Changing the Economics of Executive Compensation

Reforms are being enacted to fix the market imperfections that result in excessive executive pay, but it's likely that today's median compensation is about right

By George Paulin

It's no secret that CEOs and other high-level managers of publicly traded U.S. companies are well paid. The Wall Street Journal publishes a study every year of CEO compensation at large public companies with annual revenues above $5 billion, and its 2009 study showed median total pay (salary, cash bonus, stock options, and other types of long-term incentives) of $7.2 million. How much and how public company executives are paid is an economic transaction; investors or shareholders who own the companies buy the services of the executives in the market.

In economics, the term "equilibrium" refers to a market where supply, demand, and price are all perfectly aligned. Many believe that U.S. executive compensation is badly out of equilibrium. They think that the price senior executives are charging for their services is too high in relation to their performance compared to people doing similar jobs in other parts of the world, as well as to rank-and-file employees. Those sharing this view are the Obama Administration, most of Congress, organized labor, a number of pension funds and other institutional investors, and probably a majority of the American public.

When prices are not in equilibrium, the reason is that markets are inefficient; or, in proper economic jargon, there are market "imperfections." We should think of executive compensation in terms of these basic economic principles and ask: If the market price for U.S. executives is misaligned or out of equilibrium, can we identify and address the relevant market imperfections to restore equilibrium?

There appear to be four major market imperfections based on repeated criticisms of U.S. executive compensation and the direction of future reforms. They are:

1. The ownership structure of public companies.

Public companies are generally owned by many passive investors with diverse interests and little commonality. They elect directors who in turn hire company management, and those managers have their own self-interests that are sometimes different from the owners'. Does management self-interest enabled by passive owners impact the market? Absolutely, but the impact is less on pay levels and more on how pay is delivered.

In terms of pay levels, self-interest explains the outliers, and there will always be a few in any market. They will continue to be in the headlines and make everyone look bad. But they do not represent the majority of companies.

With regard to pay delivery, the impact of passive owners and management self-interest is more subtle. Over time, the result has been an imbalance in risk and rewards. Look at what happened at the big banks. Large severance was paid to people who were terminated because they did not perform; too much was spent on nonperformance-related pay such as perquisites, and goals were set low enough that performance-based incentive plans are likely to deliver high pay in good years and bad.

2. The corporate governance process.

Elected directors who serve on public-company boards are primarily acting or retired CEOs of other companies along with some investors, lawyers, academics, and former politicians. The boards meet four or five times a year with the bulk of they work done by committees. Board compensation committee members must be "independent" as defined by regulations from the SEC, IRS, and stock exchanges.

Critics of executive compensation look at this system and conclude that the problem is "cronyism." "You be on my board and take care of me, and I will be on your board and return the favor." They are wrong. Most compensation committees function independently of management influence, and the situation has vastly improved since adoption of Sarbanes-Oxley in 2002.

The problem is actually one of time and resources. Compensation committees, with their four or five meetings a year, don't have the full-time professional staffs and paid advisors, as does company management. In response, more comp committees are retaining their own consultants.

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