Is Executive Pay Too High? The $1 Million Question

By Eric Hosken and Dan Laddin, Compensation Advisory Partners | April 2014

Is executive pay too high? This question begs another: Relative to what? To many people, the answer seems obvious that executive pay is in fact too high. Executives are certainly paid significantly more than the typical worker in the United States. According to Equilar, in 2012 among the S&P 500, median CEO pay was $9.7 million and median CFO pay was $3.1 million. For perspective, that means that the CEO of an S&P 500 company made about 243 times the median wage for a full-time worker ($39,936) and about 190 times the median household income ($51,017) in the U.S. The more modestly paid CFO still earned 78 times the median wage for a full-time worker and 61 times the median household income. With that as background, how can anyone argue that executive pay is not too high?

For better or worse, we live in a society with extremely disparate distributions of income and wealth. However, public-company executives are not the only people who are highly paid in our society. There are numerous examples of other groups that earn comparable levels of compensation (e.g., professional athletes, entertainers) and broader groups of professionals that are not far off (e.g., hedge-fund managers, corporate lawyers, strategy consultants, etc.). In many of these cases, while people may be surprised or shocked by the level of compensation, there is a sense that they have earned their pay. LeBron James is paid an extraordinary salary to play basketball — during his first three seasons with the Miami Heat, James received an average annual salary of $17.04 million. However, one does not have to look too hard to see how his performance has positively impacted the Heat franchise. In addition to winning two NBA championships, James has helped increase the value of his team by more than 20% annually, from $425 million to $770 million between 2010 and 2013, according to Forbes. Similarly, the exceptional hedge-fund managers earn huge incentive fees, but generally have strong performance to justify their pay levels.

Executives of well-established public companies often get a great deal of flak for their pay as it is less obvious how their skills and contributions directly drive the value of the company. There is less pushback when a founder/CEO realizes extraordinary wealth, because his/her contribution, through vision, risk-taking and creativity, is often much clearer than for a CEO taking the reins of an established company.

Given the role that a CEO or CFO plays in setting corporate strategy and overseeing its execution, the change in the value of company's shares on an absolute or relative basis provides at least one means for assessing a CEO's performance. Similar to the management fees that asset managers or hedge-fund managers receive, an executive's pay level can be thought of as an administrative cost for overseeing very valuable assets. To some degree, as the market value of firms has increased over time, the value of their performance has increased as well. A 1% improvement of the share performance of a $1 billion firm is worth $10 million to shareholders; a 1% improvement of the share performance of a $10 billion firm is worth $100 million to shareholders. If the company can find an executive team that can outperform the competition even by a small amount, it is likely rational to pay the executives handsomely. When Tim Cook received $376 million to lead Apple, it may have seemed like a high price to pay, but it is less so in the context of Apple's $349 billion market capitalization at the time.

In our view, trying to systematically lower the compensation of executives across the board is fighting a losing battle and may not even be fighting the right battle. If a compensation committee tries to reduce the pay levels for the executive team, it runs the risk that a competitor will poach high-performing executives. If instead, the government attempts to cap pay levels for public-company executives in the U.S., we might see executive talent move to private companies or other countries without caps. Our view is that a more productive effort is to focus on identifying better measures of company performance and ensuring that executive compensation is closely tied to company performance and shareholder value creation. Fortunately, in our experience, this is where compensation committees are currently focusing most of their efforts.

For example, we view the shift toward long-term performance plans as a generally positive trend. When designed well, these plans help ensure that executive pay levels are aligned with demonstrable financial or stock price results. The increasing prevalence of long-term performance plans with payouts based on total shareholder returns relative to market competitors is an example of compensation committees working to ensure that pay levels for their executives are dependent on outperforming other companies. Other companies set long-term performance goals based on achieving specific financial performance objectives. For these companies, the challenge is in ensuring that achievement of the goals they set will meet or exceed shareholder expectations. In our experience, compensation committees are becoming more assertive in pushing executives to set rigorous goals and utilizing a combination of metrics, often considering relative and absolute performance.

Over time, the question of whether executive pay is too high may become less critical. If compensation committees and consultants do their jobs right, executives who demonstrate strong performance will be paid very well and executives who do not meet expectations will receive much less incentive compensation. From the perspective of shareholders, the value created by high-performing executives will tend to dwarf the amount of compensation that they receive, even if they are paid much more than the typical worker.

We cannot credibly argue that public-company executives are not very well paid, particularly when compared to the average worker. When companies begin to disclose the ratio of the pay of the CEO to that of the median worker, the ratios may be shocking to people who are unfamiliar with executive compensation. Still, we are not convinced that executive pay levels are not competitive. They are set in a competitive marketplace with much more transparency than most markets. The compensation committees that establish CEO pay levels tend to be filled with experienced corporate executives with strong negotiation skills. Shareholder advisory firms and the say-on-pay votes that many companies conduct annually help to ensure that shareholders have as loud a voice as ever when it comes to compensation.

About the Author
Eric Hosken is a partner at Compensation Advisory Partners in New York. He can be reached at eric.hosken@capartners.com.
Dan Laddin is a partner at Compensation Advisory partners in New York. He can be reached at daniel.laddin@capartners.com.

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