Are CEOs Overpaid?--Posner The media are full of stories about the compensation of chief executive officers of American companies. The theme of the stories is that CEOs are paid too much. The economics of compensation are fascinating. In the simplest economic model, a worker, right up to the level of CEO, is paid his marginal product--essentially, his contribution to the firm's net income. But simple observation reveals numerous departures from the model. For example, wages vary across the employees of the same rank in the same company by much less than differences in their contribution to the company, and employees who do satisfactory work can expect real (that is, inflation- adjusted) annual increases in their wages throughout their career with the firm, even though their contribution will not be increasing at the same rate, and eventually not at all. Let us see what sense can be made of the curious pattern of CEO compensation. American CEOs make much more on average than their counterparts in other countries-- about twice as much. You might think that this was because Americans at all levels earn more than their foreign counterparts, but this is not so; the difference between U.S. and foreign wages is much smaller below the CEO level. In other words, wages are more skewed in favor of CEOs in American companies. The disparity is related to the fact that salaries are a much smaller fraction of American CEOs' incomes (less than a half) than of foreign CEOs' incomes, with the rest consisting of bonuses but mainly of stock options. Both the fraction of CEO income that is nonsalary, and total CEO income, have been rising, dramatically in the United States, over recent decades. But there is a recent tendency of foreign CEO compensation policies toward convergence with the American practice. One can speculate about the causes of some of these differences. Stock options and other incentive-based compensation methods impart risk (variance) to CEOs' incomes, which reinforces the risk inherent in the fact that a CEO's human capital (earning capacity) may be specific to his firm, so that if he lost his job because his company had been doing badly (perhaps for reasons beyond his control), he would take a double hit--lower pay as the company declined and lower pay in his next job. Because business executives (as distinct from entrepreneurs) do not like risk, they demand a higher wage if the wage is going to have a substantial risky component. This may explain some of the difference between American and foreign CEO compensation, but surely not all or even much of it-- especially since job turnover at the CEO level is actually greater in Europe than in the United States. Another possible difference is that stock ownership tends to be more concentrated abroad than in the United States. The more concentrated it is, the more incentive shareholders have to monitor the performance of their firm's managers because they have more at stake. The more effective that monitoring is, the less need there is to create incentive- based compensation schemes: the stick is substituted for the carrot. Cultural factors may be important. European countries in particular are more egalitarian than the United States, suggesting that envy is likely to play a bigger role in compensation there. Astronomical ratios of CEO to blue-collar wages in the same company cause little resentment in the United States compared to what they would cause in Europe, though wide disparities between workers at the same level does engender resentment here even if the disparities track differences in productivity. Envy might reduce average incomes at the same time that it reduced variance in incomes, if the more generous compensation of American CEOs merely reflects the greater contribution that they make to their companies' success. But there are two reasons to doubt this, and thus to suspect that American CEO incomes are padded to some degree. First, the most significant "incentive" component in these incomes--stock options--are not well correlated with the CEO's contribution to the value of his company and thus of the value of its stock. Many things move a company's stock besides the decisions of its CEO. To tie a CEO's income to the value of his company's stock is a bit like tying the salary of the President of the United States to the U.S. GNP. Second, the choice of stock options as the principal method of providing nonsalary compensation to CEOs seems related to the fact that traditionally the income generated by these options, unlike salary or bonus income, was not reported as a corporate expense. Of course security analysts and stockholders large enough to follow closely the affairs of the companies in which they invest can calculate the expense of stock options, but the ordinary public cannot, and this is important because even in the United States envy is a factor that can influence policy and public opinion. A spate of recent articles has explained the ingenious devices by which CEO compensation that would strike the average person as grossly excessive is concealed from the public, and these articles, along with well-publicized corporate scandals, may place some downward pressure on CEO compensation. Companies cannot afford to ignore public opinion completely, because adverse public opinion can power legislative or regulatory measures harmful to a company or an industry. It might seem that, provided the shareholders--the owners of the company--are made aware of the actual compensation received by the CEO, competition will drive that compensation down to approximately the level at which the CEO is just being paid his marginal product, with appropriate adjustment for risk. But given the size of companies, the cost to a major company of even a grossly overpaid CEO is so slight when divided among the shareholders that no shareholder (assuming dispersed ownership) will have an incentive to do anything about that excess expense. What about the board of directors? Their incentive to minimize what from the overall corporate standpoint is only a minor cost is also weak, and may be offset by rather minor economic and psychological factors. The board is likely to be dominated by highly paid business executives, including CEOs, who have a personal economic interest in high corporate salaries and a natural psychological tendency to believe that such salaries accurately reflect the intrinsic worth of their recipients. Becker in his comment on this post (below) cites an interesting paper by Gaibaix and Landier which argues that the increase in CEO compensation is a function of the growth in the market value of firms. The basic idea is that the CEO of a more valuable firm is more productive, since if he increases value by say 1 percent the increase in absolute value will be greater the more valuable the firm is. If there are two equally skilled managers and one manages a grocery store and one manages IBM, the manager of IBM is probably creating greater value. The theory is too new to evaluate with any confidence. I am somewhat skeptical because rapid increases in CEO compensation should attract more talent to management, and the resulting greater competition for CEO positions should dampen the increase in compensation. An alternative explanation for the correlation between firm value and CEO compensation, one that is consistent with the evidence that such compensation is often excessive from an efficiency standpoint, is that the greater the firm's market value, the easier it is to "hide" the compensation of the top executives. Suppose that a 10 percent increase in value is associated with a 3 percent increase in CEO compensation; then the percentage of the firm's value that is going to the CEO will have fallen. This may be one reason why many mergers fail to increase earnings per share, although the overall value of the enterprise will be greater after the merger (there will be more shares): the increase in overall value enables the CEO to increase his compensation regardless of whether he will be creating greater value as the manager of the larger enterprise. Posted by Richard Posner at 09:23 PM | Comments (19) | TrackBack (1) Are CEOS Overpaid? BECKER The answer to the question of whether American CEOS are overpaid is clearly "yes" for those who earn large bonuses and generous stock options when their companies are doing badly, either absolutely or relative to competitors. Business Week has had an annual list of the most overpaid CEOS relative to the performance of the companies they head. A number of well-known companies usually top that list. But the concern in the media and in Congress over CEO pay is not motivated by some bad apples like these, but by the huge increase in the typical CEO pay in the US during the past 25 years. The total real compensation (that is, compensation adjusted for increases in the price level) of CEOS in larger publicly traded companies during this period grew a remarkable six fold, where compensation adds together regular pay, bonuses, stocks awarded, the value of stock options, and payouts from longer term pay programs. A big but not the only component of the increase is due to much greater use of stock options. Since median fulltime real earnings during the same period only just about doubled, the gap between pay at the top and the average pay of employees widened enormously. It is hard to resist the widespread perception from these trends that CEOS and other top executives are being increasingly overpaid. The case against the pay of American CEOS looks even more powerful by recognizing that the typical American company head receives greater total compensation than company heads in Great Britain, Canada, Japan, Spain, and in pretty much all developed countries. Clearly, American CEOS are much better paid than CEOS elsewhere, even when per capita incomes of the countries do not differ by very much. Yet competition for top management can explain the rapid rise over time in the pay of the average American CEO. To understand how competition works in the management market, consider the strong and stable relation at any moment between the total compensation of CEOS at publicly traded companies, and the size of the companies they head. For every 10 per cent increase in firm size, measured by the market value of assets, by sales, or by related variables, compensation increases by about 3 per cent. This "30 per cent" law held during the 1930's, and has held for every succeeding decade, including right up to the present. Note that stock options and other forms of compensation than salaries and bonuses were unimportant until the 1970's, so this relation is not due to the rapid growth of options and compensation through shares of stock. The usual explanation given by economists for the positive relation between compensation and firm size is that the largest companies attract the best management. Therefore, bigger companies have to pay their CEOS better in order to discourage them from going to head smaller companies. It is also socially efficient to have the best mangers run the largest companies because their greater skills then have a bigger influence since they would manage a larger amount of labor and capital. The efficient combining of better managers with larger companies in a competitive market for top managers would imply a positive relation between firm size and the total compensation package. This analysis does not explain why the 30 per cent rule holds, but it suggests that the relation between pay and size is likely to be sizable, even when top management in different sized companies do not differ greatly in skills and abilities. We need two additional facts to explain the sharp rise in pay over time, and the much higher pay in the United States than other countries. The first is that the average size of large American companies has grown in real terms about six fold during the past twenty- five years, regardless of how "large" is measured, as long as the same measure is used consistently over time. The other important fact is that the largest 50, 100, or 500 American publicly traded companies are much bigger than the largest companies in other countries. Clearly, if large companies pay more, and if the average size of companies has grown sharply over time, average compensation would also grow, even if the value of the increasingly generous granting of stock options and equity shares were fully understood by stock markets and boards of directors. It is also possible to understand why average compensation grew about as rapidly as average company size, although the argument here is more complicated (for the details of this argument, see Xavier Gabaix (MIT) and Augustin Landier (NYU), "Why Has CEO Pay Increased So Much?" unpublished, April 17, 2006). The allocation of better managers to larger firms, and competition for these managers among companies of different sizes, means that companies in say 2006 would have to pay more for their CEOS than even the same sized companies did in 1980, although much less than six times as much. The reasoning is that the 2006 companies of a given size are competing against relatively larger companies than comparable size companies did in 1980. Using this analysis, Gabaix and Landier are able to explain why total compensation of the average CEO of larger companies grew about six fold along with the six-fold growth in average company size during the past several decades. The same argument explains why compensation of American CEOS is much higher than that of CEOS in other countries. Since average firm size is much lower elsewhere, their pay would be more like that of pay in the US in 1980 or 1990 than the pay of CEOS in today's much larger American firms. As the market for top executives becomes increasingly global, the pay of CEOS in other countries would rise, and that of CEOS in America might fall. For example, to attract Carlos Ghosn, a Brazilian working in France, to turn around Nissan, a seriously ailing company, Nissan had to pay him not at the low Japanese CEO levels, but at the much higher levels found in other countries. I believe that the explanation based on the allocation of CEO talent largely is behind the explosion in compensation of American CEOS during the past several decades. Yet at the same time, some American CEOS are obviously grossly overpaid since they have mismanaged their companies, and still receive exorbitant compensations. But mismanagement is not new and probably has not become so much more important over time. So I am suggesting that the rapid growth of compensation of American CEOS, and its premium over compensation of CEOS in other countries, is not mainly due to a growth in the degree of excess payment of executives in the United States. Rather, on this interpretation, the main cause of the increase in pay is the greater challenges and opportunities facing executives who manage much larger combinations of resources.
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