Too Much Cash in the Corner Office

It’s proxy season, high time to figure out the right way to pay the country’s chief executives
In his first year on the job, Apple's Tim Cook received a pay package that could be worth $378 million over the next 10 years Photograph by ImagineChina/AP Photo

Chief executive officers are not the only highly paid people in America. It’s just their misfortune that, thanks to disclosure rules, they’re among the most visible. This proxy season coincides with an electoral cycle in which income inequality has become a populist issue for candidates in both parties, which means CEO paychecks will be scrutinized as never before. And what can’t evade discovery is that, even among the very rich, CEOs have been consistently overpaid.

By overpaid, I don’t mean merely highly paid. We live in a capitalist country, and talent is entitled to fetch its price. But to take just one shining example, Larry Ellison, CEO of Oracle, has gorged himself on more than $60 million in stock options every year since 2008. Even if Ellison did groundbreaking work and was a juggernaut of management brilliance, abusive would not be too strong a word.

Fixing CEO pay—making it more reflective of what executives are truly worth—would go a long way toward restoring America’s faith in business, and in equal treatment. How, is the $60 million question.

One myth should be cleared at the outset. In 2008, the CEOs who run companies in the Standard & Poor’s 500-stock index earned, in total, less than 1 percent of what everyone who’s a 1 percenter earned. So it’s unfair to blame CEOs alone for fostering inequality. Defenders of the system cite such data to advance a larger claim. Pay for public company CEOs has risen, they say, for the same reasons it has for movie stars, real estate moguls, and private entrepreneurs: Globalization and technology has created a wider market. Even President Obama, no friend of the very rich, acknowledged in December that “over the last few decades, huge advances in technology have allowed businesses to do more with less, and made it easier for them to set up shop and hire workers anywhere in the world.” Read thoughtfully, that implies that 1 percenters are taking home more because, in an economic sense, they’re earning it.

“The system has worked,” says Steven Kaplan, a professor at Chicago Booth School of Business. From 2000 to 2010, compensation for the median CEO in the S&P 500 rose from $5 million to just over $8 million. (Those figures represent actual dollars received; when calculated by the value of options at the time of grants, pay over the period began and ended at $8 million.) Kaplan asserts that CEOs are “paid for performance.” In a literal sense this is true; CEOs did earn more when their companies succeeded. But they earned so much, as well, for ordinary and unquantifiable performance as to undermine the intended effect. Apple’s new CEO, Tim Cook, may turn out to be every bit as good as Steve Jobs, or he may not. Apple’s board did not wait to find out. In his very first year as CEO, Cook was awarded a pay package worth $378 million over 10 years.

The real explanation for sky-high pay lies in the “agency” problem. Agents exploit their role as intermediaries. They thrive in imperfect markets in which pay scales do not respond quickly, if at all, to results. Hedge fund managers who deliver mediocre returns get rich thanks to their role as agents. Mortgage traders employed by banks got huge bonuses in the fat years but ducked responsibility for losses; they got a free ride on their employers’ capital.

So do some CEOs—though certainly not all. (Steve Ballmer of Microsoft, for example, gets no options and total compensation of $1.4 million.) But all CEOs compete in a warped marketplace. How often does the head of Company X leave for Company Y? How often does a corporation sack its head? It happens more than it used to, but the market remains inflexible, and firings are rarely for reasons of expense. Consider that Philippe Dauman, the chief executive of Viacom, speared $84 million in 2010, and that Eugene Isenberg of Nabors Industries was awarded $100 million last year for agreeing to relinquish his job. These may be anomalies, but it’s hard to imagine them happening in any rational marketplace.
The agency problem in the corner office is as old as public ownership, though it was most famously brought to light in the 1980s by Harvard Business School professor Michael Jensen, who observed that CEOs, unlike private entrepreneurs, owned little stock and had scant stake in the common corporate purpose. In a 1989 Harvard Business Review article, “Eclipse of the Public Corporation,” Jensen suggested that public shareholders had become passé. Of course, there was nowhere near enough private capital to replace the mass of public investors. For the public companies that remained un-eclipsed, Jensen reckoned, the next best thing would be to shower stock options on the executives, endowing them with the same incentives as their peers at private firms.

If Harvard Business School thought stock options were good for America, corporate executives were perfectly willing to take them. “Pay for performance” was the mantra, but in the aftermath of the dot-com bubble it became abundantly clear, not least to Jensen, that options had not performed as hoped.

Executives who were shielded from losses chased the upside and exposed their firms to excessive risk—Bernie Ebbers at WorldCom and Ken Lay at Enron being just two examples. When bucketfuls of options were awarded year after year, executives had nothing to lose. In 2008, after promoting Vikram Pandit to CEO, Citigroup gave him $29 million in stock awards plus $8.4 million in options. Alas, the stock cratered. Compensating Pandit (but not, of course, the public shareholders) for this bad luck, Citi’s directors last year agreed to 500,000 more stock options and a $10 million stock award. These will reward Pandit for earning back the capital that, under his tenure, Citi had previously lost. The problem is systemic. From 2000 to 2010, shareholders lost 14 percent playing the S&P 500. But CEOs kept raking it in.

Jensen, still looking for solutions, has only gotten more outraged. In a blistering new paper, “CEO Bonus Plans: And How to Fix Them,” co-authored with Kevin Murphy, he observes that “almost all CEO and executive bonus plans have serious design flaws.” The pair find, across the board, that bonuses are ripe for gaming and executives benefit from too much upside with little downside. Jensen and Murphy propose that guaranteed salaries be lower and bonuses higher—with bonuses deposited into a notional bonus “bank” and paid out over time. Poor performance would reduce the exec’s “deposit.”

That’s a fine start, but why stop there? It also makes sense to reduce the number of overlapping incentives. (Oracle paid its new president, Mark Hurd, in six different ways in 2011, totaling $78 million.) As Murphy says, “It was never our intention that companies would layer options for free on top of all these other forms of pay.” Stock grants and options should be dished out only at far less frequent intervals. Otherwise, execs get a bump merely for recouping prior losses. Also, huge exit packages, which make a mockery of Kaplan’s claim that failed CEOs suffer real punishment, have to be curbed. The best way to ensure such reforms is for Congress to legislate binding shareholder votes on any package worth more than, say, $5 million. Let shareholders be their own agents.

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