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Why do CEOs make so much?

While Congress debates how, or even whether, a cap on executive compensation should be included in the financial bailout package, taxpayers are again wondering why CEOs make so much more than ordinary workers.

And why has their pay gone up so dramatically in the last generation?

According to the  Economic Policy Institute, in the late 1970s, total compensation of chief executives in large American corporations was 35 times that of the average American worker. In 2007, it was 275 times that.

One reason could be that in 1993 Congress capped the deductibility of CEOs salaries at $1 million, unless the extra pay was linked to performance incentives. So boards of directors raised CEOs' potential income with increasingly generous stock options, which helped drive executive pay off the charts.

But the reason could be more complicated than that, so we talked with three CEO-compensation experts at the University of St. Thomas in St. Paul. Here's what they had to say:


P. Jane Saly
Saly is associate professor and department chair of the accounting department at St. Thomas. Currently on sabbatical, Saly's research specialties are executive compensation and managerial accounting.

"The research is still out on why executive salaries have soared. Why have sports salaries and entertainers compensation soared? One argument that was made several years ago is that it is the reward for winning a tournament. Others have argued that weak governance has compromised the process. (For example, I am a member of your board deciding your compensation and you are my friend who got me the board position.)

"Some believe that high salaries are a result of market pressures. Some of the high compensation is due to high stock prices. Stock options only become very valuable IF the stock price goes up. That is why they are often used — CEOs benefit when the shareholders benefit.

"Sometimes it looks like executive compensation goes up when a company's fortunes go down. But CEOs' overall wealth may actually decline while compensation appears to remain constant because much of their compensation is in stock. Reported compensation typically doesn't include wealth effects from stock ownership or changes in the value of unexercised stock options.

"Reported compensation may include rewards for previous performance. For example, if a CEO has held options for nine years and the stock price has soared in the first seven years and come down some in the last two years, he may still realize a significant increase when he exercises those options. Their wealth may go down but compensation may not decline as fast as the company value.

"Compensation is typically a combination of both fixed and contingent components to offset some of the risk the executive faces while still keeping his interests in line with the shareholders. The executive is already very tied to the company fortunes through his employment. If he were paid only a fixed salary, then he would be very risk averse so he could keep the company in business. By making some of his compensation contingent on the stock price, it gives him some incentive to take on risky projects that have potential to increase the shareholder value.

"Many firms ask CEOs to buy and hold some stock. So the overall wealth of the execs is very tied to the company's fortunes."

Mufaddal Baxamusa
Baxamusa is assistant professor of finance at St. Thomas. Baxa has a Ph.D. in finance from the University of Minnesota. His research specialties are executive compensation, mergers and acquisitions, behavioral finance, capital structure and dividend policy.

"Over the last 20 years we have seen an increase in CEO pay because of stock options. From the 1980s to 2003 they were not reported to the Securities and Exchange Commission. But with the Sarbanes Oxley Act of 2002, popularly called SOX, in 2002 there was more scrutiny, so they have dropped a bit. Before SOX boards of directors were rubber-stamping what the CEO said.

"You've also got to consider inflation. Average size of firms in the 1980s has increased when compared with the value of [the average firm in 2008. There is a strong correlation in increase in salary with increase in size of the firm. As complexity increases, responsibilities increase.

"This is largely an American phenomenon. France is more like a socialistic ideology. It's hard to fire people, which puts a downward pressure on wages. In Japan senior managers are not paid for productivity but because of sentimentality. India is so hierarchical that they get paid more just by moving from layer to layer. In the past in the U.S., people expected permanent employment. Now when people move they try to extract a premium."

Kenneth Goodpaster
Goodpaster holds the David and Barbara Koch chair in business ethics in the ethics and business law department at St. Thomas. His most recent work is "Conscience and Corporate Culture," (Blackwell Publishers, 2006).
 
"I just wrote an article that appeared in the Employee Benefits Planner where we interviewed boards of directors and former CEOs. They said there were three factors for the rise in executive compensation.

"Stock option-based compensation leads to a very short-term focus for the CEO, even down to quarterly. And stock options don't have to be expensed like cash. Feels like you're not paying out very much in real money.

"A second factor is fear of losing the current chief exec and then having to find another one. Finding a new CEO is a hassle. You have to go to a search firm, which goes to compensation firm which gets paid on a percentage of compensation. It can take a year.

"And finally, directors lack industry knowledge. Outside directors are usually from different industries and have limited knowledge of the industry of the company for which they are directors.

"There are those who argue that it executive compensation should not be regulated except by the market because it's a symbol of free enterprise and the essence of capitalism. CEOs can command what they command in the marketplace because of what they contribute to the company's bottom line. The idea of controlling it smacks of socialism. If the government can control wages at this level, it can do it at other levels, such as sports.

"One argument you see when compensation is revealed is the 'obscenity argument' to expresses moral outrage. To me it's got to be more than moral outrage.

"A stronger argument is that high compensation can create a sense of inability of the leader to identify with the workers, the rank and file. Almost like a British-style class society. The question becomes more of fellowship than obscenity.

"Ordinarily if a company promotes from within, we're talking about much more modest increments. When you disconnect somebody from afar you have to give him a much larger package to attract him.

"But the reality is that companies and boards of directors seem to get trapped in the idea that someone from afar is better than someone near. You're never famous in your own hometown. Promoting from within would put a drag on that culture. Unless the whole point is to change the culture — if the company is lethargic.

"No one is setting out to choose a CEO compensation that is a certain multiple of what the average worker is getting, unless a CEO were to say, 'I don't want my compensation to be any more than a multiple.' It happens sometimes."

Judith Yates Borger reports on legal affairs and other subjects. She can be reached at judy [at] judithyatesborger [dot] com.

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Comments (5)

"Let me get this straight, the CEO adds value to Ford, but the folks who actually build the cars and trucks are adding what?"

Manual labor. Work that takes two hands and a week or two to get proficient at.

"As we re-oriented the economy around shareholders the executives were able to focus everyone's attention on stock values rather than earnings, capacity, profits, sales etc. (think Amazon, it sold for a billion dollars even though it yet to earn a profit)"

Excellent example, Paul. It allows me to address both that statement and your conclusion regarding the value of mediocrity in gaining wealth as a CEO. It also might give you some further insight into how important a sound education in business is to a businessman.

I could fill the room with articles about Jeff Bezos (the founder and CEO of Amazon), but I think Time magazine summed up what we are looking for quite succinctly.

--From the beginning, Bezos sought to increase market share as quickly as possible, at the expense of profits. When he disclosed his intention to go from being "Earth's biggest bookstore" to "Earth's biggest anything store," skeptics thought Amazon was growing too big too fast, but a few analysts called it "one of the smartest strategies in business history".--

Neophyte investors look to profit histories; nothing wrong with that. Successful investors, like Warren Buffet, look for the future potential for profit.

Business is not quite the walk in the park you imagine it to be, Paul. Any successful CEO will tell you that quality time spent with "people that study business" is a very worthwhile investment of time.

"The final reason CEOs make so much money is simply because they have contracts."

Most autoworkers won't get to within ten feet of their air wrenches without a contract. If simply *having* one guarantees a high salary, why don't fender installers make 200% of the non-union janitorial help?

You've come to some very unothodox, yet very concrete conclusions Paul, would you mind sharing the source of your business expertise?

I found this a fairly interesting piece, Judith, which is surprising given the fact that I don't spend much time worrying about how much my neighbors make.

In fact, I have to disagree with your blanket assertion that "taxpayers are again wondering why CEOs make so much more than ordinary workers".

In my experience, such angst (some might call it avarice) is pretty well confined to left leaning taxpayers; most of my conservative acquaintances, like myself, could really care less.

Thanks for absolutely nothing except a great example of why people who study business are completely clueless.

The reason CEO pay has gone up are basically threefold. To begin with, we have a culture that celebrates mediocrity and assumes that those at the top are responsible for all good fortune. The statements to the effect that CEOs add value to the company are an example of this myth. Let me get this straight, the CEO adds value to Ford, but the folks who actually build the cars and trucks are adding what? By celebrating mediocrity what I mean is no one is expected to actually know how to do the job, or know anything about the company or business. The idea is that any suit will do, business is business so a guy who ran textile factory last week can run an insurance company this week. And if they don't know how to do it, you hire personal trainers and send them to management seminars and classes. The problem is once you disconnect expertise from qualification it's impossible to establish a real value for any given executive. Once that happens it becomes possible for clever executives to manipulate the system regardless of their actual performance.

The second reason, as some of your experts pointed out was the financialization economy. As we re-oriented the economy around shareholders the executives were able to focus everyone's attention on stock values rather than earnings, capacity, profits, sales etc. (think Amazon, it sold for a billion dollars even though it yet to earn a profit) The value of companies became disconnected from their actual performance in the market. Under these circumstances CEOs could game the system by doing things that actually hurt the companies ability to perform, but boosted the stock value for a short time, usually around bonus time. A favorite tactic was to announce lay-offs, the more the better. Investors invariably assumed that this was "cost cutting" and boosted stock value even if in reality it meant decreased productivity down the road. Another tactic was to announce a merger or buy out of some kind. Even if the even the buy out eventually fell apart as many have, the mere announcement is enough to boost the stocks enough for CEOs to collect their bonuses.

The final reason CEOs make so much money is simply because they have contracts. While the rest of the American workforce has decided that labor unions are quaint historical artifacts and that they don't need to have actual contracts with their employers, executives won't get within ten feet of the front door without a solid contract. These contracts spell out all this compensation and boards sign off on it because it's not their money anyways. One huge shift in this economy has been the collapse of private ownership. As all these privately owned companies went public we created a class of CEOs who just manage companies that someone else built. Once that happens it just doesn't seem like real money to anyone, and no one knows how to measure performance.

Mr. Swift comments on my earlier post.

Workers at a ford plant contribute not value, but:

”Manual labor. Work that takes two hands and a week or two to get proficient at.”

If you don’t understand how it is that a car manufacturer with no cars would be an entity devoid of value, I’m not sure I can help you. You can own and manage the means of production, but without any actual production, you won’t have much to brag about. Manual labor doesn’t just add value, it creates it. I remind people that many manual labors such as carpentry, electrical work, service and repair, nursing, involve a lot more than two weeks to get proficient at. You don’t have to have to pass a license test to be a CEO. How long does it take to get proficient at running a car manufacturer or the worlds largest banks into the ground by the way?

I used the sale of a profitless Amazon to make a point regarding the re-orientation of the economy towards investor returns regardless of profit or production:

”I could fill the room with articles about Jeff Bezos (the founder and CEO of Amazon), but I think Time magazine summed up what we are looking for quite succinctly.

--From the beginning, Bezos sought to increase market share as quickly as possible, at the expense of profits. When he disclosed his intention to go from being "Earth's biggest bookstore" to "Earth's biggest anything store," skeptics thought Amazon was growing too big too fast, but a few analysts called it "one of the smartest strategies in business history".—

In the land of blind a one eyed man goes forth. This was a successful strategy, but it wasn’t new, and it wasn’t rocket science. It was a gamble that paid off. I could fill a room with examples of grossly overvalued companies that are now in crises because they based their business models on inflated stock value instead of revenue. This is just history at this point, read the newspaper.

My point about CEOs having contracts provokes this:

”Most autoworkers won't get to within ten feet of their air wrenches without a contract. If simply *having* one guarantees a high salary, why don't fender installers make 200% of the non-union janitorial help?”

If the contract stipulated that they make 200% more than the janitors, then they would. I learned that from a business law book.

At the end of the day Mr. Swift makes my point nicely. Anyone with a rudimentary understanding of business would not have made the decisions that these CEOs made. Over leveraging is just a polite way of saying “being stupid” which brings us back to the point, why were these getting paid so much? I guess they should’ve talked to more business people. One would have thought however that for what these folks were getting paid, they would have wouldn’t have needed remedial education in the fundamentals of business. I’ll say it again… mediocrity.

How the CEO came to make 10 times as much money as the other employees

It was a warm spring morning in Oakwood Forest, and entrepreneurship was in air. Bear and Fox decided that today would be a good day to start a company.

Bear hired ten squirrels for his company and made one of them CEO. He paid both the worker squirrels and the CEO squirrel one acorn per day. Fox did the same thing, hiring ten squirrels (nine workers and one CEO) and paying each of them one acorn per day.

Business was split equally between the Bear's company and Fox's company.

Business continued as usual, until one day Fox had a brilliant idea. He decided to pay the CEO squirrel 10 acorns per day. The CEO squirrel didn't do any more work than he used to. He just got fat. But the other squirrels started working like crazy! They came into work early, ate lunch on the job, and worked late into the night. Some of them slept at the office. Others stopped going on vacation. All of their squirrel spouses grew quite upset and most of the squirrels working at Fox's company had sad squirrel divorces. All to have a better chance of being picked as the next CEO. But business was booming and Fox's company, with its highly productive worker squirrels, drove Bear's company out of business.

This is called "Tournament Theory" and it explains why CEOs (and Partners, upper management, etc.) are paid so much more than average employees.

Moral: pick your own acorns.