CEO Compensation is Broken

Executive Pay Gluttony
Maybe big institutional investors could make a difference.
Bloomberg, April 30, 2015




Executive compensation is in the news again as the Securities and Exchange Commission gets ready to issue new guidelines on pay disclosures. As mandated by the Dodd-Frank Act, the new rules are supposed to provide “greater transparency and allow shareholders to be better informed” about executive and director compensation.

Transparency is certainly a good first step. But it does nothing to address the underlying and deeply entrenched issue of executive compensation as a wealth-transfer mechanism. Assets get moved from shareholders to the C-suite.

A closer look at the underlying factors that led to these excesses reveals a complex situation, driven by numerous actors. Before we look at some of them, a quick reminder as to how we got here:

Roger Lowenstein’s book “Origins of the Crash: The Great Bubble and Its Undoing” describes the moment when executive pay went off the rails. In 1991, Heinz Chief Executive Officer Anthony J.F. O’Reilly received a then-eye-popping pay package of $75 million, almost all of which was due to stock awards. O’Reilly was the highest paid CEO that year, receiving the equivalent of about $130 million in today‘s dollars.

When we look around at various compensation packages today, it turns out that O’Reilly was just the beginning. Here’s just a short list of gluttonous pay: GoPro founder Nicholas Woodman, $284.5 million; Discovery Communications CEO David Zaslav, who oversees the cable empire that includes the Discovery Channel, TLC and Animal Planet, $156 million; and perennial pay hog Oracle CEO Larry Ellison, $103 million.

Next to these mind-boggling salaries it’s almost beside the point to note the latest richly rewarded executive: Yahoo’s Marissa Mayer, whose $42 million in 2014 was 69 percent more than a year earlier. The chart below shows where Mayer ranks in the industry based on data compiled by Bloomberg (there may be some discrepancies between news reports and the table because of varying stock-option valuation methods — but you get the idea) :


And here’s a table of the highest-paid executives overall:

Highest paid

Why has pay for senior executives risen so much so fast? Here’s is a partial list of the  forces at work:

• Shareholder Value: Many trace the enshrinement of this idea to a 1981 speech at the Pierre Hotel in New York by General Electric CEO Jack Welch titled “Growing Fast in a Slow-Growth Economy.” AsFortune reported in 2006, “Welch’s words marked the dawn of the shareholder-value movement. And GE eventually became its star.” The article noted that Welch’s report card was the stock price.

Since then, the credo of shareholder value has lost some of its luster. Analysts and corporate governance experts have derided it as misguided, for — among other things — encouraging short-term thinking and an obsessive focus on boosting stock prices. GMO UK Ltd. analyst James Montier issued a new white paper titled “The World’s Dumbest Idea.” Cornell law professor Lynn Stout’s book “The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public” further diminished the idea.

If you really want to see examples of some of excesses that resulted from maximizing short-term shareholder value, just look at bank CEO compensation before the financial crisis. Despite risk-taking that temporarily boosted shares, these companies either failed or needed bailouts — and all the while these CEOs were paid as if they were enormous successes.

• Stock Options: The original theory, related to shareholder value, was that aligning CEO pay with stock performance would also align management’s interests with those of shareholders. This turned out to be a flawed thesis, on at least two counts.

The first flaw is based on a simple question: How much of any given stock’s rise is unique to the company itself or the actions of its CEO? Stocks participate in multidecade secular markets, and the actions of any one CEO are almost irrelevant. Look at how closely companies within the same sector are correlated to get a better idea of how much outside forces can and do drive share prices.

Rather than merely looking at stock gains, what makes much more sense is to base a compensation system on how much of the stock performance isn’t attributable to the overall market and the company’s specific sector.

The second flaw is even simpler to understand. CEOs are hired by corporate boards on behalf of shareholders. They already get a healthy package of salary, benefits and perks to manage the company. It’s absurd to claim that they require some extra incentive that results in an extraordinarily lucrative payday merely to do their job.

• Crony Boards: The cronyism of major corporate boards is a travesty. These rubber-stamp directors, often like-minded corporate peers, use shareholder money to enrich the CEOs who appointed them. The conflict of interest isn’t hidden; it’s right out in the open. Nor do the compensation committees of these boards serve shareholders well. That might be because they rely upon a class of outside advisers whose job it is to devise novel ways of fattening executive paychecks.

• Compensation Consultants: As noted above, these consultants give boards cover for these ridiculous compensation packages.

Don’t underestimate the responsibility this group has had for supercharging executive pay. They function in much the same way that real-estate appraisers did during the housing boom: They offer no real analysis of intrinsic value, but instead devise models that feed off of and reinforce the upward spiral in pay.

• Mutual Funds: It makes no sense for someone who owns 100 or 1,000 shares to police corporate boards for pay excesses. However, the big mutual funds that own most of the shares should be operating on behalf of their investors. They have the staff, expertise and incentive to do what is clearly beyond the limited ability, time and affordability of individual shareholders. When you own millions of shares on behalf of third parties, you should be obligated to not only do the work, but also to vote your proxies and elect boards that represent the interests of shareholders.

All of which makes you wonder what good the SEC’s new rules will do.



I originally published this at Bloomberg, April 30, 2015. All of my Bloomberg columns can be found here and here




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What's been said:

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  1. DeDude commented on Apr 30

    Index funds have made this problem a lot worse. Actively investing mutual funds have an incentive to go after CEO’s robbing a company. None of the low cost index fund managers have the resources or incentives to stop the looting. So they own a lot of passive shares that becomes part of the problem by not being part of the solution.

  2. farmera1 commented on Apr 30

    No, a thousand times no, I think the opposite; CEO pay is working very well thank you very much. Since companies are managed for the benefit of management, the current arrangement is doing its job really, really well.

  3. willid3 commented on Apr 30

    and 401k funds havent helped. cause they really only care to keep the employer happy . and they do buy lots of the companies stock since thats usually how companies do their match

  4. DeDude commented on Apr 30

    We need a company list of “shame” giving us the names of the 100 worst companies with respect to how many times more the CEO compensation is relative to the median employee compensation. Then we need mutual funds that specifically refuse to invest in those shamed companies. Then finally a policy that no public pension fund can put money into the shamed companies.

  5. Michael G commented on Apr 30

    @DeDude. Index funds would argue that since they have no choice but to hold shares in a particular company, they have a real incentive to try to improve management behaviour. On the other hand, the easiest thing for an active manager to do is to sell the stock without making a fuss that might reduce the value. If the active manager keeps the stock and makes a fuss, when the stock price goes down, the manager loses position in the league tables. Also, the more egregious the CEO’s compensation, the more the fund manager will expect.

  6. Whammer commented on Apr 30

    I would make a distinction between a founder, like the GoPro guy, and CEOs of companies that have been in business a long time.

    One of my favorite examples was the outgoing CEO of Exxon, who left with something like $400 million. What, exactly, did he do that was so great? Alternatively, how much worse could Exxon have performed had any of us anonymous blog commenters been running it? Or a pot belly pig? Pot belly pigs are quite clever…..

  7. cdwight commented on May 1

    I think the whole premise of how executives should be compensated has been messed up for a long time. CEOs should be compensated for what they can control which is the business operations (measures like operating margins, earnings, cash flow and return on capital/equity). They shouldn’t be compensated on making the stock price go up. CEOs have too much incentive be promoters rather than sound business operators under the present system. I don’t think they should be compensated with stock options at all. The idea that this makes the think like an owner is flawed. It makes then think about how much stock they can divert to themselves. Most companies even if they have mediocre performance will make the CEO extremely wealthy under the current system.

  8. reedsch commented on May 1

    You’re just jealous. At least that what I’m told, any time I take philosophical exception to the way the status quo distribution of rewards works.
    Berle & Means were onto the separation of ownership and control back in the 30’s. But they had social (as opposed to socialist) restraints in place back then, which seem to have been washed away. Now it’s the Superstar alone, Hacker’s & Pierson’s Winner-Take-All, who makes the world go round, and gets to take the first bite of the apple, and a mighty big bite it is.
    Since we live in the best of all possible worlds, and Mr. Market is in charge, and Mr. Market has decided the current compensation scheme in a fair-and-square transparent manner, or so I am told, how can there be a legitimate beef? I have inquired as to some measure of value-added provided by these folks, which would justify their claim. But I’m just jealous.

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