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In predicting outcomes, we can learn a lot from rats.
A growing number of top-level people are working less to accomplish more.
Here’s a hint: It’s the most basic HR function.
It’s not that we pay CEOs too much. It’s that we pay everyone else too little.
By Don Delves
The opening sentence of my first book, published in 2003, was, “Executive compensation is out of control.” Plenty of corporate critics agreed, but I know for a fact that I was the only executive-compensation consultant to say it in print. The book went on to argue in favor of an expense for stock options, which at the time were basically viewed as having no cost and were being handed out to executives and other employees as if they were free.
I risked my career and livelihood to say those things because I thought they needed to be said and hoped they would lead to better governance of executive pay. My hopes have at least partially come true, albeit with some unintended consequences. Executive compensation was out of control, but contrary to popular belief, it is no longer so. It is just high—and there is a difference.
CEO pay rose dramatically in the mid-to-late 1980s, shocking the public with “mega-grants” of stock and options, along with the introduction of golden parachutes and tax gross-ups. Then, in the ’90s, CEO pay exploded, increasing by an astounding 400 to 600 percent in just a few years. Most of that explosion in pay was in the form of stock options. At the beginning of the decade, we were shocked when an occasional CEO received a one-time mega-grant of options valued at three times his salary; by the end of the ’90s, that was the size of the typical median annual option grant to a CEO. At the beginning of the ’90s, the total cumulative number of stock options granted to employees at most companies were about 5 percent of outstanding stock; ten years later, that number had increased to 15 percent—and was much higher at technology companies.
This means that the boards of directors of almost all publicly traded corporations gave away to employees—mostly executives—about 10 percent of the future growth in their company’s value. (Since an option is the right to buy a share of stock at today’s price anytime over the next ten years, it is the right to a share in the growth in the value of the company. Any growth in value given to employees is unavailable to other shareholders.)
Fortunately, the explosion abruptly fizzled in 2001 with the bursting of the dotcom bubble. CEO and executive compensation generally peaked that year, came down a bit, and settled in a range that has been fairly steady (adjusted for inflation) ever since. There was no undoing of the explosion of the ’90s, but pay has generally leveled off.
So how high is it? Annual pay for a Fortune 500 CEO runs between $9 million and $12 million. (Heads of smaller companies are paid much less.) It moves up and down with company performance much more than it used to. It is composed of a salary of around $1 million to $1.5 million, an annual incentive of $1 million to $4 million, and the rest in various forms of stock compensation, including stock options. The annual incentive and some of the stock compensation rises and falls with company financial performance. The value of the stock compensation rises and falls, sometimes dramatically, with the company’s stock performance. So most of the pay package is tied to company performance one way or another. None of these CEOs risks destitution for poor performance, but substantial swings in take-home pay are both possible and common.
The bottom 80 percent of the U.S. population has basically not participated in the growth of the economy for a very long time. Their standard of living may have increased due to technology and dual-income households, but their wages have not.
This does not mean that there are not egregious exceptions where CEOs and other executives are paid handsomely for failure. And many of the big financial firms engaged in highly questionable pay and incentive practices that fueled the financial crisis and recession. But CEO and executive pay in general does track company performance reasonably well, and to a much greater extent than it did ten or twenty years ago.
Beyond this, corporate governance has also improved dramatically in the last decade, largely due to the Sarbanes-Oxley Act, passed in 2002, in the wake of the Enron and WorldCom disasters. After a decade of largely independent recruiting decisions, boards are far more independent and are no longer handpicked by the CEO. Under increased shareholder scrutiny and SarbOx rules, key committees are now composed entirely of outside, independent, non-executive directors. The image of a corporate board as a group of the CEO’s cronies who just want to make him happy and do his bidding is an anachronism.
How Much Inequality Is Too Much?
This is an enormous amount of very positive change in just ten years, which leads to a key question: If CEO pay is actually tied to performance, and corporate governance has improved so much, why are people still so angry?
This question came to a head for me in an interview with a smart journalist in the summer of 2011. I was explaining how executive pay had fallen significantly during the recession and then rebounded—in a very appropriate way—as corporate profits improved. She paused and asked, “Well, Don, that is great, but what do you say to the typical factory worker in Peoria, Illinois, whose pay has not increased meaningfully in the last ten years?” I had no answer. The disparity bothered me then, and it still bothers me today. It is the crux of a significant societal problem, and may be at the core of what ails our economy.
The problem, as I see it, is not just that CEOs are paid so much. It is that most people are paid so little. In real terms, the typical American worker’s pay has increased either very little or not at all over the past thirty to forty years, depending on which study you read. The bottom 80 percent of the U.S. population has basically not participated in the growth of the economy for a very long time. Their standard of living may have increased due to technology and dual-income households, but their wages have not.
Economists and pundits have written a great deal about growing inequality in America—how the top 0.1 percent or 1 percent or 10 percent has reaped an increasingly and startlingly large share of the increase in income and wealth over the last few decades. The data is incontrovertible. The question is not whether this has happened but, rather, what are the consequences?
Granted, I have never been particularly swayed by concerns over inequality, since capitalism requires a certain amount to function. However, too much inequality poses a real problem for a capitalist economy: If the majority of workers cannot expect to make any more money, to contribute meaningfully to the performance of their company and share in the rewards, then why would they strive to work harder, smarter, or more productively?
My fear is that we have lost the hearts and minds of much of America’s workforce. The core engine of our economy is unengaged or, at least, underengaged. The workforce that was once the world’s best is no longer. If this is true, it explains at least part of our persistent economic challenges. It also raises serious questions about most people’s ability to save, to invest, and to retire—but those are topics for another article.
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