CEO pay: Aligning Shareholders, Executives - EHL Insights | Business

CEO pay has been a controversial topic in the media as some executives have enjoyed huge salaries, bonuses, stock options and other forms of compensation, even when their firms have not been performing well.

Between 1996 and 2010 there was almost a sevenfold increase in the number of newspaper articles on CEO compensation in the United States, reflecting concerns about income distribution and that CEOs may be overpaid. The number of articles in academic journals about CEO compensation also increased significantly from 1,250 pages in 1996 to 10,400 in 2010, according to Google Scholar.

While there has been a great deal of adverse publicity and shareholders have expressed concerns about excessive pay, companies – and their boards -- continue to tie incentives to performance in order to motivate key executives.

Shareholders hire executives to act in their best interests but the personal interests of the firm’s managers may not be fully aligned with those of the shareholders. In essence, they have access to information that the shareholders do not have and can exploit that information for their own benefit.

Among scholars, there are three main opposing camps with regard to this issue:

• the ‘arm’s-length’ bargaining model, by which boards try to maximize shareholders’ interests, subject to constraints set by executives’ pay;
• the perceived-cost view, which assumes that risk-adverse executives cannot hedge the risk of options and therefore are systematically dis-incentivized; and
• the managerial-power model, by which boards seek the most favorable compensation for executives, subject to possible market penalties and costs. (I find this model more readily explains the CEO pay issue because senior executives will always seek to increase their income).

Documenting changes in CEO compensation in the United States between 1996 and 2010, my study shows, using two sets of data, that CEO pay rose during the dot.com bubble to peak in nominal terms in 2000, after which it fell until 2004 and then began to increase again.

In particular, I found that CEO compensation rose on average by $2.7 million between 1996 and 2010. As one would expect, changes in CEO compensation varied greatly with the state of the stock market and the economy.

The components of compensation also changed during this period, with a huge increase in stock-based compensation. Stock options became the largest single component of compensation in 2000-2001, with most of the options on the money with vesting periods of one to three years.

In 2010, stocks constituted almost 35% of total compensation while scheduled options rose by almost 25% between 1997 and 2010. Over the period there was a more modest increase in cash-based compensation.

Most of the increase in stock-based compensation between 1996 and 2001 was due to increased grants of stock options, but these became less popular around the dot.com period as companies switched to direct grants of stocks.

The study also shows the evolution of certain practices used to inflate the value of incentives. For instance, the practice of backdating options which had proliferated in the 1990s declined following the 2002 Sarbanes-Oxley Act. Backdating disappeared when the U.S. Securities and Exchange Commission (SEC) strengthened reporting rules so that the practice became almost impossible to carry out.

Whatever the combination of incentives – whether it be salary, bonuses, stocks or options – when boards seek to motivate senior executives and enhance the firm’s performance, they should weigh the marginal cost of additional forms of compensation with the extra benefits to be gained from encouraging senior executives to make decisions which would be in the shareholders’ interests.

No matter how much the managers’ skills are worth, boards still need to align the interests of shareholders with those of the CEO.