Until recently, CEO pay was the punching bag of choice for any journalist or politician looking to exhibit massive inequality. Billionaires have taken over as proof of the dangers of unfettered capitalism. I submit that it is not unfettered capitalism, but incentives that are broken. Market mechanisms have been meddled with and the result is a perverse system that rewards accounting trickery instead of long-term performance for CEOs of publicly traded companies. Compensation packages negotiated between boards and executives suffer from asymmetric information. Public ownership means too few take a close look at contracts and directors are incentivized to play a rigged game at the expense of the average shareholder.
This comes on the heels of a vilification of the shareholder in favor of the fuzzily defined stakeholder. Shareholders are all of us; this is particularly true in the age of widely distributed exchange-traded funds and indices. The problem with charging companies to look out for stakeholders is the same is it is for countless other well-meaning policies: implementation. In practice, we would be handing executives and boards greater power instead of focusing on the underlying issues. Key among them is an imbalance of power skewed toward executives and away from shareholders.
The owners of public companies are impacted diffusely and thus do not have the same motivation to enact change. Large shareholders are nearly always passively traded funds that have no intention of taking an active role in company management. Board members enjoy cushy gigs that are frequently headed by the very person whose pay we are discussing. Even when CEOs are not chairmen of the board, they nearly always enjoy a high level of influence over its members; it’s how they got the job in the first place. Most importantly, though, the CEO has access to detailed information that boards and shareholders do not. That gives him or her a distinct advantage in salary negotiations.
The vast majority (over 80%) of a CEO’s pay comes from stock options and bonuses. This was encouraged by a Clinton era policy attempting to limit executive salaries and align executive incentives with shareholder interests. It limited the amount of CEO salary that could be expensed from taxable income to $1 million with the exception of ‘pay for performance.’ In practice, it means executives are given short-term targets that release scaling bonuses. These targets are negotiated, though, and a CEO will obviously have a large advantage over the board in the form of asymmetric information. As if that isn’t enough, accounting gimmicks and single-ply-gas-station-toilet-paper excuses are frequently accepted by boards as euphemistically stated ‘adjusted’ earnings statements. Meanwhile, share buybacks supporting stock prices are frequently scheduled around insider sales of large blocks of shares or stock option bonuses nearing exercise dates. Some bonuses are even based on share performance, which, in addition to being more correlated with general market performance than actual company health in the short term, provides more opportunities for stock manipulation via share repurchase programs on the shareholders’ dime as a way of ‘returning money to shareholders.’
Still, one could argue that shareholders are getting a harder-working steward of their money by paying for performance. The conventional wisdom says that we will perform at a higher level if we are incentivized to do so. Who would slack off at a job when your pay is directly tied to how well you are doing it/ The problem, once again, is implementation. Pay packages are nearly always annual; investment holding periods are much longer. We are asking boards with incomplete pictures of the business to determine short-term goals. That’s the CEO’s job! Given those incentives, executives attack the goals at the expense of long-term company health and profitability.
The best illustration of the problem is a comparison between privately held companies and publicly traded ones. Among similarly sized corporations, private CEOs are making roughly half that of public company CEOs. Digging deeper, bonuses make up effectively none of private company CEO pay. Rather than stock options, they receive their equity in the form of restricted stock (it vests over time). Without a liquid market to sell into, they must instead hold their equity for far longer. If they want to finance a wine cave with their equity, they must borrow against it from a bank. It all boils down to longer-term thinking from private CEOs.
This problem affects all of us in the form of reduced innovation because of less R&D spending and lower returns in our retirement accounts. It hurts communities when corporate money is spent on financial tricks instead of investment in growth. It is, however, a solvable problem. We must get rid of the tax advantages for multimillion-dollar bonuses. Real compensation (what CEOs actually are paid from bonuses and stock options) should be taxed in the same way we tax payroll for average workers. Public company executives should be compensated in more restricted stock; making it more difficult for them to sell their shares would encourage longer-term thinking. We can help them use their ingenuity to maximize innovation instead of a paycheck.
Read more of the series here.