cato executive pay regulation vs market competition cato policy analysis no 619

8/14/2019 CATO Executive Pay Regulation vs Market Competition Cato Policy Analysis No 619

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The economic slowdown and the active politi-cal season are generating calls for imposing newregulations on executive pay. The presidential can-didates ofthe two major parties have lashed out atwhat they perceive to be excessive pay for certainexecutives or for corporate executives in general.

Such populist sentiments are often based onmisunderstandings about the role of corporateexecutives in the economy and the vigorous com-

petition that exists for these highly skilled lead-ers. In the past, federal regulatory efforts basedon such misunderstandings have generatedunintended consequences, which have damagedthe economy and hurt the ability of the marketfor executives to self-regulate over time.

The labor market for executives and the asso-ciated pay levels are already subject to high levelsof regulation. Indeed, U.S. corporations are sub-ject to more stringent executive pay disclosurerequirements thancorporations anywhere else inthe world. Before additional regulatory and leg-

islative efforts are unleashed, policymakersshould examine the rationale for current paystructures and the strong links between executive

pay and corporate performance.The misperceptionsthat drive regulatoryefforts

are grounded in the idea that the market for execu-tives is not competitive and that pay levels do notreflect supply and demand for talent. Critics claimthat executivesessentiallysettheirown paythroughtheir influence over the boards of directors of cor-porations. This myth of managerial power leadssome policymakers to conclude that greater gov-

ernment regulation isnecessarybecause themarketis rigged. However, a large body of empiricalresearch documents that labor markets for execu-tives are indeed competitive, and that pay levelstrack corporate performance.

This study examines the market forces that setthe parameters of executive compensation, theprocess that boards use to determine pay pack-ages, and the data that indicate the efficient work-ings of the current pay-for-performance model.It also discusses the adverse consequences ofimposing rules and regulations on an executive

compensation system that has helped to generategreat wealth for shareholders and millions of jobsfor American workers.

Executive PayRegulation vs. Market Competition

by Ira T. Kay and Steven Van Putten

_____________________________________________________________________________________________________

Ira T. Kay is global practice director of executive compensation consulting at Watson Wyatt Worldwide. Steven VanPutten is a practice leader of Watson Wyatts executive compensation consulting practice.

Executive Summary

No. 619 September 10, 2008


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Overview of the Issues

The executive pay model widely used in theUnited States is essential to the success of U.S.

corporations and continued growth in theeconomy. But this pay-for-performancemodel is now threatened by overregulation,which is driven by misperceptions about thelabormarketforexecutivetalent.Thatis unfor-tunate, because the competitive system of exec-utive pay has helped fuel business growth,which has generated wealth for shareholdersand opportunities for corporate employees.Attempts to control the labor market for exec-utives and reshape the pay levels it producesmay undermine this successful system.

The success of the U.S. economy is closelyconnected to its unique approach to humancapital. This approach is based on relativelyunregulated labor markets, high labor mobili-ty, and a century-long reliance on variousforms of incentive pay. In general, labor mar-kets in the United States are among the leastregulated in the world.1 Job candidates enterthe market and compete with other candidatesfor the highest wages, while employers pay thewages required to recruit and retain talent andmotivate performance. Supply and demand

generally set the parameters for pay, withoutthe government restricting howmuch employ-ees can earn for the value they create.

The U.S. labor market for corporate execu-tives is an important exception to the generalU.S. policy of minimizing labor market regu-lation. Critics have argued that the labor mar-ket for executives does not reflect supply anddemand for executive talent, and that execu-tives essentially set their own pay throughpower over their boards of directors. Compli-ant human resources executives, compensa-

tion consultants, and board members bend tothe will of the chief executive officer (CEO) inshaping executive pay packages. We refer tothis view as the myth of managerial power.2

Productive discussions about the bestmethods of setting executive pay have beenpartly preempted by faulty assumptionsabout executive pay promoted in the popular

press and the business media. Media storiesoften portray a corporate America ruled byexecutive greed and excess.

Nevertheless, meaningful debates aboutexecutive compensation are taking place. In a

recent Watson Wyatt survey of board mem-bers of major corporations and institutionalinvestors, we found that board membersbelieve that the pay-for-performance modeldirectly contributes to improved corporateperformance.3 By contrast, many institutionalinvestors tend to view executive pay as exces-sive.Giventhese differencesinhow boardsandinvestors assess executive pay, the two groupsneed to work togetherto continuerefining paystructures. The important point is that execu-tive pay structures evolve over time and are

subject to ongoing reforms within a competi-tive market environment.

A Dynamic and Competitive MarketThe parameters for executive pay are deter-

mined by supply and demand, and incentivepayouts for executives are generally deter-mined by performance. In the market for topcorporate executives, companies search forand hire CEOs from an extremely small poolof people. Those people must be capable ofmanaging large and complex organizations

and be willing to risk a large portion of theirpayon their ability to increase company valueMany executives are paid handsomely, buttheir pay reflects only a small share of the tril-lions of dollars of wealth they help to createfor shareholders.

The labor market for CEOs is very com-petitive. They are hired and fired, and theirpay goes up and down, commensurate withthe performance of their companies. Thatconclusion is based on our own research andthe results of many academic studies.4 But

this reality of the competitive pay environ-ment of Americas executives is at odds withthe myth of managerial power.

Many examples show how executive pay-for-performance works, but lets look first atstock options. Although stock options havebecome less popular recently, they remain thearchetypal executive pay program and are still

2

The parametersfor executive pay

are determinedby supply and

demand, andincentive payouts

for executivesare generally

determined byperformance.


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granted to thousands of CEOs. Table 1 reportsour analysis of the relationship between the

total return to shareholders generated by com-panies and the related stock option compensa-tion for executives.5 A review of the largest1,088 companies in the United States in 2006shows that the higher-performing companiesprovided larger stock option profits to execu-tives and the largest increase in stock optionprofits over the prior year. Thus, executives incompanies that performed well were rewardedfor that better performance.

As with most markets, outliers exist in theexecutive pay market. At some companies,

the executive does not demonstrate excep-tional performance and still receives substan-tial pay. Such outliers are often challenged byshareholders and called out in the press. Butthe market usually corrects itself, and suchexecutives are commonly ousted for poorperformance. The outliers push the bound-aries of the system, but they spur self-regula-tion and reform.

Most economists and executive payexperts believe that the labor market for exec-utive talent functions well. Supply and

demand primarily determine the amount ofcompensation that executives receive, whileother institutional factors, such as manageri-al power and the structure of corporateboards, play a minor and secondary role.Here is some of the evidence that the U.S.market for corporate executives is competi-tive and efficient:

Executives always have theoptionto quit,and manydo. One ofthe primaryrespon-

sibilities of corporate boards is to ensurecontinuity of management. Boards knowthat if executives are underpaid, they canleave and gain higher pay elsewhere. Thecost of a highly skilled executive quittingcan be billions of dollars in market capi-talization.

Newlyhired CEOs from outside areoftenpaid much more than internal promo-tions. The managerial power argumentcannot explain that differential.

High-performing companies reward

executives with higher realizable paythan low-performing companies, as weexamine below.

Market pressures work. In recent years,boards and executives have responded tomarket pressures by putting in more per-formance-based pay programs and reduc-ing or eliminating non-performance-based programs, specifically severance,perquisites, and executive supplementalpensions.6

Prior attemptsto reduce paythrough leg-

islation and regulation have probablyresulted in higher, not lower,payforexec-utives. Examples include the limits ongolden parachutes, the $1 million cap onthe tax deductibility of certain corporatepay, and enhanced proxy disclosure.These rules have generally not reducedpay but forced corporate boards to adopt

3

Prior attemptsto reduce paythroughlegislation andregulation haveprobably resultein higher, notlower, pay forexecutives.

Table 1

Company Returns and Profits on Stock Options

Companies Executive Profits on Stock Options

Number of One-Year 2005 2006 Change (%),

Companies Return (%), 2006 $millions $millions 20052006

Companies Creating High Returns 544 28 6.6 10.8 63

Companies Creating Low Returns 544 -3 8.8 5.5 -38

All Companies 1,088 12 7.9 7.6 -4

Source: Watson Wyatt Worldwide data.

Notes: All numbers and percentages are medians, except for the number of companies. Returns refer to total share-

holder returns (stock price appreciation plus dividends).


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different and often less effective types ofcompensation.

Peer group pay data are used appropri-ately by corporate boards. Critics believethat corporate management cherry-

picks data to support large pay increas-es, but academic studies do not supportthat contention.7

We document and discuss these points fur-ther throughout this report.

Goals of ExecutiveCompensation

Corporate boardsdesignexecutivepaypro-

grams to attract, retain, and motivate execu-tives to perform at high levels. Motivationplays an important role in companies abilityto achieve high returns and to encourage exec-utives to make decisions that increase share-holder value. Incentive pay programs are par-ticularly effective motivators, especially at thetop level of businesses. The small cost savingsthat would occur from reductions in incen-tive-based executive compensation would like-ly be far outweighed by the resulting declinesin productivity, profitability,and stock market

returns.For executives, base pay provides a stable

source of income set at competitive levels,while other fixed pay and benefits are usefulforattracting andretainingtalent. Annualandlong-term pay incentives motivate perfor-mance that contributes to the creation oflong-term value. Pensions, supplemental exec-utive retirement plans, and deferred compen-sation plans promote retention and companyaffiliation. Severance plans allow executives totake the risks necessary to maximize share-

holder value even if that means jeopardizingtheir own jobs.

Executive pay programs must also alignwith broader employee pay programs so thatefforts are synchronized throughout theorganization. In addition, executive pay pro-grams must send effective signals to stake-holdersespecially shareholdersabout the

companys strategic imperatives. And finallypay programs must meet specific businessneeds within specific environments. If a com-pany is suffering from declining revenues, forexample, the pay program should reward

executives for not only profitability but alsofor revenue growth. At the same time, forgrowing companies pay packages shouldfocus on profitability and returns in excess ofthe cost of capital employed.

Competitive Pay Needed to ControlTurnover

Any employer who underpays an employeerelative to the market risks losing that employ-ee and the value he or she brings to the compa-ny. Boards try to ensure continuity of manage-

ment, but they face a constant threat of losinga CEO if more lucrative opportunities arise.This is the primary consideration of corporateboards compensation committees when theyset executive pay.The turnover rate for CEOs isvery high and acts as a constant reminder toboards that CEOs can leave their jobs. In 2007CEOs changed at 57 of the Standard & Poors500 companies.8 Between 1995 and 2006annual CEO turnover increased 59 percent,according to a survey of the worlds 2,500largest publicly traded corporations.9 In the

United States, almost half of the largest corpo-rations will have to replace their CEOs over thenext four years, according to aHarvard Business

Review study.10

Many of these departing CEOs are poachedby other companies. In 2005, for exampleOffice Depot took Steve Odland from Auto-zone, and Hewlett-Packard took Mark Hurdfrom NCR. The number two and three execu-tives at Motorola, NCR, Bellsouth, and GeneralElectric were recruited in the early 2000s tobecomeCEOs at Tyco,Hewlett Packard,Sprint

3M, and Home Depot, respectively.The recruiting packages offered are often

large, partly because successful executivesusually have unvested restricted stock andstock options for which they need to be com-pensated when they move. In addition, com-panies need to offer executives upside opportunities when they come on board. However,

4

Corporate boardsdesign executivepay programs to

attract, retain,and motivateexecutives to

perform at highlevels.


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compensation committees have not lostcontrol of the pay process, as critics claim,they are simply buyers of talent in a tightlabor market.

The cost of a high-performing CEO quit-

ting can be billions of dollars in market capi-talization. Imagine what it mightcost Apple tolose Steve Jobs. Among North American cor-porations, announcing the departure of aCEO with a two-year record of strong perfor-mance pulls the companys stock price downby an average of 10.2 percentage points com-pared with thebroad market average over a 30-day period, according to a 2007 Booz AllenHamilton study.11

Similarly, a 2003 study of 872 CEO depar-tures by the Federal Reserve Bank of New

York found that equity volatility increasesfollowing CEO turnover, even when the CEOleaves voluntarily and is replaced by someonefrom inside the firm.12 These market reac-tions are measures of the contributions ofCEOs to the success of companies.

Although CEOs have a substantial impacton corporate performance, CEO pay is a verysmall part of the overall cost structure ofcompanies. Table 2 compares total CEO payto total sales, market capitalization, and netincome for a sample of 1,398 U.S. corpora-

tions. Total CEO pay in 2004 was just 0.09percent of sales, 0.06 percent of market capi-talization, and 1.3 percent of net income forthe companies.

These findings are consistent with a studyby Brian Hall and Jeffrey Liebman, whofoundthat dramatic increases in CEO payarenot very large relative to the market values of

firms.13 Corporate compensation commit-tees, for good reason, are not willing to riskcontinuity and performance in an attempt tosave relatively small sums of money.

Boards also understand that the loss of key

executives threatens a large portion of corpo-rate assets in the form of disrupted strategy,hostile takeovers, loss of revenue, and othercosts. The risks and costs of losing executivesare clear to compensation committees, whichhave continued to provide high and often ris-ing executive pay despite outbursts of publicdisapproval, negative media attention, andcriticism of board members.

Low Supply, High Demand

High executive compensation is a marketoutcome caused by limited supply and highand rising demand for top talent. Considerthe supply of executive talent. The number ofindividuals who have the ability and willing-ness to make the tough decisions necessaryto run large companies is very small. A CEOmust make complex business decisions suchas pursuing capital investments that earnhigh returns and divesting underperformingunits, even if that means downsizing an orga-

nization that the executive helped to build.Across all U.S. labor markets where skill and

experience are valued, demographic trends arecreating a large number of retirements withouta sufficient supply of replacements. The medi-anageof U.S.CEOs is56,and the average age ofCEOretirement is 61.14 Fewer candidates in thelower age groups are moving into the labor

5

Although CEOshave a substantiimpact oncorporateperformance,CEO pay is a versmall part ofthe overall coststructure of

companies.

Table 2

CEO Pay and Corporate Costs, 2004

CEO Pay as a Share of

CEO Pay Sales Market Cap Net Income Sales Market Cap Net Income

$6.9 billion $8.1 trillion $12.0 trillion $552 billion 0.09% 0.06% 1.3%


Notes: The sample is 1,398 U.S. corporations. CEO Pay includes salary plus bonus plus stock options exercised plus

long-term incentive payouts. Market Cap means market capitalization.


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market for executive talent. At the same time,hedge funds and venture capital funds areincreasingly sucking top talent out of the cor-porateworldbecause ofthehuge sums they canpay. John Joyce of IBM, Vivek Paul of Wipro,

andRichard Bressler of Viacomareexamples ofhighly successful executives who left the corpo-rate world to work for private equity firms.15

In addition, as therisks andresponsibilitiesof leading major public corporations grow,top executives canbe recruitedaway by privatecompanies, which can pay executives morewithout having to faceintensive scrutiny. Also,the opening up of financial markets since theearly 1980s has given U.S. CEOs greater accessto capital for financing their own start-upbusinesses, which has raised the value of alter-

native entrepreneurial opportunities.The long-term supply of potential corpo-

rate executives is also decreasing because tal-ented people graduatingwith a masters degreein business administration (MBA) are enteringmore lucrative professions, such as investmentbanking, venture capital, and managementconsulting. While corporate boards increasing-ly want CEOs with MBA degrees, many of thebest MBAs are moving into consulting andfinancial firms where the rewards can be high-er and the risks lower.Among the 914 Harvard

MBAs graduating in the class of 2007, 22 per-cent accepted consulting jobs; 20 percentmoved into private equity, hedge funds, andventure capital firms; and 18 percent left theUnited States to work abroad.16

Although finding talented executives hasbecome more difficult, corporate boards havefaced growing pressure to terminate CEOswho perform poorly. CEOs are being fired at ahigh and rising rate. In 1995, one in eightdeparting CEOs was forced from office; in2006, nearly one in three left involuntarily.17

Proponents of the managerial power the-ory claim that the entrenchment of CEOsand boards often leads to the failure to dis-miss poorly performing CEOs. The reality isprobably the opposite. There is a growingrisk that boards are becoming too aggressiveat dismissing executives. The pressure foraccountability to shareholders has raised the

possibility that shareholders may agitate forCEO dismissal in response to short-run per-formance changes, even when those changesare beyond the CEOs control.18

At thesametime that thesupply ofexecutive

talent is shrinking, the demand for highly per-forming executives is increasing. One reason isthat corporate boards are now looking for dif-ferentskillsinhiringexecutives than they didinthe past, and the number of executives whopossess those skills is extremely limited. Todayboards look for broad managerial ability, deepexperience at the CEO level, and demonstratedmastery of management, finance, and otherdisciplines.

In addition, U.S. corporations have in-creased in size dramatically over the past

decade, thus increasing the responsibilities ofCEOs.CEOs at thelargest companiesnow han-dle revenues that run into the hundreds of bil-lions of dollars and manage tens of thousandsof employees. A 2007 Conference Board reportconfirms that compensation for CEOs riseswith company revenue, as does the portion ofpay placed at risk.19 CEOs of the 10 largest U.Scorporations collectively manage more than $2trillion a year in revenues, an amount equal to15 percent of U.S. gross domestic product.

Newly hired CEOs are paid much more

than internally promoted CEOs, another factthat undermines themyth of managerial pow-er. According to The Corporate Library, anindependent corporate governance researchgroup, the average total compensation of out-side-appointed CEOs in 2005 was 2.6 timesmore than inside-appointed CEOs.20 Theanalysis is based on a study of the compensa-tionof52CEOsintheS&P500:32wereinsideappointments and 20 were not.

In addition, the increasingly global andcompetitive business environment pushes

boards to hire outsiders with broad skills,rather than just firm-specific skills. In animportant 2007 study, Kevin Murphy andJn Zbojnk document the shift toward hir-ing outside CEOs who have broad manageri-al ability.21 The broader skill set needed bytop corporate executives today commandshigher pay in the marketplace.

6

U.S. corporationshave increased insize dramatically

over the pastdecade, thus

increasing theresponsibilities

of CEOs.


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Murphy and Zbojnk report that duringthe 1970s and 1980s, outside hires accountedfor 15 percent and 17 percent of all CEOreplacements, respectively. By 2005,40 percentof all CEOs were hired from outside of com-

panies.

22

Boards have also raised their require-ments for these outside hires. The percentageof outside hires with prior experience as CEOat a publicly traded company rose from lessthan 20 percent in the 1970s to nearly 50 per-cent in the 1990s. Further, boards increasinglydemand that new CEOs have an MBA. In the1970s 13.8 percent of all new hires held MBAs,which compares with 28.7 percent in the1990s.

Murphy and Zbojnk find that the body ofknowledge that must be mastered by an effec-

tive CEO has exploded. For example, CEOsincreasingly must be able to communicatewith external constituencies, including thecapital markets, stock analysts, large institu-tional shareholders, and the media. In contrastto claims that executive pay is rising becausethe market is broken, Murphy and Zbojnkconclude that higher pay is evidence that themarket for CEOs is becoming more importantin determining CEO pay levels.23

Another mark of a robust labor market isthe substantial variation in pay for executives

across companies, which reflects differences indemand and growth opportunities. Executivecompensation reflects the different skillsrequired in various industries and the degreeto which CEOs can affect a companys perfor-mance. Companies in regulated industries, forexample, generally pay less than companies inunregulated industries, in part because of themore limited growth opportunities.24

Executive Pay TracksCorporate Performance

Executive pay has risen dramatically overthe past 10 to 15 years, faster than inflationand faster than average employee pay.However, pay has generally not risen fasterthan the broad stock market and individualcompany share prices. Indeed, there is a tight

relationship between executive compensa-tion and corporate financial performance, aswe explore here.

To understand whether executive paytracks corporate performance, we need to

distinguish between pay opportunity andrealizable pay. The key differences are asfollows:

Pay Opportunity. This is what a boardscompensation committee actually con-trols and sets, namely annual bonusopportunities and the fair or economicvalue of new long-term incentive awards,including stock options, time-vestedrestricted stock, and performance shares.

Realizable Pay. This is the actual cash

bonus paid, the in-the-money value ofstock options, the real value of restrictedstock, plus the payout from performanceplans.Realizable payis determined by theactual financial performance of compa-nies and stock price appreciation. Com-pensation committees do not directly setrealizable pay, in large part because com-mittees do not know what stock priceappreciationwill occur when they set payopportunity.

The key to accurately evaluating executivepay is to look at realizable pay compared withcorporate performance over a specific period.Our research demonstrates that realizablepay closely tracks corporate performance. Ifboth company financial performance andstock price appreciation are weak, then real-izable pay will be low. If company perfor-mance and stock appreciation are strong,then realizable pay will be high. By contrast,we find no correlation between pay opportu-nity and company performance because pay

opportunity is competitively set and relativelyindependent of recent performance.

The Data on Pay and PerformanceTable 3 examines data on 1,072 major cor-

porationsinthe S&P Super1500between 2004and 2006. The data are broken out betweencompanies generating high total returns to

7

Our researchdemonstratesthat realizablepay closely track

corporateperformance.


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shareholders andthose generatinglowreturns.The two right-hand columns show that CEOsin high-earning companies earned far morerealizable pay than CEOs at companies withlow earnings. They earned 75 percent morerealizable total direct compensation (TDC),which is annual cash compensationbasesalary plus actual annual incentive earnedplusthe economic value of long-term incentive

awards on the date of grant. And these CEOsearned three times as much in realizable long-term incentives (LTI), which comprise the in-the-money value of stock options, period-end value of restricted stock, and payouts fromlong-term performance plans.

These higher returns for high-performingexecutives are not baked in the cake when

executive pay packages are originally offeredThe proof is that the correlation betweencompany performance and LTI opportunity isvery weak, as shown in Table 4. Thus, execu-tive skill at producing high returns for share-holders is what generally determines theactual compensation that CEOs receive.

Table 5 further illustrates the alignmentof pay and performance. Executives at low-

performing firms earned a much smallershare of their LTI opportunity and TDCopportunity than did CEOs at high-performing companies. These results show the sensi-tivity between actual pay and performanceamong todays executivesCEOs who do notachieve strong performance do not earn theirfull pay opportunity.

8

CEOs who do notachieve strong

performance donot earn their full

pay opportunity.

Table 3

Realizable Pay for CEOs and Company Performance

Companies Executive Compensation

Cumulative Cumulative Cumulative

Number of Returns (%), Realizable Realizable

Companies 20042006 LTI, $millions TDC, $millions

Companies Creating High Returns 536 99 5.2 10.5

Companies Creating Low Returns 536 17 1.7 6.0

All Companies 1,072 49 3.3 7.9


Notes: LTI is long-term incentives; TCD is total direct compensation; returns refer to total shareholder returns (stock

price appreciation plus dividends). All numbers and percentages are medians, except for the number of companies.

Table 4

Pay Opportunity for CEOs and Company Performance


Cumulative Cumulative LTI Cumulative TDC

Number of Returns (%), Opportunity, Opportunity,

Companies 20042006 $millions $millions

Companies Creating High Returns 536 99 4.8 9.9

Companies Creating Low Returns 536 17 4.3 8.4

All Companies 1,072 49 4.6 9.2


Notes: LTI is long-term incentives; TCD is total direct compensation; returns refer to total shareholder returns (stockprice appreciation plus dividends). All numbers and percentages are medians, except for the number of companies.


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A common myth is that CEO pay onlyincreases over time, regardless of companyperformance, creating ever-higher compensa-tion levels. Our data show that while execu-tive payoften increases, it sometimes decreas-es. As noted earlier, realizable TDC dependson company performance. Not surprisingly,

Table 6 shows a decrease (3 percent) in realiz-able TDC for low-performing companies andan increase (13 percent) for high-performingcompanies in the period examined.

CEOs also experienceincreases anddecreas-es in annual paid cash bonuses. Table 7 showsthat paid annualincentives fluctuate fromyearto year depending on company performance.

CEOs at low-performing companies saw a 23percent decline in their paid annual incentivesfor the year shown, while CEOs of high-per-forming companies enjoyed a 22 percentincrease.

Factors in Setting Pay

Skeptics of the efficiency of executive paypractices argue that managerial power createsupward bias in all forms of CEO compensa-tion. They claim that directors approve exces-sive pay packages to curry favor with CEOs inexchange for high fees, reappointment, andspecial perquisites. That claim overlooks themarket-based process that boards use to set

9

A common myth

is that CEO payonly increasesover time,regardless ofcompanyperformance.

Table 5

Company Performance and Full Pay Opportunity


Ratio of Ratio of

Cumulative Cumulative

Cumulative Realizable LTI to Realizable TDC to

Number of Returns (%), Cumulative LTI Cumulative TDC

Companies 20042006 Opportunity (%) Opportunity (%)

Companies Creating High Returns 536 99 122 109

Companies Creating Low Returns 536 17 45 79

All Companies 1,072 49 77 96


Notes: LTI is long-term incentives; TCD is total direct compensation; returns refer to total shareholder returns (stock

price appreciation plus dividends). All numbers and percentages are medians, except for the number of companies.

Table 6Change in Cumulative Realizable Pay between Three-Year Periods

Companies Cumulative Realizable Pay (TDC)

Cumulative Change in

Number of Returns (%), 20032005, 20042006, Median

Companies 20042006 $millions $millions (%)

Companies Creating High Returns 379 94 9.8 11.1 13.1

Companies Creating Low Returns 379 17 6.9 6.6 -3.4

All Companies 758 48 8.6 8.7 1.8

Source: Watson Wyatt Worldwide data.Notes: TDC is total direct compensation; returns refer to total shareholder returns (stock price appreciation plus divi-

dends). All numbers and percentages are medians, except for the number of companies.


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executive pay opportunity, beginning withpeer group benchmarking.

Virtually all boards use peer group bench-marking to gain knowledge of the pay levelsoffered by competitors. An important 2007study of pay-setting practices found that com-petitive benchmarking is used to gauge themarket wages of CEOs and to efficiently adjustpay as necessary to retain executive talent.25

The managerial power explanation is alsoundermined by the fact that boards have

become more, not less, independent over time.This increased independence coincides with ariseinexecutivecompensationandtheincreasein CEOs hired from outside companies, whichis contrary to the idea that rising pay is evi-dence of powerful incumbents controlling cap-tive boards.

The Securities and Exchange Commissionrequirescompaniesthat usepeer groupdata formaking benchmark comparisons of executivepayto disclosethenamesofthepeer companiesin their proxy statement. Also, compensation

committees aggressively seek out objectiveinformationtohelp them with thedifficulttaskof setting CEO pay. Compensationcommitteesmustcontinuouslybalance twogoals: retainingand motivating their executive team and mini-mizing company costs.Committees struggle toensure that they do not waste corporate assetsin the form of excessive pay.

Creating the right CEO pay package at thetime of hiring, and at annual reviews, takes anintensive effort on the part of compensationcommittees. It requires data, expertise, and judgment. In addition to peer group datacompensation committees consider companyperformance and possible changes to compa-ny strategies, which may entail acquisitions,new product lines, and other changes. Theyconduct risk assessments of the voluntarydeparture of their CEO and the costs of

replacing their CEO. In sum, compensationcommittees must balance many factors tomotivate and retain executives while aligningtheir objectives with those of shareholders.

Some critics of U.S. executive paypoint outthat top executives in other countries are gen-erally paid less than their U.S. counterparts.The international pay gap arises, they claim,because foreign CEOs do not have the samepower over their boards. However, an impor-tant study by Randall Thomas of VanderbiltUniversity LawSchooldocumentsthereal rea-

sons behind the pay differential.26 The studyfinds that U.S. CEOs are paid more, on aver-age, than foreign CEOs because they con-tribute more to their firms value. AmericanCEOs typically play a much larger role in thedecisionmaking processes of their firms thanCEOs at foreign firms. In addition, Americanfirms have greater growth opportunities and

10

U.S. CEOs arepaid more, onaverage, thanforeign CEOs

because theycontribute more

to their firmsvalue.

Table 7

Change in Actual Paid Annual Incentives for Executives, 20052006


Actual Actual

Paid Annual Paid Annual Change

One-year Incentive Incentive in

Number of Change in in 2005, in 2006, Median

Companies Returns (%) $thousands $thousands (%)

Companies Creating High Returns 544 28 746 907 22

Companies Creating Low Returns 544 -3 647 500 -23

All Companies 1,088 12 670 728 9


Notes: Returns refer to total shareholder returns (stock price appreciation plus dividends). All numbers and percentages

are medians, except for the number of companies.


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more resources to be deployed because theyare oftenlarger.Furthermore, AmericanCEOsreceive more of their pay in the form of stockoptions, and may hold more of their wealth incompany stock than foreign CEOs, thus their

higher pay also reflects a risk premium.

Fixing the Marketfor Executives

The issue of CEO compensation has oftenbecome political fodder, which has promptedfederal policymakers to enact new laws and reg-ulations tocontrolvariouselementsofexecutivepay. In the 1992 presidential campaign, BillClinton promised to end the practice of allow-

ingcompanies to takeunlimitedtax deductionsfor excessive executive pay.27 More recently,both major candidates in the 2008 presidentialelection have lashed out at what they perceive tobe excessive pay for executives.28 History teachesus, however, that federal reforms and new reg-ulations distort markets and will likely haveunintended consequences.

Direct regulation of executive pay occursthrough the actions of the Securities and Ex-change Commission, the Financial AccountingStandards Board, and the Internal Revenue

Service. In addition, Congress occasionallypasses legislation that attempts to control exec-utive compensation practices.

One example of the unintended conse-quences of new federal rules arose from therecessionof theearly 1990s.At thetime, criticsargued that inefficient executive pay policieswere hurting Americas ability to compete inthe international marketplace. That concernled to legislation passed in 1993 creatingSection 162(m) of the Internal Revenue Code,which eliminated corporatetax deductions for

executive pay in excess of $1 million that wasnot deemed to be performance-based pay. Butrather than limiting executive pay as intended,Section 162(m) led to dramatic increases inthe use of performance-based compensation,particularly stock options, which subsequent-ly came under attack as a source of excessivecompensation.

Concerns about excessive executive payduring the 19901991 recession also touchedoff new disclosure efforts. In 1992, the SECissued rules that required greater executivecompensation disclosure. As with most

reform efforts, however, this too had an unin-tended consequence. With enhanced disclo-sure, executive pay levels were transparent toall, which worked to the benefit of those exec-utives who were undercompensated relative tothe norm. Those executives then demandedhigher compensation.

In the mid- to late 1990s, criticisms ofexecutive pay and efforts to reform it dimin-ished as the economy flourished and share-holders reaped large returns. Throughout the1990s, the stock market continued its climb

virtually unabated. When the bubble poppedin the 2001 recession, it was clear that theexcessive use of options by some companieshad led to a short-term focus and, at a fewcompanies, illegal behavior. After the Enronscandal broke in the fall of 2001, a rush ofexternal pressures pushed open the door forradical changes in the laws and regulationsrelated to executive pay, including mostnotably the Sarbanes-Oxley Act, signed intolaw in 2002.

One of the more important parts of

Sarbanes-Oxley for executive compensation isthe prohibition on executive loans. Because ofthis prohibition, boards now need to be morecreative in how they induce executives to jointheir companies, often leading to more costlyalternatives such as restricted stock awards,up-front signing bonuses, and enhanced sev-erance. Ironically,these areallnow criticized aspay for nonperformance and as evidence ofinefficient executive pay structures.

Although U.S. executive compensationwasalready the most transparent in the world, the

SEC issued new executive compensation dis-closure requirements in early 2006. However,as often happens, the market reacted morequickly than regulatory bodies did, and hadalready implemented improved disclosure.The new disclosure rules may serve to reducethe outliers, but for most companies the newrules simply mandated what had already

11

Both majorcandidates in the2008 presidentiaelection havelashed out atwhat theyperceive to beexcessive pay forexecutives.


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become a best practice in executive compensa-tion.

The Financial Accounting StandardsBoard also rode the momentum of the post-Enron era and put in place mandatory stock-

option expensing under FAS 123R, effectivefor fiscal years beginning after June 15, 2005.This change has also produced unintendedeffects. One effect is that many companieshave reduced the number of employees whocanparticipate in equity programs. In the late1990s, the trend among employers was togrant more stock options to more employees,but with the expensing requirements of FAS123R, those plans have been scaled back.

This unintended effect of FAS 123R is dis-turbing because it reduces performance-en-

hancing incentives for nonexecutive employ-ees, which minimizes the alignment ofincentives throughout organizations. If any-thing, we should strive to make the pay mod-el for all employees more like the executivepay-for-performance model, not less.

The impact of FAS 123R is borne out byboth the magnitude of stock-option grantsand their value. Table 8 shows that total grantsize, as measured by the run rate (defined asstock options awarded as a percentage of acompanys common shares outstanding),

declined by almost a third from 2004 to 2006.Also, the estimated value of options grantedhas declined from $52 billion in 2004 to $40billion in 2006.

In the post-Enron environment, the IRSalso saw an opportunity to further regulateexecutive compensation. IRS scrutiny of non-qualified deferred compensation plans ulti-

matelyledCongress to passlegislation creatingSection 409A of the tax code. The new rulescreated significant restrictions on deferredcompensation programs. As a result of Section409A, and the reduced income tax rates of

recent years, the prevalence of deferred com-pensation is likely to decline. That is unfortu-nate because deferred compensation denomi-nated in company stock is an effective way topromote long-termshareholderalignment andshare ownership.

Executive Pay Practices Self-Regulate overTime

All these new rules as well as other federalinterventions are misguided because variousexternal and competitive pressures already

work effectively to reform executive pay prac-tices over time. Increasingly aggressive share-holder scrutiny, especially from institutionalinvestors, has created substantial pressure onexecutive pay practices. For example, largeinstitutional investors, and the organizationsthat advise them, generate detailed corporategovernance reform recommendations. Thesegroups wield substantial power, and corpo-rate boards are highly sensitive to their rec-ommendations.

The largest mutual funds also monitor

and evaluate executive pay practices; andunion-sponsored funds are another forcefulvoice. Other organizations have also steppedup their efforts to monitor and influenceexecutive compensation policies, includingthe Council of Institutional Investors andInstitutional Shareholder Services, Inc.

In response to suggestions from these

12

Competitivepressures already

work effectively toreform executive

pay practicesover time.

Table 8

Company Stock-Option Grants after FAS 123R

Percentage Change

2004 2005 2006 20042006 20052006

Grant Size (run rate) 1.6% 1.4% 1.1% -31% -21%

Total Estimated Grants, $billions $52 $43 $40 -23% -7%

Source: Watson Wyatt Worldwide data based on companies in the S&P Super 1500. The data for 2004 is prior to the

rule change.


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groups, and to keep up with the growing bodyof knowledge about best practices in compen-sation, boards are increasing the portion ofperformance-based pay in overall pay, reduc-ing severance, and reducing perquisites and

executive pensions. Some companies, forexample, are reducing cash severance pay-ments or moving from single triggers to dou-ble triggers on equity-vesting acceleration.29

Other companies are eliminating or modify-ing change-in-control gross-ups, which com-pensate executives for excise taxes imposed onseverance packages. Boards are also reducingexecutive benefits and perquisites that havebeen particularly criticized. From 2005 to2006, the median total value of benefits andperquisites for Fortune 100 CEOs declined

slightly.30

In 2006, 16 percent of Fortune 100companies reported that they were eliminat-ingsome perquisitesforexecutives. Allof theserecent reforms reflect the fact that the execu-tive labor market andthepay levelsit producesself-regulate over time.

Conclusion

Many types of evidence indicate that themarket-based and competitive executive pay

model in the United States is very effective.But the private sector should continue torefine best practices to sustain this effective-ness, while identifying specific shortcomingsthat companies should address on a volun-tary basis. At the vast majority of companies,boards work hard to determine the right mixof executive incentives in order to achievemaximum performance for shareholders.

The managerial power theorythat execu-tives are not compensated in an open andcompetitive mannerhas contributed to

meaningful and ongoing discussions aboutcorporate governance. However, when thattheory is taken too far, it leads to fundamen-tal misunderstandings about executives, theirpaylevels, andtheir role in building successfulcorporations. These misunderstandingssometimes lead policymakers to impose dam-aging regulations on the labor market and on

a pay model that is critical to vigorous busi-ness expansion and American economicgrowth. Occasional excesses in executive paycan be dealt with without regulating the over-all market and abandoning the core model of

pay-for-performance.Whether corporate success is measured instock price performance, productivity, oremployment, it starts at the top of the corpo-rate structure. The U.S. corporate model thathas generated so much wealth for Americancitizens will be seriously damaged if we takeaway or severely restrict the system of risksand rewards that attracts talented executivesand pays them to make the right decisions ona sustained basis.

Notes1. World Bank, Doing Business in 2008: UnitedStates (Washington: The World Bank, 2007),www.doingbusiness.org/documents/countryprofiles/usa.pdf.

2. For the managerial power argument, see LucianBebchuk and Jesse Fried, Pay without Performance:The Unfulfilled Promise of Executive Compensation(Cambridge, MA: Harvard University Press, 2004).

3. Watson Wyatt Worldwide, Reporton Directorsand Investors Views on Executive Pay and Corp-

orate Governance, February 28, 2008, www.watsonwyatt.com/research/resrender.asp?id=2008-US-0004&page=1.

4. See, forexample, the list of academic articles onpay-for-performance and the effectiveness of theexecutive labor market in Ira T. Kay and Steven

Van Putten, Myths and Realities of Executive Pay(New York: Cambridge University Press, 2007),pp. 24346.

5. Background on the concepts and data used inmany of the tables in this study can be found inKay and Van Putten.

6. Ibid.

7. For example, see John M. Bizjak, Michael L.Lemmon, andLalitha Naveen,Does theUse of PeerGroups Contribute to HigherPay andLess EfficientCompensation?Journal of Financial Economics, forth-coming, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1017338#paperdownload.

8. Meghan Felicelli, 2007 YTD CEO Turnover,

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The market-baseand competitiveexecutive paymodel in the

United States isvery effective.


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Spencer Stuart, December 31, 2007, www.spencerstuart.com/research/articles/1227.

9. Chuck Lucier, Steven Wheeler, and Rolf Habbel,The Era of the Inclusive Leader, strategy+business47 (Summer 2007): 3. Largest corporations mea-sured by market capitalization.

10. Kevin P. Coyne and Edward J. Coyne Sr.,Surviving Your New CEO,HarvardBusinessReview,May 1, 2007.

11. Cited in Lucier, Wheeler, and Habbel, p. 7.

12. Matthew J. Clayton, Jay C. Hartzell, and JoshuaV. Rosenberg, The Impact of CEO Turnover onEquity Volatility, Federal Reserve Bank of New

York Staff Reports no. 166, May 2003, p. 1.

13. Brian J. Hall and Jeffrey B. Liebman, Are CEOsReally Paid Like Bureaucrats? Quarterly Journal of

Economics 113, no. 3 (August 1998): 65391.

14. Spencer Stuart, Leading CEOs: A StatisticalSnapshot of S&P 500 Leaders, January 2008.

Available at www.spencerstuart.com.

15. Geoffrey Colvin, Catch a Rising Star,Fortune,February 6, 2006, p. 50.

16. Harvard Business School, MBA RecruitingReport 2007/2008 (Cambridge, MA: HarvardUniversity, 2008), p. 7.

17. Lucier, Wheeler, and Habbel.

18. Ray Fisman, Rakesh Khurana, and MatthewRhodes-Kropf, Governance and CEO Turnover:Do Something or Do the Right Thing? HarvardBusiness School Working Paper no. 05-066, April2005, p. 1.

19. The Conference Board, The Conference BoardFinds that CEOs Have a Lot of Financial Interest in

Common with Their Shareholders, news releaseDecember 31, 2007, p. 2.

20. TheCorporate Library, Inside/Outside CEOs,news release, March 12, 2007.

21. Kevin J. Murphy and Jn Zbojnk, Managerial

Capital and the Market for CEOs, Queens Uni-versity, Ontario, Department of Economics Working Paper 1110, April 2007.

22. Ibid., pp. 12.

23. Ibid., pp. 45.

24. Steve Balsam, An Introduction to ExecutiveCompensation (New York: Academic Press, 2002),pp. 4244.

25. Bizjak, Lemmon, and Naveen.

26. Randall S. Thomas, Explaining the Inter

national CEO Pay Gap: Board Capture or MarketDriven? Vanderbilt University Law School, Lawand Economics Working Paper no. 03-05, February7, 2003, pp. 613.

27. Politics and PolicyCampaign 92: FromQuayle to Clinton, Politicians Are Pouncing onthe Hot Issue of Top Executives Hefty Salaries,Wall Street Journal, January 15, 1992.

28. For example, see Joann S. Lublin, CandidatesTarget Executive Pay, Wall Street Journal, April 12,2008, p. A4.

29. Single triggers permit accelerated vestingupon a change in control, while double triggersadditionally require loss of job to trigger an accel-eration in vesting.

30. Equilar, Equilar Releases 2007 CEO Benefitsand Perquisites Report, November 9, 2007, http

//equilar.com/press_20071109.php.

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105. FASB: Making Financial Statements Mysterious by T. J. Rodgers(August 19, 2008)

104. A Fork in the Road: Obama, McCain, and Health Care by Michael Tanner(July 29, 2008)

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102. The Klein Doctrine: The Rise of Disaster Polemics by Johan Norberg(May 14, 2008)

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100. Is the Gold Standard Still the Gold Standard among Monetary Systems?by Lawrence H. White (February 8, 2008)

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cato executive pay regulation vs market competition cato policy analysis no 619

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