There is little argument that the CEOs of many major U.S. corporations are overpaid. The relevant questions involve the degree of overpayment and what, if anything, government should do to correct the problem.
Of course, “overpaid” is a value judgment that varies with the beholder. But one can make comparisons over time and between countries that support that conclusion.
The ratio of executive salaries to that of their average employees or to per capita income in the general population is one measure that has grown sharply in recent years. Compensation expert Graef Crystal notes that a century ago, J.P. Morgan stated that a 20-1 ratio of CEO earnings to that of average workers was fair. Years later, management guru Peter Drucker agreed on that number.
In 1974, the actual ratio was 35 to 1. By 1991, CEO compensation had increased to 150 times worker pay. In 2008, Crystal found a factor of 293 for all Fortune 500 corporations and 525 to 1 for the largest 50. The Pioneer Press survey this year put the ratio for CEOs at Minnesota’s 50 largest public companies at 66 times the pay of the average wage earner.
If you look at the ratio of top management pay to overall corporate earnings you find the same pattern. The slice of the pie that goes to top executives has grown over time.
Studies consistently find that U.S. executives are paid more than their counterparts running similar companies in other industrialized countries.
The gap is narrowing, however, when one compares major multinationals based in Europe to similar U.S. firms.
One study, using somewhat different definitions of compensation than Crystal did, found that CEOs outearned the income per capita by a factor of 475 in the United States compared to 22 in Britain, 20 in Canada and Italy, 12 in Germany and 11 in Japan.
Some argue that rising executive pay simply reflects superior management performance. But it is hard to square a change from a factor of 35 to 293 over the span of three decades. Earnings have not improved that markedly.
It is similarly hard to argue that U.S. managers earn 20 times more for their shareholders than their Canadian counterparts.
Another argument is that there is more competition for really superior CEOs, just as there is for star professional athletes. Large corporations therefore have no choice but to pay large sums or they will lose superior managers to competitors. But again, it is hard to see why this has only become important recently and why it is not true elsewhere.
Free-market enthusiasts argue that however pay levels have changed, this is the outcome of a free-market process and hence must be economically efficient. Any government response will only make society worse off.
But other economists see clear market failure. Burgeoning CEO pay is an example of a “principal-agent problem,” in which the incentives for top executives (the agents) differ from the best interests of the stockholders who employ them (the principals).
Poorly matched incentives mean executives can feather their own financial nests at the expense of the stockholders in whose interests the managers theoretically work. The majority of economists probably think this is true to at least some extent.
As long as stock prices are rising, analysts argue, the average stockholder does not mind management skimming some cream off the top. But when dividends and share prices fall, individual share owners have little power to change compensation policies.
It is part of a wider pattern of failure of corporate governance. CEOs can come to dominate the boards of directors that, in theory, are supposed to monitor management and safeguard the interests of the stockholders. But CEOs influence who gets named to the board and what information the board gets.
Even among those who agree that excess executive pay is a problem, there are sharp differences on what government should do. Some argue it should do nothing. It is shareholders who are hurt, not the general public, and it is shareholders who have to band together to solve the problem.
Others note that one of the key functions of government is to set and enforce “rules of the game” for business. Current law is tilted toward CEOs and directors, as opposed the interest of shareholders, but the law can be changed.
One suggestion is to require that top executive compensation be approved by a vote of the shareholders.
This “say on pay” might be largely symbolic, since management and the board still have the upper hand in most shareholder voting. But it would give shareholders a bit more power, if only to embarrass boards and managers.
Another measure would be to require that compensation committees consist only of independent outside directors, excluding anyone on the board by reason of his executive position.
This also would ban the practice of CEO Joe from the ABC Corporation serving on the board and compensation committee of XYZ Inc. while CEO Mary from XYZ fills the same role on the ABC board.
These sorts of “you scratch my back and I’ll scratch yours” arrangements are all too common.
Large institutional investors are the shareholders with the most power. State laws governing state employee pension plans like CALPERS or MSRS could specify that the managers of such public funds take into account the reasonableness of executive pay in their role as shareholders in a corporation.
The same mandate could be given to foundations or other nonprofit organizations that have a fiduciary obligation to the general public.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.