What’s wrong with senior executive pay? – lots (in my view)

There are three things I do not like about top management pay: 1) they usually get paid too much, 2) way too large a part is flexible, performance-related pay, 3) often, a very sizeable chunk of it is paid through stock options. 

I used to think – naively – that high top management pay was high simply due to supply and demand: these smart people with lots of business acumen and experience are hard to come by; therefore you have to pay them lots. These grumpy anti-corporates claiming their pay is too high are just envious and naive. Turns out I was (maybe not envious, but certainly naive).

Pay level

Because digging into the rigorous research on the topic – and there is quite a bit of it – I learned that there is really not much of a relationship between firm performance and top management pay. These guys (mostly guys) get paid a lot whether or not their company’s performance is any good. Moreover, I learned what sort of factors push up top managers’ remuneration – and it ain’t supply and demand. It has much more to do with selecting the right company directors (to serve on your remumeration committee) and making sure you are well networked and socialized into the business elite.* Now I have to conclude: top management pay is generally too high, and quite a bit too high. 

Flexible pay

Secondly: where does this absurd idea come from that 80+ percent of these guys’ remuneration has to be performance related?! “To reward them for good performance and stimulate them to act in the best interest of the company and its shareholders” you might say? To which I would reply “oh, come on!?” If your CEO is the type of guy who needs 90 percent performance-related pay or otherwise he won’t act in the best interest of the company, I would say the perfect time to get rid of him is yesterday. You and I do not need 90 percent performance related pay to do our best, do we? So why would it be allowed to hold for top managers? As Henry Mintzberg put it: “Real leaders don’t take bonuses”. 

Moreover, one should only pay performance-related remuneration if you can actually measure the person’s performance. And that is – especially for top managers – actually pretty darn hard to do. The strategic decisions one takes this year will often only be felt 5 or 10 years from now, if not longer. Moreover, the performance of the company – which we always take to proxy the CEO’s performance – is influenced by a whole bunch of other things; many not under a CEO’s control. Hence, short term financial performance figures are a terrible indicator of a top manager’s performance in the job and long-term performance contracts all but impossible to specify. If you can’t reliably measure performance, don’t have performance-related pay, and certainly not 80+ percent of it. We know from ample research that humans start manipulating their performance when you tie their remuneration to some strange metric and, guess what, CEOs are pretty human (at least in that respect); they do too.


 Finally: stock options… Once again, I have to say “oh, come on…”. We pretty much take for granted that we pay top managers by awarding them options, but don’t quite realize any more why. When I ask this question to my students or the executives in my lecture room (“why do we actually pay them in options…?”) usually a stunned silence follows after which someone mumbles “because they are cheap to hand out…?”. I usually try to remain polite after such an answer but why would they be cheap; cheaper than cash, or shares for that matter? True, it does not cost you anything out of pocket if you give them an option to buy shares for say 100 one year from now, while your present share price is 90, but if the share price by that time is 150 it does cost you 50. Moreover, you could have sold that stock option to someone who would have happily paid you good money for it, so in terms of opportunity costs it is realy money too. No, stock options are not cheaper than cash, shares, or whatever.

We give them options to stimulate them to take more risk. “Risk?! We want them to take more risk?!” thou might think. Yes, that’s what you are doing if you give them options. If the share price is 150 at the time the option expires, the CEO can buy the shares at 100 and thus make 50. However, if the share price is 90 the option is worthless, and the CEO does not make anything. However, the trick is that the CEO then does not care whether the share price is 90 or, say, 50 – in either case he does not make any money; worthless is worthless. As a consequence, when his options (i.e. the right to buy shares at 100) are about to expire and the company’s share price is still 90, he has a great incentive to quickly take a massive amount of risk. Going to a roulette table would already be a rational to do.

Because if you placed the company’s capital on red, and the ball hits red, share price may jump from 90 to 130, and suddenly your options are worth a lot of money (130-100 to be precise). However, if your bet fails, the ball hits black and you lose a ton of money, who cares; the share price may fall from 90 to 50, but your options were worthless anyway. Hence, options give a top manager the upside risk, as we say, but do not give them the downside risk. Therefore, we incentivize them to take risk. You might think “I seldom see herds of CEOs in a casino by the time options expire, so this grumpy Vermeulen guy must be exaggerating” but I’d reply we have seen quite a lot of casino-type strategy in various businesses lately (e.g. banks). More importantly, we know from research that CEOs do take excessive risk due to stock options (see for instance Sanders and Hambrick, 2007; Zhang e.a. 2008). I think it would be naive to think that we give CEOs 90 percent performance related pay and most of it in stock options, and then think that they will not start acting in the way the remuneration system stimulates them to do. Of course it influences their decisions, and if it didn’t, there would be no reason left to make their pay flexible and based on options, now would there?

Therefore, I would say, out with the performance-related pay for top managers (a good bottle of wine at Christmas and, if you insist, a small cheque like the rest of us would do). And while we’re at it, let’s try to reduce the level as well.

* e.g. O’Reilly, Main, and Crystal, 1988; Porac, Wade, and Pollock, 1999; Westphal and Zajac, 1995.

9 Comments on “What’s wrong with senior executive pay? – lots (in my view)”

  1. Peter Klein says:

    Hmmm…. Readers looking for an introduction to this literature from a slightly different perspective might consult the debate between Steve Kaplan and Jim Walsh in the 2008 Academy of Management Perspectives. Personally I thought Kaplan blew Walsh out of the water.

  2. teppo says:

    For anyone interesting in the debate that Peter is referencing – Brayden summarized some of the points in an orgtheory post three years ago – http://orgtheory.wordpress.com/2008/07/15/ceo-compensation-faceoff/

  3. Peter Klein says:

    Walsh’s reply to Kaplan — quoted approvingly by Brayden! — is just a bunch of ad hominems. He ignores Kaplan’s substantive points, e.g., that CEO compensation has risen roughly in line with the compensation of other highly paid professionals (lawyers, fund managers, entertainers) whose compensation has nothing to do with agency problems, board capture, deregulation, etc.

  4. I thought options were cheaper because US tax law limited the the ability to deduct executive compensation over a certain amount, unless it was “performance based”. If a company pays an executive $5m in cash, I thought they would pay higher corporate income taxes than if they paid the same executive $5m via options. I could be wrong on that (I haven’t reviewed the tax code), but I’ve certainly heard people argue it.

  5. davidburkus says:

    I’ll confess too. I used to be a proponent of stock options, but you post mirrors the thought process I’ve been through the past year or so….(albeit summarized and organized much better).

  6. stevepostrel says:

    We have lots of evidence from corporate America of the 1950s-1970s about what happens when you pay CEOs in non-variable compensation. It isn’t pretty.

    1. CEO pay goes up as the log of the number of employees, so CEOs all become mad empire builders and create giant, useless conglomerates. They also keep reinvesting in dead-end businesses and never cut anything or anybody. Incentives to do painful things like let people go as productivity increases in mature markets are missing, so we end up with low-productivity, feather-bedded companies.

    2. CEOs have risk-averse utility functions like everybody else. Shareholders of public corporations are not risk averse with respect to any corporation’s performance because they can easily diversify. Result: CEOs gear everything to minimizing the chance of a bad outcome that would get them fired. In an easy, high-growth environment like the 1950s and 1960s that was okay, but once energy prices, technological volatility, social change, and foreign competition became major factors, a more entrepreneurial mentality was called for.

    3. CEOs just roll over to organized labor until their companies are in such bad shape that the only answer is corporate raiders willing to lever them up and take them through Chapter 11 to void their unsustainable labor agreements.

    4. CEOs supinely watch a flood of government regulations reduce the value of their companies.

    There are three obvious flaws in the argument:

    1. The idea that stock prices are hostage to short-term earnings fluctuations and that this leads managers to underinvest in long-term projects is a nice fairy tale, but not consistent with, say, the behavior of the stocks of biotech companies. I agree that there are a lot of “beauty-contest” investors out there looking for any “news” that might move prices, but you also have to consider that today’s earnings and sales figures do have information content about the long-run trajectory of a company.

    2. As Steven Kaplan pointed out in the debate Peter referenced above, private equity CEOs, not subject to all the alleged institutional distortions and hired by people with their own wealth on the line, are usually paid more than comparable public CEOs.

    3. If CEOs having a big stake in stock performance were a bad thing, then founder-CEOs with large stock positions, such as Jeff Bezos or the late Steve Jobs, would be especially bad managers. I don’t see that jumping out from the data, but maybe something surprising is in there when you do a careful empirical study.

    • CEOs in the 1950s-70s were compensated for creating jobs, making prudent decisions, maintaining cordial labor relations, and complying with the law? When you put it that way, it is clear why these were such nightmare decades in America.

      • stevepostrel says:

        Prudent decisions in the 1960s and 1970s = Ignore those silly Japanese with their statistical process control, innovative use of electronics in low-end products, and total quality management.

        Maintaining cordial labor relations = allowing inefficient union work rules and general white-collar featherbedding.

        Complying with the law = failing to fight passage of destructive laws.

        With these slight clarifications, your comment is right on target.

  7. […] What’s wrong with senior executive pay? – lots (in my view) « StrategyProfs.net – interesting take […]

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