Executive Compensation

Executive Compensation

Introduction

Executive compensation is presently a topic of concern. President Bush recently mentioned it during the most recent State of the Union address. The media frequently speaks of executives that are paid vast sums of money, showered with perks such as corporate jets, vacation homes, gifts, and staff positions for friends and family. Almost as frequent, we read of executives that fail to meet stockholders expectations but somehow manage to step down and depart with lucrative “exit packages”. In addition, it has been noted by analysts of “The Corporate Library,” CEO’s of Standard & Poor's 500 companies receive an average of $13.51 million in compensation per year. Based on our observations, the average CEO of our sample of the S&P 500 receives a comfortable $67 million in compensation per year.

Although a reasonable compensation system for executives and workers is fundamental, the past has seen record growth in compensation for top executives. More frequently than one would expect, boards of directors vote on setting CEO pay. Too often, directors have awarded compensation packages that go above and beyond what is required to attract and retain executives, even rewarding poor performing CEOs. Further, some CEOs may have far greater control over their pay than anybody previously suspected. According to a statement in the Wall Street Journal, “Year after year, some companies’ top executives received options on unusually propitious dates,” certain CEOs may be backdating their own stock option grants to capitalize on their value.

One such executive is Martin C. McGuinn of Mellon Financial. Mr. McGuinn currently averaged 5.5 million dollars a year in compensation while his company realized a -2% annualized return during his tenure (Forbes Magazine, 2005). Another executive, Richard Grasso, the former CEO of the New York Stock exchange, separated after a meager eight years with $187.5 million in compensation (www.oag.state.ny.us/press, 2004). Other exit packages that have gained investor attention are Bob Nardelli of Home Depot ($210 million), Ex-Pfizer Inc. (PFE) chief Henry McKinnell ($200 million), and ExxonMobil (XOM) leader Lee Raymond ($357 million). These are just a few of the CEO’s that have helped to attract the attention of Washington and concerned investors over excessive executive pay.

While excessive CEO pay is a “corporate governance” problem, it stems from the loss of board ownership and control. Ironically, one of the jobs of the board of directors is to protect shareholder interests and minimize agency costs; however, approximately two-thirds of companies have CEO’s as the board’s chair. When one single person serves as both chair and CEO, it is virtually impossible for others to police, monitor, or evaluate their performance. One would ask, what’s the result of this? When CEOs have too much power they are able to extract “economic rents” from shareholders. These “rents” are known as “agency costs,” and can lead to the equivalent of a monopoly. Excessive CEO salaries come at the expense of shareholders, employees, and retirements. Further, a poorly designed compensation package can reward decisions that are not in the long-term interests of a company. This increase in the ratio between the compensation of executives and employees can sometimes prove detrimental. Recent studies have linked CEO stock options to accounting fraud and other financial restatements. For this reason, stock options can serve as a driver for executives to “cook the books.”

Combined with a perception that America is becoming stratified into an economic caste, it is evident why people are scrutinizing executive compensation. Knowing this, we chose this topic we chose is relevant, timely, and worthy of study and analysis.

Related Research/ Literary Review

There has been much research conducted anecdotally in the popular media (Fortune, Forbes, Business Week magazines), as well as some study of the issue from a perspective of defending CEO compensation in trade publications (Warner, 2007), and there is also a tremendous amount of scientific analysis on the topic. We found many useful explorations of the subject and they contributed greatly to our understanding of the scope of the issue. We gained much of the raw data that we used from Business Week magazine’s annual analysis of S&P 500 companies’ performance (Business Week, April 2003/2004/2005).

Information on CEO remuneration was gathered through Forbes magazine annual report on CEO compensation . Perhaps the most interesting analysis on the issue we discovered was an analysis written for the Journal of Corporate Law by Patrick Bolton, JosÐ"© Scheinkman and Wei Xiong entitled, “Pay for Short-Term Performance: Executive Compensation in Speculative Markets” . Their thesis is that the CEO’s compensation is based on a somewhat abstract approach in which the CEO’s ability to hype a company (in effect, becoming the Cheerleader-in-Chief) is a metric that is to be considered in the compensation package but his performance over the long term seldom is. The market demands ever-greater numbers, especially during speculative periods, like the dot.com boom, which forces companies to select leaders who respond to that kind of environment but may not be best suited to make the company profitable and healthy over the long term. Furthermore, Bolton, Scheinkman and Xiong assert that a company’s board is less concerned with compensation that is not linked to the bottom line when the stock price is booming (2005, p. 723). We found this study enlightening but felt that given the scope of our project, we could not fully explore the role of over 100 corporate boards in respect to compensation.

A key analysis that we referred to frequently during our study was Pay Without Performance: The Unfulfilled Promise if Executive Compensation by Lucian Bebchuk and Jesse Fried. They approach the problem, again, from a corporate governance standpoint with the identification of several issues that helped us frame the discussion: 1) many boards approved executive pay deals that do not serve shareholders, 2) That the scope of the problem is not widely understood and that 3) “It’s the barrel, not a few apples”: the problems have been widespread, persistent,