The Controversy Associated with Executive Compensation



Fogelman College of Business and EconomicsThe Controversy Associated with Executive CompensationDr. Keef; MGMT 4240 -001By Gary Jenkins4/30/2012AbstractExecutive compensation has been a hot button issue for the last decade. Although this is a very complex issue with many legal political, economic, and moral aspects, the underlying issue is rather simple: executives get paid much more than other workers. To some people, this pay gap is a normal and just occurrence. To others it is a problem that needs to be reconciled. Both sides have reasons for their position on the issue. For or against high executive pay, the government is doing something about it. However, this government action may be too much for some, and not enough for others. Regardless, the issue will likely remain outstanding unless both sides can compromise.IntroductionThe fact that corporate executives get paid substantially more than other professionals has been a concern for decades, but it became a big issue when the economy declined after 2001. Lucrative salaries, bonuses, and stock options at a time when huge billion dollar corporations are getting government bailouts, laying off employees, and performing poorly are not setting well with many lower managers, stockholders, and other stakeholders. Laws have been passed to make shareholders have some control over executive pay. The questions are should executive compensation be further limited, and if so, what kind of limits should executive compensation be confined by? The answer differs depending on who you ask. Advocates of high executive compensation argue that it is an essential part of maximizing companies’ performance and competitive advantage. People who are against overly lucrative pay for executives argue that, not only is the pay gap unfair to other contributors, but its basis for correlating high firm performance with high executive pay is flawed. This paper briefly explains what executive compensation exactly is made up of, examines the opposing sides of the issue, and brings attention to some of the most solid proof of the claims that high executive compensation is necessary or not necessary. Briefing on Executive Compensation When discussing U.S. executive pay, one must keep in mind that most reports in the news media about executive pay single out the top-500 companies that get paid considerably more than the executives of tens of thousands of smaller companies. According to Scott DeCarlo (2011) of , the top 500 hundred executives earned about 4.5 billion dollars in 2010. This averages out to about 9 million dollars each if distributed evenly, but the top paid executive (UnitedHealth Group’s chief Stephen J. Hemsley) earned $102 million in total pay according to . Figure 1 shows the 10 highest paid executives as of 2011. On the other hand, the average executive pay is much less than the top-500 at $338,300 according to (2011). Executive compensation includes more than just a base salary. In some cases, it also includes bonuses, retirement benefits, long-term incentive plans, gains from stock grants and options, and golden parachutes. According to Lee and English (2011), “most important is the value of stock options, which give executives the right to buy shares in a corporation at a given moment at the price the share sold for on that day”(p. 1). This way, executives can then sell the vested stock in the future when the value of the stock increases. “ Since the value of corporate shares, and the hope that the price will rise over time, is the reason investors buy stock in the first place, stock options are widely viewed as a means of assuring that an executive's personal incentives are in line with the goals of investors” (Lee & English, 2011, p.). This logic is the reason why executives have the opportunity to substantially increase their wealth. For example, 98 million dollars out of 101.97 million of Stephen Hemsely’s earnings came from vested stock options according to DeCarlo (2011). The fact that stock options are the most lucrative part of an executive’s compensation is evident in Figure 2. Reasons for the ControversyExecutive pay has been an issue ever since the union of the United States. George Washington, when he became the first President, earned pay of 25,000 dollars a year, which was 1,000 times more than the average worker (Ellig, 2006). More resent controversy over corporate executive compensation began to gain attention in the early 1980’s when the gap between the lowest worker salaries and executive earnings increased significantly. According to Ellig (2006), “Executive pay began to increase, parallel with the growth of the bull market that began in 1982 (p. 59). From 1982 to 1983 the Dow Jones Industrial Average jumped from 777 to 1,258 (Ellig, 2006). As the value of stocks and bonds increased, new tax policies were adopted, and the rate of globalization sped up, companies’ boards were more able to, and felt the need to give better stock options and pay to executives who could increase the organization’s performance. Executive compensation issues became a bigger issue when the economy took a dive after 2001. After companies like Enron, WorldCom, Adelphia, and Tyco collapsed, it was clear that executives manipulated the accounts to increase the share prices that made up most of their disposable wealth. These executives where getting paid on the notion that the companies where performing well. The public, seeing that executives were still being heavily rewarded while companies were not doing so well, caused an up roar. In the late 80’s, executives were making 107 times the pay of the average American worker (Lee and English, 2011). By 2006, the year before the recession began, executives where making 365 times the pay of the average American worker (Lee and English, 2011). The steep rise in executive compensation seems to correlate with the increased wealth of the top 5 percent of Americans compared to the smaller increase in wealth in the middle class, and has brought about concerns about whether such large variances in compensation and wealth are in line with a democracy. In addition, the noticeable fall of organizations whose top executives depart with pre-negotiated well-paid compensation packages seems deceitful while most employees lose their jobs, benefits, and retirement savings, with no golden parachute.Advocates of Executive PayPeople who support the current rate of executive compensation argue that it is necessary for a company to maintain a high level of performance in this complicated global economy. They have proof through a number of studies, conducted in the late 1980’s, on the correlation between executive pay and company performance. According to Murphy (1985), “…firm performance, as measured by the realized return of shareholders, is strongly and positively correlated with managerial remuneration in specifications that controlled for firm” (Abowd and Kaplan, 1998, p.3). He also noted “that growth of firm sales is also strongly related to managerial remuneration” (Abowd and Kaplan, 1998, p.3). CEO compensation especially has been strongly linked to company performance in many studies. Deckop (1988) found that “CEO compensation is positively related to firm profits as a percentage of sales” (Abowd and Kaplan, 1998, p.3). In a study conducted later by Gabaix and Landier (2008), they found that “although CEO pay increased six fold between 1980 and 2003, the market value of the companies these CEOs managed also increased six fold during this period” (Larcker &Taylon, 2012, p. 1). People for lucrative executive pay say that executives get paid the going rate, so companies have to pay executives high to compete for the best talent in the market. In drawing the best executives for the job, compensation levels are very important. In making decisions about the compensation of executives, companies are aware that their decisions carry many risks. One major risk is the company might lose the services of the best-qualified individual to a competitor. Advocates argue that it would not be sensible to sacrifice the opportunity to increase profits or to beat the competition just because executives' pay might create dispute because it is considerably more than what most workers make.Advocates of current executive pay also argue that the task and responsibilities of an executive are vitally important to the survival and success of a corporation and that these tasks and responsibilities warrant higher compensation than other workers. According to Larker & Taylon (2012), “if compensation levels are high among the largest U.S. corporations, it is simply a reflection of the demands of a position that require considerable time, skill, and attention” (p.1). Finding executives with the right mixture of skills and talents can be hard, so the ones that are picked should be paid substantially. According to Jacobs and Hoagland (2001), “Making the right decisions in running a large corporation is a complex mixture of technical knowledge--not only about the operations of the company, but also about intricacies of corporate finance, shifting markets throughout the world, and moves by competitors” (p. 1) In addition to needing technical skills, executives have to make short-term and long-term strategic decisions that can make or break a company. So, executives are responsible for taking risks that many other types of workers are not responsible for taking. When looking at the Bureau of Labor Statistics’ description of executive duties, one can realize how much of an impact executive duties have on the company:Establish and carry out departmental or organizational goals, policies, and proceduresDirect and oversee an organization’s financial and budgetary activitiesManage general activities related to making products and providing servicesConsult with other executives, staff, and board members about general operationsNegotiate or approve contracts and agreementsAppoint department heads and managersAnalyze financial statements, sales reports, and other performance indicatorsIdentify places to cut costs and to improve performance, policies, and programsAdvocates also say that higher pay helps give a symbolic perception of importance that is necessary for executives who represent the company as figureheads. This is under the notion that higher paid individuals are more respected and admired.Finally, people who support the current executive pay system say that the extent of executive pay is a decision for and the responsibility of the owners of the firm. The board of directors, who are elected by the stockholders (owners), should have the only say about what the company pays its executives form this point of view. Stockholders that do not like board decisions about executive compensation can vote to have members substituted, but non-owners should not have a voice in it.Opponents of Executive PayThose who are against overly lucrative pay argue that the systems used to judge the effectiveness and performance of executives are flawed. In some cases, lower paid executives outperform higher paid executives. Stephen Miller of SHRM (2010) has some evidence of this:The 2010 BDO Compensation Trends by City Study examined the change in CEO compensation for companies ending their fiscal years in December 2009 or later, compared to the total shareholder return at the top 25 performing companies and the bottom 25 performing companies across 10 U.S. cities: Atlanta, Boston, Chicago, Washington, D.C., Houston, Los Angeles, Miami, New York, and San Francisco… When comparing the bottom tier of the top performing companies with the top tier of the bottom performing companies across all 10 cities, the links between pay and performance became elusive. The one constant across all 10 cities is that CEO compensation decreased (by 21 percent) for the companies with positive shareholder returns who were on the lowest quartile. (para. 2 & 4)The reasons for this may be because executives’ pay is being decided by executives’ reputation of being a good leader instead of their actual performance. Those in opposition of the current rate of executive pay argue that executives’ actual performance has little to do with company performance. In other words, just because a company is performing well doesn’t mean that it is because of the top management. Earlier studies by Thomas (1988) showed empirically that only 3.9 percent of the percentage of variance in firm performance is caused by a firm’s CEO. Later studies conducted by Wasserman, Nohria, and Anand (2001) estimated the percent to be higher at 14.7% (Mackey, 2005). Nevertheless, this is still substantially lower than the effects the industry and competition has on firm performance. Given that these stats are for CEO’s, other executives’ effect on firm performance should be even less.From an ethical point of view, those against overpaying executives say that it is not fair to the public and other workers. According to Evinger & Grant (2011), “Excessive executive pay is unfair to workers, increases economic disparities, and is undermining the foundation of American democracy” (p.1). Most people agree that top managers should be paid more than other workers, but the fact that the average executive gets paid more than 300 times that of average worker is excessive according to opponents of executive pay. They argue that since corporations are such a big force in our country the government should do something about this wide pay gap. In argument against those who say the non-owners should not have a say in executive pay, Evinger & Grant (2011), say that “the compensation of CEOs and the financial performance of publicly-held companies are a matter of public record (at least theoretically), so that every American can be informed about executive pay and whether there is a connection between pay level and performance” (p.2). Aside from the public, even stockholders have little control over decisions that are not in their best interest made by the board. According to Evinger & Grant (2011), “studies show that chief executives nominate individuals to become members of the board of directors, individuals whom they know and who may not be totally objective when it comes time to vote on CEO compensation” (p.2). Government Action on the Executive Pay IssueThe economic down turn in 2001 and the financial crisis of 2007 led to laws being passed to increase corporate executive pay regulation. There are restrictions on the amount of pay that companies that got government bailouts through the Troubled Asset Relief Program (TARP) can give to executives. However, in 2008, the House of Representatives passed a "say on pay" bill that would require all public corporations to give shareholders a vote on top executives' pay. By the 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act were solidified. Among other provisions, this amendment to the Securities Exchange act of 1934 allowed for a 'say on pay' for all public institutions in the United States. This say on pay gives shareholders a number of voting rights. According to the Library of Congress, public corporations are obligated to get the votes of shareholders to approve of executive compensation every three years. Every six years shareholders vote on whether approval of executive pay should be more frequent than every 3 years. Also, shareholders can vote yes or no on Golden Parachute payment to executives. Shareholders must also be given information on the comparison of executive pay and the financial performance of the organization. So how do people feel about government legislation acting on executive pay? Well, a Gallup poll (2009) showed that 59 percent of people were in favor of the government limiting executive pay, 35 percent opposed, and 5 percent had no opinion (Jones, 2009). The Figures 3 and 4 break these percentages down to people of different party affiliation and household income. The say on pay bill is a step forward when it comes to regulating executive pay, but how much affect, if any, does it have on organizations? Not very much according to a study conducted by the Society of Human Resource Management (2011): The first mandated U.S. say-on-pay proxy season in 2011 had relatively little impact on most U.S. public corporations… 79 percent of respondents said say-on-pay had no or only little to moderate impact on their focus for the 2011 proxy season… 16 percent of respondents received less than 80 percent of shareholder support for their executive compensation programs. (Stephen Miller, 2011, para. 1). The study conducted by SHRM (2011) also showed 64 percent of the employers surveyed are “only moderately concerned about the pending U.S. Securities and Exchange Commission (SEC) implementation of the Dodd-Frank law requirement to show executive pay vs. company performance” (Miller, 2011).Possible Internal Solutions to the Executive Pay ProblemAlthough there are laws set to attempt to rectify executive pay, companies may want to look at some changes they can make on their own. Some internal solutions that have the potential to settle the executive compensation controversy are bonus- malus, debt like compensation, and indexing operating performance.Bonus- Malus SystemA bonus-malus (good-bad in Latin) system is a pay system where executives carry potential risk in addition to potential reward as far as bonuses and incentives are concerned (Weaver, 2012). With this system, incentive bonuses are like double edged swords: they reward exceptional results, and penalize poor performance. Yearly incentives can be taken in case of losses in future years. The purpose is to line up incentives with long-term performance and inspire long-term growth, while avoiding risks that may only produce short-term profits. This helps companies better recognize when executives manipulate earnings to get bonuses in early years, while the company suffers a loss in the long- term (Rajan, 2008). Debt- Like CompensationSimilarly to Bonus-malus pay, debt like compensation aims to reduce the risks executives take to earn short-term profit. According to Raviv & Sisli-Ciamarra (2011), the executive would take the maximum possible level of asset risk when the proportion of equity-based compensation is greater than the loss of inside debt upon default, and the minimum possible level of asset risk if the reverse relationship exists. Raviv & Sisli-Ciamarra (2001) go on to say that “Empirical studies also find a positive relationship between equity-based compensation and risk and a negative relationship between debt-like compensation and risk” (p. 6). Many professionals believe that the executives’ spur to take risks depends on organizations’ dependence on equity based compensation and risky debt. With debt-like compensation, executives’ motivation to take risk can be waned.Indexing Operating PerformanceIndexing operating performance is a relatively accurate way to measure executive performance. Indexing operating performance equates a company’s fiscal performance with the fiscal performance of other similar companies by the use of financial statements. Indexing operating performance aligns bonuses with the specific business cycles. This is a way to make bonuses dependent on specific business. Since indexed bonus goals change with the business cycle, they are more reasonable and usable for a more extensive amount of time (Stern, 2009). ConclusionExecutive compensation is an issue that is controversial due to sizable inequalities when compared to the compensation of most people in the workforce. The average executive makes more than 300 times the average non-executive as of today, and the top 500 executives makes a huge portion of their companies’ earnings. However, the United States business environment is very competitive. On top of that, companies here have to compete with companies all over the world. Simply putting a cap on the amount of compensation executives can make would leave U.S companies vulnerable to better paying companies abroad. To be able to compete, survive and excel in today’s volatile global economy, the leaders of these companies must be the best of the best to be able to compete, survive and excel. The best potential executives get offered pay packages by interested companies, so the desired executives are in a position to pick the best offer. Like an auction, the bidder with the best offer gets the prize: a potential high performer. Sometimes bidders have to pay more than they want to in order to outbid the competition. Paying the minimum not only makes a company miss out on good talent, but they will probably have to compete against the winner of that good talent. Is it unfair that executives get paid more than executives? In the writer’s opinion, the amount of an executive’s pay is not as unfair as a Mega Millions Lottery winner’s earnings in the sense that they both are paid more than the average worker. But unlike the lottery winner, the executive is earning this pay by contributing high performance. There is substantial evidence that high performing executives improve company performance, so the amount paid is justified if the value of the company is increasing.Then again, could the amount of executive pay get out of hand? Judging by the recent protests on Wall Street, it already has. If money that large corporations are making does not trickle down to the middle class, the middle class could be substantially threatened. A society such as the U.S needs balance to stay afloat today more than ever. The success of a company is a team effort, and the team should reap the benefits in a fairer manner. The large pay they receive should somehow be limited so that more of the reward goes to the middle class so they too can be satisfied with their place in the economy and there way of life. ReferencesAbowd, J.M. & Kaplan, D.S. (1998). Executive compensation: six questions that need answering. Retrieved March 15, 2012, from R Ellig. (2006, January). 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