CEO pay: because you're worth it?

Jun 27 2005 by Brian Amble Print This Article

The stratospheric pay levels of many U.S. CEOs is often thought to be a reflection of sheer avarice. But according to a new study, eye-watering compensation packages reflect the need to recruit, retain and motivate talented individuals to manage increasingly complex organisations.

Writing in "Seven Deadly Sins", a new report for the Economic and Social research Council (ESRC), Martin Conyon, Assistant Professor of Management at Wharton Business School, argues that far from stemming from an attitude of 'greed is good', CEO compensation in the U.S. provides the right incentives for managers to focus on maximising corporate wealth.

Firms with more growth opportunities in the competitive global economy provide their CEOs with greater incentives than firms in mature industries, he suggests, but for all firms, these incentives arise not only from current pay but also from aggregate shares and share options owned.

Executive compensation typically has four components: base salary (usually competitively 'benchmarked' against peer firms); annual bonus (typically based on accounting performance); share options (which give the right to purchase shares at a pre-specified 'exercise' price); and other pay such as 'restricted stock grants'.

The combination of these elements means that U.S. CEOs are often handsomely rewarded. In 2000, for example, Jack Welch of General Electric received total compensation of about $125 million, including a $4 million salary, a $12.7 million bonus, $57 million in options and $48.7 million in restricted stock grants.

This package was linked to firm performance and was therefore well structured. Welch managed a large and complex organisation and under his leadership, General Electric's share price soared.

But in the wake of US corporate scandals like Enron and Tyco, even CEOs with stellar performance records have faced criticism: Welch was censured in the press for alleged non-disclosure of lavish retirement benefits.

There is also considerable variation in the way that CEOs are paid. For example, in 2003, Steve Jobs of Apple Computer received a salary of just $1 and no annual bonus or options, instead receiving restricted stock grants worth approximately $75 million.

This unusual arrangement illustrates how some pay packages are riskier than others, Conyon suggests, and provide powerful incentives to focus on increasing shareholder wealth.

He points out that if a CEO is paid in options, then as the share price increases, the value of their holdings also increases; if the share price declines, so too does the CEO's wealth. Salaries, in contrast, are typically not related to performance.

In the top US firms (those in the S&P 500) in 2003, average annual remuneration was $9 million and the median $6.7 million. But the majority of CEOs earn relatively low compensation while a small number of CEOs receive excessively generous rewards.

Based on this analysis, Conyon asserts that the idea that all CEOs are paid stratospheric sums is incorrect. Another reason he cites for some earning more than others is that CEO pay is positively correlated with firm size. Large, complex firms are more complicated to manage and require managers with relevant expertise. It is not surprising, he claims, that such firms pay their CEOs more.

The make-up of CEO pay has changed radically, too. Most importantly, the use of options exploded while salaries became a much less significant part of the overall pay package.

In 1992, salaries accounted for approximately 37 per cent of total pay and options a relatively modest 22 per cent. As the decade wore on, options became the single most important pay element while salaries declined in importance.

Now, salaries account for about one fifth of total pay and while the percentage of pay received as options has fallen to just over one third, it still remains the largest element.

So is CEO pay effectively linked to performance? Conyon argues that a considerable body of research demonstrates that U.S. CEOs have significant financial incentives, making an important distinction between pay received in a given year and the aggregate amount of shares and options that CEOs maintain in their companies.

In short, CEOs who own a significant amount of shares has powerful incentives to act in the interests of shareholders. Precipitous falls in share prices clearly have adverse consequences for CEO wealth, and so provide important incentives.

The corollary is that CEOs who increase the share price become wealthy, which is precisely the point of incentives - to align managerial and shareholder interests.

The important point, Conyon stresses, is that incentives arise not only from current pay but also from the aggregate amount of shares and options owned. Likewise, shareholders and boards must be vigilant in the design of compensation contracts.