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Why do CEOs make so much?

By Judith Yates Borger | Thursday, Sept.

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.