Ethics of Executive Compensation

Introduction

How much compensation is enough for a CEO in one year?  Is $1 million per year more than adequate pay for a person to live on?  Would $5 million ensure the top talent executives are both attracted and retained by an organization?  If millions of dollars are paid out to individuals then how does a person rate and justify an executive’s performance?  Who will make the decision on how much should be awarded?  These are the questions our society is contemplating on the subject of executive compensation.

The following analysis evaluates the ethics of executive compensation and whether or not limits should be imposed on Company X. The analysis will not debate if there should be a disparity between certain employees compensation in an organization because there are good reasons for such a disparity. By analyzing the perspectives of historical and current executive compensation in the US, this analysis will question the validity, justification, and legitimacy of executive compensation through an “interest-based” approach. Ultimately recommendations will be made on how our leaders should move forward on this issue for Company X.

Background – Historical

        In the late 1890s the executive compensation debate first took root in the US.  Surprisingly, the Dow Jones Industrial Average and JP Morgan took the stance that CEO pay should not exceed 20 times the pay of the company’s average worker.  From the 1930s - 1950s, the US government in the created new legislation to limit the executive compensation by imposing large tax payments and freezing compensation increases.  However, these attempts for compensation control were met with creativity and innovation on how to provide payment to employees through the use of bonuses.  By 1980 the average CEO was paid 40 times more than the average company employee.  

Background – Current State

When analyzing the executive compensation levels at corporations it is important to begin by looking at overall trends and not necessarily one specific individual (this decreases the likelihood of extreme outliers skewing the data). This analysis took annual salaries of the top 25 paid CEOs from 2004-2008 and recalculated their average payout for each year.  The overall average payout for a top 25 highest paid CEO over these four years was $90.35 million. While the average payout each year was greater than $75 million with a high of $125.14 million in 2006, the year prior to the recession beginning (3, 4, 5, 6).  

To put these amounts in perspective, the median household income in the US in 2007 was $50,740 (US census bureau).  This means the US median income is only .06% of the average compensation of the top 25 CEO’s.  Another way to interpret the amounts is to convert the difference into a 2000 hour work year; which is the standard work year for a full-time employee.  Upon converting the dollar difference into actual work time, it took 1 hour 7 minutes and 20 seconds for the average top 25 paid CEO to earn the median household income in the US. To maintain full objectivity it should be stated that CEOs generally work more than 2000 hours in a year.  However to be completely fair it should also be noted that if a CEO worked 16 hours a day and 365 days a year, assuming no vacation at all, they would only work 5,840 hours. This is about 3 times the number of hours an average employee works and it still does not fully explain the large discrepancy (approximately 1,800 times) between CEO and employee pay; a far cry from the recommendation originally set by the Dow Jones Industrial Average and JP Morgan.

Value Based Analysis

The goal of interest based reasoning is to provide the greatest benefit to the greatest amount of people. Kenneth Goodpaster wrote “The fundamental idea behind interest-based analysis is that the moral assessment of actions and policies depend solely on their consequences, and that the only consequences that really matter are the interests of the parties affected (usually human beings).”  One of the big concerns regarding high executive compensation is that the welfare of a large number of people, including employees, inventors and the society as a whole are being compromised in order to pay a few executives large compensation packages.  Interest based reasoning would argue that it is unethical for a large number of people to experience a loss in utility in order for a few individuals to receive a benefit.  The following sections will review each of the stakeholders in Company X’s executive compensation dilemma.

Employee Perspective:

A way to look at this situation through interest based reasoning is by asking the following questions.  Which path leads to the best performance for the company and the stakeholders?  A very important factor that influences a company’s performance is the welfare of its employees. If the company keeps employees happy by avoiding layoffs, pay cuts or unequal treatment of executives, morale will be higher?  Will the higher morale lead to higher productivity, better business decisions, increases in performance and higher profits?  Excessive pay for executives risks negative effects on employees that could possibly lead to further bad performance.  An interest based approach would state that if the executive received less compensation and either more money is given to the employees or reinvested into the enterprise for future benefit; then that would be performing the greatest good at the sacrifice of the fewest.  

Executive Perspective:

When examining the aspects of executive compensation it is important to look at the benefits that can occur through higher levels of pay. It could be reasoned that higher pay for executives could be the key to better company performance. One way to obtain and keep good executives is to reward them for their efforts. Strong executives can lead a business to a more profitable future thus benefiting employees, investors and society. High executive pay could also encourage employees to work harder in hopes of achieving an executive role in the future. Better incentives, including high executive pay, encourage better performance from employees and the company overall will be better off leading to more benefits to employees and inventors.  However, there is still a chance for employees to make the incorrect short-term decisions because they are driven to receive the additional compensation.  If this occurs it will be extremely detrimental to the organization in the future.