CEO Pay is a Shareholders Issue !!!
Presidential candidates once campaigned on taxes, government spending, and foreign policy. But more recently, executive compensation has suddenly become a hot topic for winning the public’s approval. In the U.S., Donald Trump has called high CEO pay “a total and complete joke” and “disgraceful,” arguing that CEOs stack boards with their buddies who rubber-stamp excessive pay. Hillary Clinton has lamented that “There’s something wrong when the average American CEO makes 300 times more than the typical American worker.” And in the UK, Theresa May launched her ultimately successful campaign to become Prime Minister with a speech that proposed to curb executive pay.
Politicians typically make two suggestions for pay reform. First, to cap, or at least force the disclosure of, the ratio of CEO pay to median employee pay. Second, to put pay packages to an employee vote, or as May suggests, put workers on boards.
While I agree that a) in many companies, pay is far from perfect and ought to be reformed, and b) that political leaders are right to be concerned about how wealth is distributed in society, there are a number of problems with the proposed approaches.
It is shareholders who bear the costs of paying the CEO, and so it is unclear whether the government should intervene. A common argument is that high pay has indirect costs — in particular, it incents CEOs to take actions that hurt society. However, there is no evidence that the level of pay indeed has these effects. While it’s the level of pay that captures politicians’ (and the public’s) attention, it’s the structure of pay which matters more for firm value – for example, whether it vests in the short-term or long-term. Vivian Fang, Katharina Lewellen, and I find that, in quarters in which significant equity vests, CEOs cut R&D and capital expenditure in quarters in which significant equity vests. The electorate will be more impressed by a politician who proposes a headline-grabbing law to halve a CEO’s salary than a politician who extends the vesting horizon from three years to seven years, even though the latter will have a far greater impact on long-term value creation. Moreover, even shareholders didn’t take into account the effect of poorly-designed contracts on CEO actions; it’s not clear why the government should regulate pay rather than these actions themselves – surely the most direct route to curtailing them.
A second motivation to lower pay is to reduce inequality. However, attempts to curtail pay through regulation may backfire. Kevin J. Murphy describes how the entire history of executive compensation regulation is filled with unintended consequences. For example, the forced disclosure of perks in 1978 increased perks as CEOs could see what their peers were receiving; the 1984 law on golden parachutes – a response to a single contract at one firm — catalyzed the adoption of golden parachutes by alerting CEOs without them to their existence; and President Bill Clinton’s $1 million salary cap led to CEOs below the cap raising their salaries to above it, and those above merely reclassified salary as bonus.
Thus, while the motivation to reduce inequality is sound, a focus on pay ratios may have similar unintended consequences – and could even increase inequality. A CEO might reduce his company’s pay ratio by firing low-paid workers, converting them to part-time status, or increasing their cash salary but reducing their non-financial compensation (such as on-the-job training and superior working conditions). A cap could also lead boards to focus on the “optics” of pay (e.g. a low ratio) and ignore more important dimensions, such as performance targets being long-term rather than short-term.
So if capping the pay ratio wouldn’t work, what about putting workers on boards, or submitting CEO pay packages to an employee vote? There are reasons to be skeptical here as well. An employment contract is an extremely complex issue and cannot be whittled down to a simple number such as a pay ratio, which the vote might focus on. It covers topics such as the optimal vesting schedule, the appropriate mix of stock vs. options vs. salary vs. pensions vs. bonuses, whether industry performance be filtered out and, if so, how (indexed options? indexed stock? options on indexed stock? Stock with indexed performance vesting thresholds?) Confused? Well, so might employees be, should CEO pay contracts be put up for a vote.
Companies already have natural incentives to treat employees as valued partners to the business – one of my own studies showed that firms with high employee satisfaction beat their peers by 2-3%/year. Even if boards only cared about maximizing shareholder value, they should be consulting with employees and looking for ways to keep them happy. But there’s a big difference between consulting employees and putting them on the board. Firms do market research consulting customers, but don’t put them on the board. Indeed, Gary Gorton and Frank Schmid found that worker representation on German boards is associated with lower profitability and firm value.
Is the message to do nothing? Far from it. It’s to leave the decisions to major shareholders, who have the expertise and incentives to get these decisions right. After all, high CEO pay comes straight out of shareholder returns, and if the contract causes the CEO to take bad decisions – or demoralizes employees and customers – shareholders suffer the consequences. Unlike regulation, which is one-size-fits-all, shareholders can decide what the optimal pay package is for that particular firm.
And things are being done. We’ve indeed seen a substantial increase in shareholder power. 11 countries have passed say-on-pay legislation since 2002; Ricardo Correa and Uger Lel show in a forthcoming paper in theJournal of Financial Economics that such legislation has led to a significant reduction in pay and an increase in pay-performance sensitivity. We have also seen innovation in other dimensions of pay that are more important than ratios – for example, the lengthening of vesting horizons (to encourage the CEO to think for the long term) and paying executives with debt rather than just equity (to dissuade excessive risk-taking).
Moreover, when pay is inefficient, it is often a symptom of a more underlying corporate governance problem, brought on by conflicted boards and dispersed shareholders. Addressing pay via regulation will solve these symptoms; encouraging independent boards and large shareholders will. That will improve not only pay, but other governance issues.
What about equality? Steven N. Kaplan and Joshua Rauh showed that high CEO pay has actually not been a major cause of the rise in inequality – it’s risen much more slowly than pay in law, hedge funds, private equity, and venture capital. If inequality is truly the concern, it may be better addressed by a high rate of income tax and closing loopholes that tax investments at a lower rate. This will address inequality resulting from all occupations (including sports, entertainment, and trust funds); it’s not clear why CEOs should be singled out.
The bottom line is that, to the extent pay is a problem, it should be shareholders, not politicians or employees, who fix it.