For the past several decades, the topic of executive pay has increased in relevance and controversy nearly as much as the executive salaries themselves. Since 1978, CEO and executive pay for publicly held corporations has increased 940%.[1] As of 2015, the average pay for the CEO of an S&P 500 company was 335 times that of its average worker[2]. Naturally, this has generated a spotlight on the issue, with one of the main questions being whether this is even an issue at all. Should CEOs be compensated at a rate so far beyond their employees? How did executive pay reach such heights in the first place? And perhaps most importantly, what is the best way to ensure a fair and transparent pay regime?
Is the Pay Ratio the Right Metric?
The “pay ratio” has become the go-to metric for describing how CEO pay has exploded. The pay ratio essentially pins the top executive salary to that of the average employee of the company. Richard Trumka, the president of the AFL-CIO, has called the pay gap between CEOs and average workers a “disgrace”,[3] but the sticker shock that comes with pay ratios only tells part of the story. For one thing, the CEO market is vastly different from that of the typical labor market, in that there is very little reason for them to be linked together other than some sort of natural business intuition regarding the vertical makeup of any given company.[4] Put another way, the average value of a Fortune 500 company is roughly $20 billion.[5] The $10 million salary of the CEO is an incredibly small share of that. It is also worth considering that executive actions play out on a vast scale due to the nature of broad managerial authority. A CEO’s decision to implement a policy or make a decision that affects 1% of the business can cause a $200 million change in the company’s balance sheet.[6] This reframes the conversation in a way that puts the authority and relative impact of an executive in a less shocking perspective.
While there are concerns that CEO pay does not properly address accountability or performance,[7] it is also worth considering that a large amount of any given compensation package is made up of equity holdings (often subject to vesting schedules) specifically tied to the performance of the company’s stock price.[8] Furthermore, the average tenure of a Fortune 500 CEO is only 5 years,[9] meaning that the market for executive decisionmakers is inherently very risky, and high asking prices in part account for this risk.
The drawbacks to such high salaries, however, are still fairly obvious. Beyond the shock value of such large pay gaps, there are significant questions about whether or not the high salaries are an accurate reflection of the value of the expertise required to do the job–as well as if such high salaries are in the best interests of the company as compared to the best interest of the executives. As mentioned, much of executive pay is comprised of equity, meaning that they are taxed under capital gains rather than income, providing both the company and the executive with a windfall.[10]
Transparency and Disclosure
In 2015, the SEC adopted stricter rules mandating CEO pay disclosure among publicly held companies.[11] Ostensibly, the aim of this provision, which came out of the Dodd-Frank Act, is to 1) promote transparency and 2) promote accountability in a way that would essentially provide a check on the ever-growing executive pay ratio.[12] It’s safe to assume that the “shame” factor would potentially play a role in lowering salaries, in that the disclosure of such high payments would potentially force corporations to start paying their executives less.[13] While well-intentioned, results have been mixed. Indeed, executive pay has become more transparent given the mandatory disclosure requirements, but the pay ratio has not reversed course.[14]
A study by a trio of University of Cambridge Professors helps to explain why:[15] The disclosure requirements have created a cottage industry of executive compensation consultants cropping up.[16] Taking advantage of the detailed information about compensation structures, the study shows “a 7.5 percent increase in CEO pay compared to other firms, and such companies where CEOs get a pay boost are less likely to turn over consultants the following year.”[17] Evidently, disclosure has not changed the trajectory or intent behind CEO compensation. Instead, it merely created a sub-industry that utilizes the newly available information so as to better justify the large salaries.[18] It is also worth noting that disclosure is costly. The new SEC rules are expected to total $520 million in annual compliance costs.[19] This leads to the obvious question of whether or not disclosure is an effective means for policing executive pay standards.
So, what’s the solution? There are compelling concerns on both sides of the issue and the conversation is not likely to abate anytime soon. In fact, it is common for the scrutiny on executive pay to be thrust into the national conversation during periods of economic contraction––one can look at the PR fiasco regarding the litany of executives given massive bonuses during the Great Recession as an example.[20] With many economists predicting recession in the next 18 months, it is likely that this conversation will become even more elevated within the national discussion.[21]
Endnotes:
[1] Lawrence Michel & Julian Wolfe, CEO Compensation has Grown 940% since 1980, Economic Policy Inst. (Aug. 14, 2019), https://www.epi.org/publication/ceo-compensation-2018/.
[2] Denver Nicks, CEOs Make 335 Times What Workers Earn, Money.com (May 17, 2016), http://money.com/money/4339078/ceo-pay-compare-workers/.
[3] Mary Thompson, It’s a ‘Disgrace’: Here’s How Much More CEOs Make Than Workers, CNBC News (May 17, 2016), https://www.cnbc.com/2016/05/17/its-a-disgrace-this-is-how-much-more-ceos-make-than-workers.html.
[4] Alex Edmans, Why We Need to Stop Obsessing Over CEO Pay Ratios, Harv. Bus. Rev. (Feb. 23, 2017), https://hbr.org/2017/02/why-we-need-to-stop-obsessing-over-ceo-pay-ratios.
[5] See id.
[6] Id.
[7] Ric Marshall & Linda Eling-Lee, Are CEOs Paid for Performance?, MSCI, 16, (July 2016), https://www.msci.com/documents/10199/91a7f92b-d4ba-4d29-ae5f-8022f9bb944d.
[8] Id.
[9] Dan Marcec, CEO Tenure Rates, Harv. L. Sch. F. on Corp. Governance and Tenure Rates (Feb. 12 2018), https://corpgov.law.harvard
.edu/2018/02/12/ceo-tenure-rates/.
[10] Paula Loop & Arthur Kohn, Tax Implication on Executive Pay: What Boards Need to Know Harv. L. Sch. F. on Corp. Governance and Financial Reg.(Feb. 8 2017), https://corpgov.law.harvard.edu/2017/02/08/tax-implications-of-executive-pay-what-boards-need-to-know/
[11] Press Release, Sec. & Exch. Comm’n, SEC Adopts Rule for Pay Ratio Disclosure (Aug. 5, 2015), https://www.sec.gov/news/pressrelease/2015-160.html.
[12] Biagio Marino, Show Me the Money: The CEO Pay Ratio Disclosure Rule and the Quest for Effective Executive Compensation Reform, 18 Fordham L. Rev. 1355, 1364 (2016).
[13] See id.
[14] Andrew Ross Sorkin, More Transparency, More Pay for C.E.O.s, N.Y. Times (Nov. 10, 2014), https://dealbook.nytimes.com/2014/11/10/more-transparency-more-pay-for-c-e-o-s/.
[15] Jenny Chu, Jonathan Faasse, and P. Raghavendra Rau, Do Compensation Consultants Enable Higher CEO Pay? A Disclosure Rule Change as a Separating Device, Management Science, Forthcoming, 26 (April 29, 2017), https://ssrn.com/abstract=2500054.
[16] See Sorkin, supra note 13.
[17] See id.
[18] See id.
[19] Sec. & Exch. Comm’n, 17 CFR Parts 229 and 249, Nos. 33-9877, 34-75610, 245 (Aug. 5, 2015), https://www.sec.gov/rules/final/2015/33-9877.pdf.
[20] Frank Bass & Rita Beamish, $1.6B of Bailouts Went To Execs, CBS News (Dec. 21, 2008), https://www.cbsnews.com/news/16b-of-bank-bailout-went-to-execs/.
[21] Reade Pickert, Yue Qiu, & Alexander McIntyre, U.S. Recession Chances Hit 27% Within Next 12 Months: Tracker, Bloomberg News (Oct. 14, 2019), https://www.bloomberg.com/graphics/us-economic-recession-tracker/.
