Are CEOs Overpaid?--Posner

The media are full of stories about the compensation of chief executive officers of American companies. The theme of the stories is that CEOs are paid too much. The economics of compensation are fascinating. In the simplest economic model, a worker, right up to the level of CEO, is paid his marginal product--essentially, his contribution to the firm's net income. But simple observation reveals numerous departures from the model. For example, wages vary across the employees of the same rank in the same company by much less than differences in their contribution to the company, and employees who do satisfactory work can expect real (that is, inflation-adjusted) annual increases in their wages throughout their career with the firm, even though their contribution will not be increasing at the same rate, and eventually not at all. Let us see what sense can be made of the curious pattern of CEO compensation. American CEOs make much more on average than their counterparts in other countries--about twice as much. You might think that this was because Americans at all levels earn more than their foreign counterparts, but this is not so; the difference between U.S. and foreign wages is much smaller below the CEO level. In other words, wages are more skewed in favor of CEOs in American companies. The disparity is related to the fact that salaries are a much smaller fraction of American CEOs' incomes (less than a half) than of foreign CEOs' incomes, with the rest consisting of bonuses but mainly of stock options. Both the fraction of CEO income that is nonsalary, and total CEO income, have been rising, dramatically in the United States, over recent decades. But there is a recent tendency of foreign CEO compensation policies toward convergence with the American practice. One can speculate about the causes of some of these differences. Stock options and other incentive-based compensation methods impart risk (variance) to CEOs' incomes, which reinforces the risk inherent in the fact that a CEO's human capital (earning capacity) may be specific to his firm, so that if he lost his job because his company had been doing badly (perhaps for reasons beyond his control), he would take a double hit--lower pay as the company declined and lower pay in his next job. Because business executives (as distinct from entrepreneurs) do not like risk, they demand a higher wage if the wage is going to have a substantial risky component. This may explain some of the difference between American and foreign CEO compensation, but surely not all or even much of it--especially since job turnover at the CEO level is actually greater in Europe than in the United States. Another possible difference is that stock ownership tends to be more concentrated abroad than in the United States. The more concentrated it is, the more incentive shareholders have to monitor the performance of their firm's managers because they have more at stake. The more effective that monitoring is, the less need there is to create incentive-based compensation schemes: the stick is substituted for the carrot. Cultural factors may be important. European countries in particular are more egalitarian than the United States, suggesting that envy is likely to play a bigger role in compensation there. Astronomical ratios of CEO to blue-collar wages in the same company cause little resentment in the United States compared to what they would cause in Europe, though wide disparities between workers at the same level does engender resentment here even if the disparities track differences in productivity. Envy might reduce average incomes at the same time that it reduced variance in incomes, if the more generous compensation of American CEOs merely reflects the greater contribution that they make to their companies' success. But there are two reasons to doubt this, and thus to suspect that American CEO incomes are padded to some degree. First, the most significant "incentive" component in these incomes--stock options--are not well correlated with the CEO's contribution to the value of his company and thus of the value of its stock. Many things move a company's stock besides the decisions of its CEO. To tie a CEO's income to the value of his company's stock is a bit like tying the salary of the President of the United States to the U.S. GNP. Second, the choice of stock options as the principal method of providing nonsalary compensation to CEOs seems related to the fact that traditionally the income generated by these options, unlike salary or bonus income, was not reported as a corporate expense. Of course security analysts and stockholders large enough to follow closely the affairs of the companies in which they invest can calculate the expense of stock options, but the ordinary public cannot, and this is important because even in the United States envy is a factor that can influence policy and public opinion. A spate of recent articles has explained the ingenious devices by which CEO compensation that would strike the average person as grossly excessive is concealed from the public, and these articles, along with well-publicized corporate scandals, may place some downward pressure on CEO compensation. Companies cannot afford to ignore public opinion completely, because adverse public opinion can power legislative or regulatory measures harmful to a company or an industry. It might seem that, provided the shareholders--the owners of the company--are made aware of the actual compensation received by the CEO, competition will drive that compensation down to approximately the level at which the CEO is just being paid his marginal product, with appropriate adjustment for risk. But given the size of companies, the cost to a major company of even a grossly overpaid CEO is so slight when divided among the shareholders that no shareholder (assuming dispersed ownership) will have an incentive to do anything about that excess expense. What about the board of directors? Their incentive to minimize what from the overall corporate standpoint is only a minor cost is also weak, and may be offset by rather minor economic and psychological factors. The board is likely to be dominated by highly paid business executives, including CEOs, who have a personal economic interest in high corporate salaries and a natural psychological tendency to believe that such salaries accurately reflect the intrinsic worth of their recipients. Becker in his comment on this post (below) cites an interesting paper by Gaibaix and Landier which argues that the increase in CEO compensation is a function of the growth in the market value of firms. The basic idea is that the CEO of a more valuable firm is more productive, since if he increases value by say 1 percent the increase in absolute value will be greater the more valuable the firm is. If there are two equally skilled managers and one manages a grocery store and one manages IBM, the manager of IBM is probably creating greater value. The theory is too new to evaluate with any confidence. I am somewhat skeptical because rapid increases in CEO compensation should attract more talent to management, and the resulting greater competition for CEO positions should dampen the increase in compensation. An alternative explanation for the correlation between firm value and CEO compensation, one that is consistent with the evidence that such compensation is often excessive from an efficiency standpoint, is that the greater the firm's market value, the easier it is to "hide" the compensation of the top executives. Suppose that a 10 percent increase in value is associated with a 3 percent increase in CEO compensation; then the percentage of the firm's value that is going to the CEO will have fallen. This may be one reason why many mergers fail to increase earnings per share, although the overall value of the enterprise will be greater after the merger (there will be more shares): the increase in overall value enables the CEO to increase his compensation regardless of whether he will be creating greater value as the manager of the larger enterprise.

Comments

[Don Lloyd]

When a board of directors is hiring a new CEO, it is unlikely to have a large number of available, plausible, superior candidates, no matter how much it spends on executive search firms.

If the final choice has been narrowed down to three, the board is still going to be buying a pig in a poke as the future, long term performance of the company under a given CEO is largely unpredictable.

However, it is highly predictable that the likely variation in future shareholder returns that result from a given choice in CEO will be enormous, even if none of the choices is company-killing. Given this fact, it would likely be irrational to settle for a second-ranked candidate if the only reason to do so involves a compensation package difference.

The board of directors has little solid information that will allow it to accurately rank, let alone measure, the CEO candidates in the order of future shareholder returns. But because the choice is so critical to future shareholder returns, it must fully utilize all of the information that it has.

In retrospect, shareholders will judge the decision by the dollars in their portfolio, which will be little affected by the compensation package unless it wasn't enough to tempt the best candidate.

The market supply of available CEO candidates who can be relied upon to produce superior future results is likely a null set.

Regards, Don

[michael]

I would add to this discussion the built-in tendency to increase board of director compensation in general (not just CEO). This is due to the "you scratch my back I scratch yours" problem. They set each other's salaries so there is a built-in factor artificially pushing them to increase each other's wages more than their market value.

In response to Don, even if you don't know how well they are going to perform when you hire them, it doesn't mean you should set their compensation in stone, you could tag it to performance just like all the other employees - they get a base compensation and then they get benefits based on how well they do.

[Don Lloyd]

Michael,

...In response to Don, even if you don't know how well they are going to perform when you hire them, it doesn't mean you should set their compensation in stone, you could tag it to performance just like all the other employees - they get a base compensation and then they get benefits based on how well they do.

Isn't what you've just described the purpose of stock and option grants? It's the stock value that matters to shareholders, not the more narrowly focused business performance.

Regards, Don

[Wes]

On the subject of the difficulty of quantifying CEO performance, there seems to be a trend that the easier it is to quantify an employee's output, the more a company will choose to hire more employees but pay them less.When a company needs more productivity on its assembly line, it will choose to hire more workers at the current salary rather than replacing existing workers with workers attracted at a higher salary.Even when it comes to engineers and scientists, a company that needs more engineering or science will usually just hire more engineers and scientists at the current salary. A rare exception is when a company hires a super-star scientist because it wants a major scientific discovery (and progress toward major scientific discoveries is hard to quantify).Interestingly, when a company needs more CEO "productivity" (ie. better leadership), it doesn't just hire more CEO's but instead it raises the compensation of the existing CEO. This is like people in medieval times who thought that if their king had a more luxurious palace then that would somehow make the king a better ruler.

[BJ]

The problem is that even bad CEOs are paid much more than their European counterparts, and seem to rake in big bucks regardless of their performance. Take Time-Warner for example. The stock and company performance have been terrible. The purchase of AOL destroyed billions of dollars in shareholder value, yet the CEO continues to receive raises year after year. And what's the benefit to shareholders of giving retiring CEOs a huge pension on top of a ludicrous farewell bonus? How has Jack Welch helped GE in his retirement?

I think the answer is that shareholders have little or no control of how much is given out in compensation. Shareholders could replace the entire board, but the ensuing chaos could negatively impact the company and hurt performance. Shareholders are held hostage and blackmailed into giving CEOs whatever they want, or the CEO will run the company into the ground before he can be replaced. That's the real answer.

[Haris]

I think it's fairly clear that CEOs are overpaid compared to the value they add. Any impact an Exxon CEO might have, for example, is negligible compared to circumstances beyond his control, like the price of oil in this case. Even if a CEO does add significant value, it is not much more than a significantly cheaper replacement would add. [I'd love to see a company outsource its CEO job to India at ten cents to the dollar.]

I think the major reasons for outrageous CEO pay have been outlined well on this board: one is the composition of corporate boards, and the other is the difficulty of shareholder oversight. Small, organized groups are much much more effective at getting their way than large dispersed ones. Board members, many of whom are former, current, or potentially future executive officers, have a real interest in maintaining artificially high CEO pay. Since there are relatively few board members compared to workers and shareholders in corporate America, it is much easier for them to organize and maintain artificially high CEO salaries. I don't mean to insinuate that there is any formal organization or conspiracy, just that it is easy for these people to coordinate with little or no organization or guidance. On the opposite end of the spectrum, shareholders are widely dispersed with little individual incentive to fight high CEO salaries. This type of collective action problem is difficult to overcome especially when a company is doing well. The current public outrage against these salaries hasn't done much to curtail them, and it is difficult to foresee what kind of public pressure it would take to do so.

[Robert]

Two Comments: first, successful CEOs of major corporations are no different than professional athletes whose near-unique talents allow them to demand a premium for their services (think of someone like Jack Welch as the pluperfect example).
Second, in the end, the compensation of CEOs is--or, more accurately, should only be--the business of the shareholders and the Board of Directors of that corporation. The idea that the rest of society should weigh in on this issue is, absent fraud or illegality on the part of CEOs, entirely misplaced. CEOs are not public officials being paid with public monies, nor are they accountable to the public beyond their responsibility to act legally.
The fact that CEO compensation has become a public matter is suggestive of something else: a culture-wide envy of success and achievement and, more to the point, of those who make such things possible.

[James]

The normal justification for people reaping large amounts out of their companies is that the person who sets up the business takes all the risks and has had all the imagination, and will be taking the largest fall if it fails, so by rights should be entitled to the rewards if it is a success. But that idea isn't strictly applicable to CEOs, who are employees and usually of companies where many have been responsible for their inception (represented by the shareholders). It is especially inapplicable with privatised businesses.

What I find really objectionable is that one of the chief devices for concealing the true remuneration of CEOs is the issuing of 'bonuses', yet time and again in the UK (I am sure the USA is no difference, though am of course open to correction) these 'bonuses' are paid to CEOs whose companies are failing dismally.

If it was the case that a bonus was truly a bonus, and other forms of pay were performance related, then there would be a lot fewer objections to large paypackets to executives.

[Haris]

in the end, the compensation of CEOs is--or, more accurately, should only be--the business of the shareholders and the Board of Directors of that corporation. The idea that the rest of society should weigh in on this issue is, absent fraud or illegality on the part of CEOs, entirely misplaced.

I agree that these matters should be internal, but the members of the public that are weighing in on this issue are usually shareholders themselves. The reason that the public should get involved is because of the collective action problems that stockholders face. It is inordinately difficult for them to exercise the kind of control that, in theory, they should. Public/government involvement should restrict itself to lowering the obstacles to effective shareholder control. If any steps taken are limited to that, there is no reason not to have a public debate about the actions of companies.

[PLM]

A question which has always puzzled me is how much of the "excess" CEO compensation is due to a more or less accurate appraisal of value added by the CEO and how much is simply a market failure--those in charge (the CEO and board of directors) simply dipping into the corporations wealth for their own benefit (directly for the CEO, indirectly for the other board members because many are CEO's elsewhere and thus benefit from high CEO salaries) free from any effective intervention by the shareholders (usually unorganized) or other sources. My suspicion is that it is that more often it is the latter.

On occasion the analogy is made to sports figures who receive huge salaries (or, more recently, Howard Stern) but in those cases the person who pays the outsized salary isn't self-dealing but rather is making an independent calculation on how much the "star" is worth, and is also bidding against others who perceive a similar value. If the person paying (e.g., the sports club owner) makes a mistake it comes out of his or her own pocket, not out of the pocket of others who had no effective say in the matter.

If I'm correct that some (much?) of the extremely high CEO compensation is the result of market failure rather than compensation truly based on value added, what is the cure? A blanket limit for all corporations on CEO compensation (e.g., x times the median corporation employee salary) penalizes the CEO's who truly do add immense amount of value (some might classify Jack Welch at GE in this category, though I don't have enough information to determine whether this is justified). But, I don't know of any solution for the problem of separating out "worthy" CEOs from CEOs who skim some of the value of the company simply because there is no one to stop them. Of course, in the long run, if too much money is skimmed off by an over-compensated CEO, the corporation will lose value and investors will shun it, but this is hardly an immediate solution because the unjustified compensation is being paid out in the short run.

[michael]

"first, successful CEOs of major corporations are no different than professional athletes whose near-unique talents allow them to demand a premium for their services (think of someone like Jack Welch as the pluperfect example)." - Robert

In Response to Robert's sports analogy, there are tons of sports athlets who get overpaid relative to their value. Teams miscalculate athlete's values all the time. Even the best athletes get miscalculated and overpaid - look at Alex Rodriguez for example, he is the best or second best hitter in baseball. The Rangers had to pay a premium to get him, but they paid too much and it cost their team 4 straight seasons of finishing last place in their division. Even great CEO's can get overpaid relative to their value.

Additionally, there's tons of professional athletes who are bad who get paid way too much relative to their value - look at those pitchers the yankees signed last year Jaret Wright and Carl Pavano. Similarly, there are plenty of CEO's out there who get paid way more than they are worth... look at Carly Fiorina she was horrible for Hewlett Packard yet she made tens of millions a year and got a $20 million golden parachute when she was fired after leaving the company in ruins. Even the best professional athletes' buyouts are only in the few hundred thousand dollar range. Those multi million dollar parachutes are ridiculous and yet they have been all the rage for CEO's.

[Bernard Yomtov]

successful CEOs of major corporations are no different than professional athletes

They are different for a couple of reasons.

First, athletes' skills are subject to all kinds of measurement. There's a reasonably objective basis for deciding that pitcher A is better than pitcher B. The records of business managers are much less amenable to objective evaluation.

Second, those who hire athletes are spending their own money, and have no incentive to overpay in order to maintain their own position. There is not the cronyism and mutual backscratching that goes on in the boardroom.

[Collestro]

Mitchel,

Aren't you inputting a moral value onto a market price? The MLB seems the freest and the least coercive of the American sports labor markets. Baseball players offer their services and the market sets the price. Is there were an auction of goods, would not the auction price be the market price for that instant the gavel hit the block? How could auctioned goods over be, "overpaid relative to their value?"

[Wes]

A couple more differences between professional athletes and CEO's:Professional sports are specifically designed to showcase individual abilities. For example, a baseball team is not allowed to accomplish their "pitching" by sending a team of technicians onto the field with a rail gun. On the other hand, a corporation can (and should) evaluate its business decisions by hiring teams of specialists backed up by powerful computers, sophisticated algorithms and extensive databases. In fact, it would be massively negligent for a corporation to make major business decisions based solely on the individual abilities of its CEO.Furthermore, professional sports is about entertainment and entertainment relies on people feeling connected to the entertainers. Even if someone else might be a better player technically, an established sports figure will be generate more public interest and therefore more revenue for the sports enterprise. On the other hand, a successful business is supposed to be based on good business decisions rather than the popular appeal of its CEO.

[Will]

Posner notes
The theory is too new to evaluate with any confidence. I am somewhat skeptical because rapid increases in CEO compensation should attract more talent to management, and the resulting greater competition for CEO positions should dampen the increase in compensation.

A major problem with this point is that the effect of attracting new CEO with high pay (rather than luring existing CEOs from other firms) is highly lagged. People on the executive track (for the most part) already want to eventually be CEOs. The sorts of people not on the executive track with the level of abilities to be great CEOs such as Brain Surgeons, Rocket Scientists, or Law/Economics Professors have typically spent so much time on their present track that they would have great difficulty switching to the executive track and would be behind on learned skills and experience. So the major effect of higher CEO wages in terms of attracting more competition for CEO jobs is likely that someone graduating college opts for a corporate job instead of grad school. It will be at least 15 years before such a person could compete for a CEO job and drive down wages.

[N.E.Hatfield]

Most CEO compensation packages are a negotiated settlement between the Executive and the Board of Directors. In some cases, guess who is the better negotiator? Most boards function as rubber stamps for executive management, and there in lies the problem. CEO compensation is just a symptom of a malaise in Corporate America. Ask yourself why was your pension plan underfunded all these years and where did all that money go? Not too mention the plan itself. It cetainly didn't go into R/D in most cases or recapitalization of the business. BTW, where was Congress with all this going on? A lot of them sit on Boards.

[David]

Here's a radical idea, just to throw out for discussion. What if corporate executives were prohibited from owning stock (shares or options) in the companies they served? Would that make them more responsive to the shareholders and more concerned about doing a good job rather than lining their own pockets? Maybe it would be good for the country -- and for companies -- if CEOs (and other executives) saw themselves as employees rather than "rock stars." The cult of personality that has grown around CEOs -- and their celebrity status -- seems counterproductive to business as a whole.

[Haris]

David

Wouldn't that make it worse? Stock options are the only way that a CEOs compensation is tied to his performance. If we remove that, what incentives does a CEO have to increase the share price? CEOs would just demand more guaranteed money if we did away with them. If anything, a greater percentage of CEO compensation should be in stock form, but if those stocks aren't options that vest years later, that would create a different problem. CEOs would maximize value in the short run, cash out, and possibly ruin the company for the long term. The way to ensure that CEO acts with long-term company health in mind is compensation conditional on performance with stock options that don't vest till well after the CEO is gone.

[st]

Just like apple: Pay $1 for the excellent CEO. If the company perform well, like apple, give him an airplane... fair enough.

The low pay CEO usually perform well... just look at the Japan as example. As for most of not so "bright" CEOs (like those got pay too much... or play trick to get too much... like K. Lay), pay them $100 per year... Guess what, I am sure you will get the one that really can perform left in the position.. (the one that can earn an airplane for example)...

-st

[Henry Manne]

I am somewhat dismayed that this lengthy discussion of CEO compensation fails to notice the most obvious point of all: restrictions on the functioing of the market for corporate control, raise the rents available for someone in the corporation to claim, and there is no good candidate other than the top managers (though there is some indication they share with labor, perhaps as a payback for getting restrictive takeover legislation adopted). Clearly if the market for corporate control functioned with zero transactions costs, then there could, almost by definition, be no overpayment of executives, since an overpayment of even one dollar in a corporation whose control number of shares was on the market would force a change in managerial control and a lessening of the payment. As these costs, probably substantial in any event, are raised by such legislation as the Federal Williams Act and the various state laws countenancing poison pills and otherwise making takeovers more costly,the amount of takeover transactions costs resulting from these laws, minus one dollar, is available to be captured by incumbent managers.

The modern increases in executive remuneration closely track increased difficulty in mounting hostile takeovers. Foreign countries have far fewer corporations with control available through takeovers in the stock market, that is fewer companies with the venerable separation of ownership and control. Thus in these companies contolling shareholders will directly intervene to prevent compensation from getting out of line, and this will probably have some effect on the compensation culture of the country.

I suspect that the force of these remarks is noted in the pricing of IPOs, with the shares of companies having effective poison pills and other "shark repellants" going for lower prices that those of companies which subject themselves to the discipline of the market. But though most state laws are merely enabling, and controlling shareholders who voluntarily adopt pills get what they deserve, the Williams Act is mandatory and has been enormously costly to all American shareholders.

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