The Controversy Associated with Executive Compensationgaryjenkins.weebly.com/uploads/1/2/9/1/12919643/...com… · Web viewExecutive compensation includes more than just a base

Fogelman College of Business and Economics

The Controversy Associated with Executive Compensation

Dr. Keef; MGMT 4240 -001

By Gary Jenkins4/30/2012

The Controversy Associated with Executive Compensation 1

Abstract

Executive 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.


Introduction

The 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

Forbes.com, 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 Forbes.com. 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 Prweb.com (2011).

Rank Executive Company Total Year Compensation (in millions)1 Hemsley, Stephen J UnitedHealth Group $101.972 Mueller, Edward A Qwest Communications 65.83 Iger, Robert A Walt Disney 53.324 Paz, George Express Scripts 51.525 Frankfort, Lew Coach 49.456 Lauren, Ralph Polo Ralph Lauren 437 Martin, John C Gilead Sciences 42.728 Hackett, James T Anadarko Petroleum 38.949 Chambers, John T Cisco Systems 37.910 Seidenberg, Ivan G Verizon Commun 36.75

Top Paid Executives of 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 Controversy

Executive 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 Pay

People 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 procedures

Direct and oversee an organization’s financial and budgetary activities

Manage general activities related to making products and providing

services

Consult with other executives, staff, and board members about general

operations

Negotiate or approve contracts and agreements

Appoint department heads and managers

Analyze financial statements, sales reports, and other performance

indicators

Identify places to cut costs and to improve performance, policies, and

programs

Advocates 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 Pay

Those 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 Issue

The 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 Problem

Although 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 System

A 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 Compensation

Similarly 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 Performance

Indexing 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).

Conclusion

Executive 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.

References


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DeCarlo S. (2011). Show me the money. Retrieved April 2, 2012, from http://www.forbes.com/2011/04/12/compensation-chief-executive-salary-leadership-ceo-compensation-11-intro.html

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Jones, J. M. (2009). Most Americans favor gov't. action to limit executive pay. Retrieved April 22, 2012, from http://www.gallup.com/poll/120872/Americans-Favor-Gov-Action-Limit-Executive-Pay.aspx

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Library of Congress. (2009). Bill Summary & Status 111th Congress Retrieved

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Mackey, A. (2005). How much do CEOs influence firm performance - really? Retrieved March 20, 2012, from http://ssrn.com/abstract=816065

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The Controversy Associated with Executive Compensationgaryjenkins.weebly.com/uploads/1/2/9/1/12919643/...com… · Web viewExecutive compensation includes more than just a base