Once concept I have been thinking about for a while is executive compensation. The media and average person will say these people are paid outrageous sums of money even when their companies go down the drain. The only exception I actually agree with these people on was the financial bailout where CEOs were paid a lot even though their companies were bailed out by the government.
Beginning in the 1970’s companies began as part of executive pay to give certain employees stock options in order to align the same values between employees and managers. In 1992, the Securities and Exchange Commission (SEC) wanted publicly traded companies to offer more disclosure in terms of how executives were paid in order to allow shareholders more transparency. Companies before June 2005 did not have to expense stock options on their income statement. After June 2005 companies had to expense stock options or show them as a cost. Today options make up a large part of executive compensation. What is ironic however is that when CEOs were paid millions of dollars without stock options people complained because it was too much. When these people complained and said that CEOs should be paid based on how well the company does the CEOs started to make even more money and people complained even more. People seem to get upset with the amount of money other people make no matter how they are compensated.
Steven Kaplan at the University of Chicago has studied executive compensation and has some interesting data on executive compensation. Kaplan makes the important observation that when looking at CEO pay there are important things to look at. First, since such a large part of how much CEOs are paid is in stock options. Stock options are awarded to CEOs but they are not really worth anything until they are exercised. I really don’t believe people understand how executives are granted these options. Basically, executives who often have worked at the company are awarded them because they have performed well, created value, and often have been with the company more than a decade. All these are requirements just to get the stock options. On top of all this there is a time CEOs have to wait from the time the options are awarded to exercise them. Once employees are granted stock options they can’t sell them. A vesting period or waiting period is requires and this could be as little as 2 years or 10 years. Usually companies that are established have longer vesting periods since they want to reward long term behavior. So to complain and say that executives and CEOs are in it for the short term is nonsensical considering they have to wait long periods of time to cash out their stock options.
Kaplan’s research also shows that companies in the top ten percent of actual pay (not what the options were worth when granted but only after exercised) had stock returns that were 90% greater than companies within the same industry over the previous 5 years. However, companies in the bottom ten percentile in their industry saw their stock underperform 40% over the previous 5 years. So in essence what this means is that CEOs that don’t perform well will lose money since most of their compensation comes in the form of stock options. Turnover in these companies has also been increasing. In the 1970s, around 10% of Fortune 500 CEOs lost their jobs. In modern times, around 60% of Fortune 500 CEOs lose their jobs. One large reason CEOs are fired are because of poor performance. Another explanation for why CEOs are making lots of money is that the only way a company can make more profit is by expanding or adding more employees. CEOs will only add employees if they think value can be created. So as a firm grows in the number of employees CEOs are in charge of managing more resources. Research from Gabaix and Landier in 2008 showed that since the 1980s firms have increased in size by a factor of four to seven times which is the same increase in CEO pay. According to Kaplan’s data CEO pay from 2000-2007 was decreasing (I haven’t seen his data after 2007). CEOs these days are put under more scrutiny than ever before. After the 1992 rule by the SEC there was more shareholder activism and regulation regarding publicly traded companies. Sarbanes Oxley has also made CEOs basically sign their life away if there are any mistakes. It is interesting to see how many CEOs going into private equity and hedge funds as opposed the other way around.
CEOs are actually underpaid compared to people in private equity and hedge fund managers. In 2010, John Paulson earned $2.4 billion. In the same year Larry Ellison was paid $84.5 million. Or to put this in a perspective a union leader would understand a hedge fund manager is making 28 times the amount of a CEO! In fact the top twenty five hedge fund managers are paid more than the combined amount all of the CEOs in the S&P 500. Hedge fund and private equity firms don’t have to worry about the same kinds of regulation as public companies (maybe this is one of the reasons they make more).
So the case by be that CEOs are underpaid. CEOs work extraordinary hours, have to deal with burdensome regulations, have to take the blame if the company goes down the tubes. Shareholders can always vote CEOs out of their position. To think that CEOs just sit around and count their money and pick out wallpaper like I believe some people do is foolish. Firms have been expanding which explains some of why CEOs are now making more. Also the technological revolution of the 1980s and 1990s allowed CEOs to create more value. If people really believe CEOs are overpaid they should try to become a CEO so they can make oodles of money and drive down the price an average CEO can make.
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