A look at how U.S. corporations choose to motivate their top officers and a presentation of evidence showing that linking executive compensation too closely to firm performance may be a mistake.Executives - Salaries

Joseph G. Haubrich

English

Research Papers in Economics

eCONOMIC
GOMMeNTORY
Federal Reserve Bank of Cleveland
November 1,1994
Fear and Loathing in Executive Pay
by Joseph G. Haubrich
Xor some reason, people take offense
when a corporate executive begins to
make as much money as a basketball star
or swimsuit model. Though at first
glance some might see this as another
example of the ill-informed anti-business
bias of the American public and media,
the disgruntlement in fact arises from a
serious concern: the connection between
executive pay and company performance.
It's not hard to imagine that successfully
running a major corporation is a skill as
rare and valuable as the ability to hit
three-point shots or to look photogenic in
spandex. The trouble comes in when a
CEO does not run the company very
well. Is a pay cut or termination in order?
The model has an incentive to stay slim.
Is the CEO motivated to do as well?
This Economic Commentary looks at
the economics of executive incentives,
focusing on how companies choose to
motivate their top officers. Perhaps sur-
prisingly, it appears that CEO pay
should not be extremely sensitive to
company performance.
• Incentive Schemes
Discussions about executive compensa-
tion frequently sound like a foreign lan-
guage. Compensation schemes take many
forms, at times designed as much to
exploit provisions in the tax code as to
motivate managers. But despite its com-
plexities, compensation boils down to
five elements: salaries, bonuses, stock
ownership, stock options, and dismissal.
In most cases where pay depends strongly
on a firm's performance, the executive
has large stock holdings. Warren Buffet,
who controls 45 percent of Berkshire
Hathaway's stock, feels any change in the
company's fortunes quite directly.
Several more involved forms of compen-
sation also tie executive pay to a firm's
performance level. For instance, a com-
pany may grant its executive an option to
buy stock in the firm. Typically, he must
wait 12 months before exercising the
option (buying the stock), and at that
time, can exercise only one-quarter of the
options granted, with another quarter
becoming vested at the beginning of each
year. Some corporations grant bonuses
at the discretion of the board of directors,
while others establish objective perform-
ance goals.
The rewards for meeting these goals fre-
quently, but not always, depend on the
firm's stock price. Many companies use
restricted stock awards, which give man-
agers a fixed amount of stock that they
cannot sell before the end of a given
period. Others find that the rapidly devel-
oping derivatives market allows more
exotic ways to compensate executives,
such as through equity swaps.
1 Combin-
ing these elements leads to a wide range
of possible compensation plans.
2
Unsatisfactory performance can also
result in dismissal. One study revealed
that firms doing poorly (in the bottom 10
percent of the performance distribution)
had roughly twice the CEO turnover of
firms that were doing well (top 10 per-
cent).
3 Neither number was excessive,
however—6 percent versus 3 percent.
According to a well-known executive
compensation critic, America's most
overpaid CEO has pocketed $91 mil-
lion more than warranted by his com-
pany's performance since 1991. Many
are understandably outraged by such
reports, and there is a movement
afoot in both the United States and
Britain to rein in what is viewed as
excessive executive pay. In this arti-
cle, the author examines how U.S.
companies choose to motivate their
top officers and whether pay for
performance is in fact desirable.
Surprisingly, the evidence suggests
that linking executive compensation
too closely to firm performance may
be a mistake.In companies that did exceptionally
badly (either defaulting on their bonds
or going bankrupt), more than half of
the CEOs lost their jobs.
4
These complexities should not be al-
lowed to obscure the ultimately simple
relationship between executive compen-
sation and firm performance. Any remu-
neration scheme, no matter how convo-
luted, reduces to a basic measure of
incentives: How does the executive's
wealth depend on the value of the firm?
In other words, when the firm becomes
more valuable (when the stock price
rises), what does the CEO get? Below, I
use a measure developed by two Harvard
professors that attempts to assess pre-
cisely that. Called the performance/pay
ratio, it measures how a CEO's wealth
changes as the worth of a firm shifts.
• The Facts
The data used here are taken from
Michael Jensen and Kevin Murphy's
"New Survey of Executive Compensa-
tion," in which they look at how the
wealth of 430 American CEOs varies
with changes in total shareholder
wealth.
5 In ascertaining performance
pay, the authors add together salary and
bonuses, other pay, expected lifetime
salary and bonus change relative to cur-
rent performance, threat of dismissal,
stock options, restricted stock awards,
and inside stock holdings. Table 1
shows how the different components of
compensation contribute to total incen-
tives. Notice the importance of stock,
both as direct holdings and as options.
Bear in mind, however, that the data
come from statistical estimates and thus
are subject to various types of error.
6
In addition to these measures of compen-
sation, the measure used for firm per-
formance also deserves some degree of
notice. Jensen and Murphy use the in-
crease in total shareholder value, calcu-
lated as the change in stock price multi-
plied by the number of outstanding
shares, instead of company profits or sur-
veys of worker satisfaction. This decision
reflects the vantage of modern corporate
finance. Stockholders, or equityholders,
legally own the firm, and the stock price
reflects the market's valuation of the firm
as an asset. The price should reflect both
TABLE 1 COMPONENTS OF EXECUTIVE
COMPENSATION AND INCENTIVES
3
A $1,000 change in shareholder
wealth corresponds to: Median Middle 50 percent
Change in current salary and bonus
Present value of a two-year change
in salary and bonuses
Change in value of stock options
Wealth effect of change in chance of dismissal
Total change in pay-related wealth
Change in value of direct stock holdings
Total change in CEO wealth
$0,087
0.58
1.58
0.10
1.58
0.96
3.37
$0.01 to 0.22
0.05 to 1.86
0.08 to 1.35
0.03 to 0.23
0.48 to 3.59
0.32 to 3.02
1.24 to 8.13
a. Estimates for CEOs of 430 large U.S. companies.
NOTE: Because the median of the sum does not equal the sum of the medians, the numbers do not add up.
SOURCES: Michael C. Jensen and Kevin J. Murphy, "A New Survey of Executive Compensation" (foot-
note 5); and author's calculations.
current assets (factories, cash accounts)
and expected future profits.
The numbers in table 1 hide huge differ-
ences across firms in the amount of in-
centives offered to chief executives. Fig-
ure 1 plots the estimated performance/
pay ratio of all 430 CEOs. Not surpris-
ingly, the largest incentives go to those
who own a major portion of the firm —
people such as Warren Buffet, Laurence
Tisch of Loews Corporation, and An
Wang of Wang Laboratories. If the stock
value of Berkshire Hathaway increases
by $1,000, Warren Buffet's total com-
pensation rises by $447. If the stock of
Wang Laboratories increases by $1,000,
An Wang's compensation rises by $139.
The results also show symmetry, mean-
ing that a drop in stock value decreases
these executives' wealth.
According to the estimates, some CEOs'
pay depends negatively on firm perform-
ance. For every $1,000 that Navistar
International's stock dropped between
1979 and 1982 (when it plummeted
from $41 to $4.25 per share), its CEO
saw his compensation pick up by $ 1.41.
Likewise, the stock value of Sundstrand
Corp. and the compensation of its chief
executive moved in opposite directions
over the 1975 - 89 period, with every
$ 1,000 decrease in stock price corre-
sponding to a $7.37 increase in pay.
Overall, the numbers show a small but
positive response of CEO pay to firm
performance. For all 430 firms, the mean
response is $13.96 and the median is
$3.37. Salaries of the CEOs of the big-
gest 250 companies tend to show less of
a response, mainly because fewer chief
executives hold a truly large fraction of
their company's stock: The median share
attributable to stock holdings is $2.59.
On the surface, this looks like firm per-
formance hardly matters for executive
pay — a fact decried by several promi-
nent observers. Corporate compensation
critic Graef Crystal expressed his dis-
taste this way: "The easy part of pay for
performance is high pay for high per-
formance; the hard part is no pay for no
performance."
7 Michael Jensen goes
further and argues that in many sectors,
public corporations have become obso-
lete and will be replaced by leveraged
buyout associations — largely because
of the executive compensation issue. He
states, "It's not hard to understand why
an executive who receives $200 for
every $1,000 increase in shareholder
value will unlock more value than an
executive who receives $3.25."
 8
• The Economic View
Such comments, however, do not imply a
broad consensus. The experts disagree
dramatically about the appropriate size of
executive incentives. One group, taking
what may be called the "principal-agent"
view, considers CEOs in need of substan-
tial motivation. They believe that when
compensation is not tied directly to firmFIGURE 1 PERCENTILE PLOT OF PROFIT SHARES
Performance/pay ratio
bUU
450
400
350
300
250
200
150
100
50
0
_
-
-
-
-
-
/
)
i i i i i i i i i i
0.0 0.1 0.2 0.3 0.4 0.5 0.6
Percent
0.7 0.8 0.9 1.0 1.1
SOURCES: Michael C. Jensen and Kevin J. Murphy, "A New Survey of Executive Compensation" (footnote 5); and
author's calculations.
profits, the CEO is apt to redecorate the
executive suite, beef up the fleet of cor-
porate jets, and show excessive concern
for clients in Jamaica, Cancun, and
Hawaii. But the hefty profits from buy-
ing a new computer for the company
engineers will make the sacrifice of a
corporate jet worthwhile provided that
the CEO shares in those profits. Jensen
and Murphy explain: "Highly talented
people who would succeed in any field
are likely to shun the corporate sector,
where pay and performance are weakly
related."
9
But even here, the matter is not cut and
dried. Because corporate performance
depends on many factors outside the
control of the CEO (for instance, the
general condition of the economy, oil
shocks, wars, or new regulations), link-
ing pay too closely with performance
subjects CEOs to excessive risk. Indeed,
in an earlier study I show that with even
a small aversion to risk on the part of ex-
ecutives, the principal-agent view sug-
gests low levels of performance pay.
1
0
In contrast, adherents of the "underpric-
ing" view lament that executive pay
depends too closely on firm perform-
ance.
1
1 At the heart of their attitude is a
different belief about CEOs' tempta-
tions, rooted in the outside market's in-
ability to know everything about a firm.
Insiders, most notably the CEO, under-
stand their company's tremendous fu-
ture profitability — a fact that outsiders
do not yet recognize. Consequently, the
firm's stock is undervalued, as the cur-
rent shareholders are sitting on a gold
mine but don't realize it.
Under these conditions, let us consider a
CEO's decision to expand the firm and
take on a new project that is less prof-
itable than those already in place (a nat-
ural consequence of declining marginal
returns). With everyone perfectly
informed, he would issue stock at the
correct price, take on the project, and be
done with it. As it is, though, the stock is
undervalued, and new stockholders get
not only a piece of the moderately prof-
itable expansion project, but also a piece
of the tremendously profitable current
set. This means that old shareholders see
the value of their stock diluted, since
they must split the future stock price
increases with the new shareholders.
One may shed a quiet tear for this pure
wealth transfer and chalk it up to the per-
ils of living in an imperfect world. How-
ever, if the CEO acts on behalf of the
original stockholders, he will perceive
the loss from the underpriced new shares
and may cancel the new project. Com-
pensation tied excessively closely to
firm performance in effect makes the
CEO an original shareholder — to the
detriment of new investment.
1
2
The underpricing view is a bit like basing
your point guard's salary on his scoring.
He might then neglect his passing, play
calling, and defense, which are more val-
uable to the team. Clearly, there is a dan-
ger in giving people the wrong incentives.
Fortunately, there is a compromise view,
since the real world possesses far greater
complexity than any theory. The reality
is that both problems — principal-agent
and underpricing — exist, and often are
combined in the same firm. Most com-
panies lie between the archetypical
mature cash cows, whose primary cor-
porate governance issue is to prevent
management featherbedding, and the
archetypical start-ups, anxiously weigh-
ing new investments in unproven tech-
nologies. The diverse mixture of these
two extremes explains the wide variation
observed in CEO compensation.
• Conclusion
Appropriate performance-based pay
depends on many factors, including (but
certainly not limited to) industry, relative
size of the company, importance of
research and development, competitive
posture, and unionization. Even the age
and personality of the CEO are apt to be
important: Some may respond better to
one type of incentive than another.
These incentives — not pay levels — are
the real issue. Though a $3.37 salary
boost for every $1,000 stock market
jump may seem like very little motiva-
tion, such numbers should not be sur-
prising. The economics of executive
compensation predict as much, both
because executives dislike bearing too
much risk, and because linking their pay
too closely to stock prices can lead to the
neglect of profitable new projects.
The challenge is to get executive per-
formance of the same caliber that leads
to NBA championships and sells fashion
magazines. But misunderstanding the
problem can produce more than a poor
season or flabby thighs: Just ask the
nation's unemployed workers or bank-
rupt investors.
• Footnotes
1. See Floyd Norris, "Keeping Votes as Stock
Is Sold," New York Times, March 29, 1994.
2. See Stacey R. Kole, "The Bundling of
Compensation Plans," University of Roch-
ester, Simon School of Business, Working
Paper, June 1993.3. See Michael S. Weisbach, "Outside Direc-
tors and CEO Turnover," Journal of Finan-
cial Economics, vol. 20, nos. 112 (January/
March 1988), pp. 431-60.
4. See Stuart C. Gilson, "Management
Turnover and Financial Distress," Journal of
Financial Economics, vol. 25, no. 2 (Decem-
ber 1989), pp. 241-62.
5. See Michael C. Jensen and Kevin J.
Murphy, "A New Survey of Executive Com-
pensation: Full Survey and Technical Appen-
dix to 'CEO Incentives — It's Not How Much
You Pay, But How,' " Harvard Business
School, Division of Research, Working Paper
90-067, June 1990.
6. Jensen and Murphy use a variety of statis-
tical techniques to calculate incentives from
compensation data. They regress the change in
salary and bonuses against current and lagged
changes in shareholder wealth using data from
1974 to 1988. To convert this to a measure of
CEO wealth, they add in other pay, assume
that the changes in salary and bonuses are per-
manent, and take the present discounted value
of the changes using an interest rate of 3 per-
cent. They then regress the change in this
wealth against current and lagged changes in
shareholder value. Dismissal probability is
determined by regressing the log of CEO
turnover odds against industry, company size,
and relative performance, again from 1974
through 1988. Stock options are assumed to
change by $0.60 for every $1.00 change in
stock price. See Jensen and Murphy's original
article on this subject, "CEO Incentives —
It's Not How Much You Pay, But How," Har-
vard Business Review, vol. 68, no. 3 (May/
June 1990), pp. 138-53.
7. See Alison Leigh Cowan, "The Gadfly
C.E.O.'s Want to Swat," New York Times,
February 2, 1992.
8. See Michael C. Jensen, "Eclipse of the
Public Corporation," Harvard Business
Review, vol. 67, no. 5 (September/October
1989), pp. 61-74.
9. See Michael C. Jensen and Kevin J.
Murphy, "CEO Incentives" (footnote 6),
p. 149.
10. See Joseph G. Haubrich, "Risk Aversion,
Performance Pay, and the Principal-Agent
Problem," Journal of Political Economy, vol.
102, no. 2 (April 1994), pp. 258-76.
11. For an excellent discussion of the under-
pricing view, see Stewart C. Myers and
Nicholas S. Majluf, "Corporate Financing
and Investment Decisions When Firms Have
Information that Investors Do Not Have,"
Journal of Financial Economics, vol. 13,
no. 2 (June 1984), pp. 187-221.
12. Two finer points deserve mention. First,
not every firm can be an unrecognized gold
mine all the time. The underpricing argu-
ment, then, should hold for some but not all
firms. Second, aside from selling stock, com-
panies could issue debt to raise funds. How-
ever, if the debt is risky, the underpricing
argument still holds because now the new
debtholders capture part of the initial stock-
holders' gain. The reason is that when the
new information is released, the firm is seen
to be more valuable (less likely to default on
its debt), and the price of the debt rises.
Joseph G Haubrich is an economic advisor
at the Federal Reserve Bank of Cleveland.
The opinions stated herein are those of the
author and not necessarily those of the Fed-
eral Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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