 2006). In 2005, the pay for CEOs rose 7.1% to an average of $2.4 million, according to Mercer HR Consulting’s CEO compensation survey. But a survey conducted by Pearl Meyer and Partners put median pay increases at 10.3%, and The Corporate Library put median increases at 11.3%. “All three studies,” reports IOMA’s Report on Salary Increases, “found no steady pattern matching pay with their companies’ performances. In some cases, the link was strong; in others, CEOs took home huge sums while their organizations faltered.” The Corporate Library study indicates that the biggest gaps between pay and performance over the previous five years occurred at 11 of the largest U.S. companies (“Executive,” 2006).
So, assuming that the link between executive pay and performance really is broken at some firms, what can or should organizations be doing? First, it should be noted that some important reforms have already occurred or are in the works. Sarbanes-Oxley, for example, requires option grants to be reported within two business days, which may well have put an end to the backdating phenomenon (Colvin, 2006). And the Securities and Exchange Commission (SEC) has already proposed new rules that could result in the biggest changes to executive compensation disclosure laws since 1992. The rules, which would take effect with 2007 proxy filings, may require companies to clearly report compensation for their top five executives and all directors (Pomeroy, 2006). Meanwhile, companies have already reduced their use of stock option grants and are using more restricted stock grants, probably in response to new accounting rules.
But some experts argue that such changes won’t adequately address the pay and performance gap. Prof. Lucian Bebchuk of Harvard University, coauthor of Pay Without Performance, argues the performance gap could be narrowed by changing aspects of corporate governance. He states that there aren’t enough good incentives for today’s directors to keep shareholders’ best interests in mind when negotiating compensation with CEOs. He suggests, “Directors should be paid much of their fees in the form of restricted stock grants. Holding a significant stock position that cannot be unloaded for a reasonable period of time helps focus directors on shareholder interests.” He also thinks that it should become easier for shareholders to replace board members.
In addition, Bebchuk is in favor of greater transparency in the compensation system and advocates specific practices for tying performance to pay more rigorously. For example, he supports “filtering out gains that are connected to marketwide or sectorwide movement of options” (Vogl, 2005).
The bottom line is that corporations are likely to come under growing pressure to justify their executive compensation rates. The link between performance and pay will be even more closely scrutinized, especially given the increased transparency that’s likely to be demanded by the SEC. It’s possible that, down the line, such pressure will affect not only compensation plans but also the roles and allegiances of corporate directors.
For a Fortune article titled “The Real CEO Pay Problem,” click here.
For an Across the Board interview with Prof. Lucian Bebchuk, click here.
For a Watson Wyatt Worldwide item on institutional investors’ dissatisfaction with executive pay systems, click here.
For more on the SEC’s proposal to change disclosure requirements, click here.
For an article on the backdating story, click here.
Documents used in the preparation of this TrendWatcher include the following:
Bogle, John C. “The Executive Compensation System Is Broken.” Journal of Corporation Law. ProQuest. Summer 2005.
“CEO Pay and Corporate Performance Closely Aligned.” Workspan. ProQuest. June 2006.
Colvin, Geoffrey. “A Study in CEO Greed.” Fortune. ProQuest. June 12, 2006.
“Executive Pay Increase Is Modest; Pay for Performance Remains Mixed.” IOMA’s Report on Salary Surveys. ABI/INFORM Trade and Industry. June 2006.
Kirkland, Rik. “The Real CEO Pay Problem.” Fortune, June 2006.
Marshall, Jeffrey. “Looking Hard at Executive Pay.” Financial Executive. ProQuest. May 2006.
Pomeroy, Ann. “Few Executive Pay Changes Expected.” HR Magazine. ProQuest. May 2006.
Vogl, A.J. “Out of Control?” Across the Board. ProQuest. March/April 2005.
Watson Wyatt Worldwide. “Institutional Investors Dissatisfied with U.S. Executive Pay System, Watson Wyatt Study Finds.” Press release. December 13, 2005.
Below are some other informative articles on the subject of executive compensation:
Hymowitz, Carol. “Sky-High Payouts to Top Executives Prove Hard to Curb.” Wall Street Journal. ProQuest. June 26, 2006.
Lashinsky, Adam. “Options Gone Wild.” Fortune. ProQuest. July 10, 2006.
“Leaders: Looking for Alternatives; Stock Options.” The Economist. ProQuest. June 3, 2006.
O’Byrne, Stephen and S. David Young. “Why Executive Pay Is Failing.” Harvard Business Review, p. 28.
“Q&A: Getting a Grip on CEO Pay Levels.” Directorship. ProQuest. June 2006.