Chief executive pay in the Unites States: Avarice or incentive?

06/17/05

Do the high levels of pay of US chief executive officers (CEOs) reflect the 'greed is good' attitude of avarice? Not according to Professor Martin Conyon, writing in ESRC's new report Seven Deadly Sins.

Professor Conyon argues that there other equally plausible explanations that explain pay outcomes, such as the need to recruit, retain and motivate talented CEOs to manage increasingly complex organisations in the competitive global economy.

The evidence suggests that CEO compensation provides the right incentives for managers to focus on maximising corporate wealth. For example, firms with more growth opportunities provide their CEOs with greater incentives than firms in mature industries. But for all firms, these incentives arise not only from current pay but also from aggregate shares and share options owned.

Executive compensation typically has four components: base salary (usually competitively 'benchmarked' against peer firms); annual bonus (typically based on accounting performance); share options (which give the right to purchase shares at a pre-specified 'exercise' price); and other pay such as 'restricted stock grants'.

US CEOs are often handsomely rewarded. In 2000, Jack Welch of General Electric received total compensation of about $125 million, including a $4 million salary, a $12.7 million bonus, $57 million in options and $48.7 million in restricted stock grants. This package was linked to firm performance and was therefore well structured. Welch managed a large and complex organisation and under his leadership, General Electric's share price soared. But in the wake of US corporate scandals like Enron and Tyco, even CEOs with stellar performance records have faced criticism: Welch was censured in the press for alleged non-disclosure of lavish retirement benefits.

There is considerable variation in the way that CEOs are paid. For example, in 2003, Steve Jobs of Apple Computer received a salary of just $1 and no annual bonus or options, instead receiving restricted stock grants worth approximately $75 million. This unusual arrangement illustrates how some pay packages are riskier than others and provide powerful incentives to focus on increasing shareholder wealth. If a CEO is paid in options, then as the share price increases, the value of their holdings also increases; if the share price declines, so too does the CEO's wealth. Salaries, in contrast, are typically not related to performance.

In the top US firms (those in the S&P 500) in 2003, average annual remuneration was $9 million and the median $6.7 million. But the majority of CEOs earn relatively low compensation while a small number of CEOs receive excessively generous rewards.

So the idea that all CEOs are paid stratospheric sums is incorrect. One reason that some earn more than others is that CEO pay is positively correlated with firm size. Large, complex firms are more complicated to manage and require managers with relevant expertise. It is not surprising that such firms pay their CEOs more.

The level of CEO compensation has changed over the past decade. The 1990s were good times: average CEO pay increased, reaching a peak in 2001 at about $7.6 million and falling back slightly since then. The make-up of CEO pay has changed radically too. Most importantly, the use of options exploded while salaries became a much less significant part of the overall pay package.

In 1992, salaries accounted for approximately 37% of total pay and options a relatively modest 22%. As the decade wore on, options became the single most important pay element while salaries declined in importance. Now, salaries account for about one fifth of total pay and while the percentage of pay received as options has fallen to just over one third, it still remains the largest element.

So is CEO pay effectively linked to performance? A considerable body of research demonstrates that US CEOs have significant financial incentives, making an important distinction between pay received in a given year and the aggregate amount of shares and options that CEOs maintain in their companies.

For example, a CEO may receive 100,000 options this year, adding to 400,000 options granted in previous years. Since the CEO cares about the whole stock of 500,000 options, not simply this year's 100,000, compensation received in any given year provides only a partial picture. A CEO who owns a significant amount of shares has powerful incentives to act in the interests of shareholders.

In 2003, the median value of total annual pay for CEOs in S&P 500 firms was about $6.7 million. But the median total value of exercisable and un-exercisable shares was $30.1 million, nearly five times greater. Moreover, a 1% increase in the share price would increase the value of these holdings by $430,000. This means that if the share price were to fall by 20%, then CEO wealth would decline by $8.6 million, which is more than total compensation.

Precipitous falls in share prices clearly have adverse consequences for CEO wealth, and so provide important incentives. The corollary is that CEOs who increase the share price become wealthy, which is precisely the point of incentives to align managerial and shareholder interests. The important point is that incentives arise not only from current pay but also from the aggregate amount of shares and options owned.

Source: Eurekalert & others

Last reviewed: By John M. Grohol, Psy.D. on 21 Feb 2009
    Published on PsychCentral.com. All rights reserved.

 

 

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