Index Funds Are Fueling Out-of-Whack CEO Pay Packages
CEOs get paid handsomely. The pay of top managers has risen faster than those of other star earners. Often they’re paid generously even as the firms they head underperform relative to their peers.
Such performance-insensitive pay packages seem to defy both common sense and established economic theory on optimal incentives. Top management compensation packages guarantee a high level of pay, but are often only weakly linked to the performance of the firm relative to its industry competitors. Why, then, do company boards and shareholders of most firms approve those packages?
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We propose an answer to that question in our new research paper. By endorsing performance-insensitive compensation packages, broadly diversified investors are indeed incentivizing CEOs for good performance. Except that the performance that they’re rewarding is industry performance, not company performance. Why? These days, most firms’ most powerful shareholders tend to benefit more from the performance of the entire industry than the performance of an individual firm.
To understand this new explanation for seemingly exorbitant CEO pay, it’s important to understand a recent, fundamental shift in the ownership of U.S. public companies. Nowadays, the same handful of large, diversified asset management companies controls a significant proportion of US corporations.
For example, BlackRock is the largest shareholder of about one in five publicly-listed US corporations, often including the largest competitors in the same industry. Similarly, Fidelity is the largest shareholder of one in ten public companies and frequently owns stakes of 10-15% or more. Even Bill Gates’ ownership of about 5% of Microsoft’s stock is small compared to the top five diversified institutional owners’ holdings, which amount to more than 23%.
Magnifying their already large individual power, large asset managers also appear to coordinate many corporate governance activities, including those regarding compensation. The potential of coordination among BlackRock, Vanguard, and State Street is particularly potent given that their combined power makes themthe largest shareholder of 88% of all S&P 500 firms.
This sweeping development known as “common ownership” – the same firms owning the competing firms in the same industry – is relatively new. Twenty years ago, BlackRock and Vanguard were only very rarely among the top ten shareholders of any firm. On average, common ownership concentration has almost doubled in the last 20 years in the construction, manufacturing, finance, and services sectors.
Our research reveals that common ownership has had a significant impact on the structure of executive compensation. In industries with high common ownership concentration, top executives are rewarded less for the performance of their own firm but rewarded more just for general industry performance.
To understand the effect of common ownership on CEO pay packages, we analyzed total pay (including the value of stock and option grants) of the top five executives of S&P 1500 firms (which cover 90% of U.S. market capitalization) and 500 additional public companies. We studied those pay packages in relation to the firm’s performance, rival firms’ performance, measures of market concentration, and common ownership of the industry. We also examined interactions of profit, concentration, and common ownership variables. This allowed us to estimate both the sensitivity of CEO compensation to the performance of their own firm and of the industry’s other firms, as well the impact that common ownership has on these sensitivities. (We used a variation in ownership caused by a mutual fund trading scandal in 2003 to strengthen a causal interpretation of the link between common ownership concentration and top management incentives.)
We found that when firms in an industry are more commonly owned, top managers receive pay packages that are much less performance-sensitive. In other words, these managers are rewarded less for outperforming their competitors. This difference in compensation has a sizeable effect. In industries with little common ownership, executive pay is about 50% more responsive to changes in their own firm’s shareholder wealth than in industries with high common ownership.
What’s more, in industries with high common ownership, top managers receive almost twice as much pay for the good performance of their competitors as managers do in industries with low common ownership. This effect is even more pronounced for CEOs alone. Essentially, CEOs are rewarded more for the good performance of their competitors than they are for the performance of the company they run.
It’s not just the incentive package. The base pay reflects this, too. Our research shows that top managers’ base pay – the part of pay that does not depend on firm or industry performance – is also higher in industries with high common ownership.
In short, our research suggests that BlackRock, Vanguard, State Street, and other large asset management companies may be endorsing high, performance-insensitive compensation packages, because those don’t encourage competition among portfolio firms. These packages may be inducing managers to carefully consider the impact of their strategic choices on other portfolio firms.
Large asset managers have economic reasons not to incentivize competition among firms they own. After all, their revenue and their investors’ wealth depend on the total value of the portfolios they hold. As a result, it is not in their interest that one portfolio firm competes vigorously against another firm in their portfolio, such as engaging in a price war.
It is not clear that large, diversified shareholders such as BlackRock intentionally choose performance-insensitive CEO compensation for the explicit goal of discouraging intra-industry competition. They may choose it for other reasons, for example, to encourage cooperation or innovation. Maybe it’s not a conscious choice at all. It could simply be that large, diversified investors let performance-insensitive executive compensation slide because their corporate governance efforts are more passive than those of undiversified activist investors.
Still, other empirical studies have identified anti-competitive effects of common ownership. It has resulted in higher prices in the airline and banking industries. The underlying economic rationale is quite simple: if shareholders own not only one, but two or more firms competing in the same industry, these shareholders reap larger gains if the firms they own cooperate rather than compete aggressivelyagainst each other.
A question left open by the previous research is exactly how investors manage to convince the top executives of portfolio firms not to engage in costly price wars against each other, and instead to practice restraint when it comes to competitive strategy. One way to induce managers to act in their investors’ economic interest is executive pay.
But paying executives more when they outperform a competitor (academics call such a reward scheme “relative performance evaluation”) would have the effect of pitting one firm’s CEO against the other and of inducing such costly price wars.
There’s evidence of this dynamic in the tension between smaller undiversified investors (such as hedge funds) and large asset management companies. Whereas the former fight for more performance-sensitive pay that is benchmarked against competitors, the latter vote against them, instead often passing high and performance-insensitive pay that discourages competition between firms in the same industry.
This is an issue – and a tension – that we expect to grow as the trend toward common ownership continues. Our research sheds light on the changing nature of executive compensation, and apparent negative effects of weaker competition and more performance-insensitive pay. However, there may also be positive effects to common ownership. It’s possible that increased cooperation between firms benefits consumers. Certainly, people have benefited from the low-cost, diversified exposure to the stock market that large asset managers offer.
We hope our findings will lead to a better understanding of the effects of common ownership. Shareholders appear to benefit from diversification and higher industry profitability, and there are potential benefits to society from greater cooperation between firms. However, there is a negative impact on consumers due to reduced competition. Ultimately, we hope effective solutions can be reached to resolve the growing tension between shareholders, consumers, and society.