Wednesday, November 20, 2002

Executive compensation

Although it has nothing to do with technology, I thought I'd post some numbers on executive compensation -- a hot topic these days. Executive compensation has risen between 1950 and now (although it was comparably high in the 30s when Ford was running Ford). According to Forbes, average CEO pay was $4M in 1996 and $7.5M in 2002 (it was 11% higher in 2001).

But to put this in perspective, total CEO pay in 1991 was $6B out of an organizational market capitalization of $9.1 trillian. That means that if all the CEOs decided to work for free forever, it would add just 0.006, or 60 points, to the Dow. To put it another way, if they were to work for free and all the money went to employees, the average employee salary would go up $54.

So, to say high executive pay is robbing shareholders or employees is wrong -- the transfer effects here are trivial.

Instead, let's look at how CEO pay effects their incentives. CEO's raise a classic agency problem, because a CEOs job is to manage the firm for the benefit of shareholders, not to indulge in ivory backscratchers. The thinking is that tying CEO compensation to firm performance reduces this agency problem and gets him to act in the shareholders' best interest. Moreover, since CEOs are risk averse and shareholderes are risk neutral, compensating them in options (which reward risk) aligns incentives even better. Most CEO compensation in the US (and to a lesser extent in the UK) comes from performance pay, of which options are a common component.

The best options isolate company performance from broader market performance. After all, why pay a guy if he does a lousy job but the market as a whole goes up, and why penalize him if he does everything right but the market tanks? If you look at how much CEO wealth depends on company performance vs. market performance, it turns out that things work out roughly correctly -- CEO wealth is more closely tied to how his firm does. But, compensation is more closely tied to broad measures of market performance (like the that S&P 500) than narrow measures (such as close competitors) -- which is the opposite to a good compensation scheme.

So, if you want to complain about CEO pay, it is not right to argue that shareholders or employees are getting a bad deal -- the effect on them is trivial. It is correct to complain that pliant boards don't index options to close competitors (which reveals a whole new agency problem between boards and shareholders). And it is right to say that stronger incentives also call for greater monitoring, as CEOs with lots of options have more reason to cook the books.


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