The gap between pay for U.S. chief executive officers and the people who work for them has widened sevenfold in three decades. Are bosses seven times smarter or scarcer these days? Company boards seem to think so. They say that the pay packages they award result from fierce competition for talented and valuable managers leading larger organizations, and that pay is tied to performance. Critics argue that rising pay comes from strong-arming by executives who take more out of the economy than they put back in. They’re abetted by pliant directors, according to Warren Buffett, who calls them less “Doberman” than “Chihuahua.”
Starting this year, publicly traded U.S. companies must calculate how their CEO's compensation compares with median pay for rank-and-file employees. The pay ratio must be disclosed in the proxy statement -- the document sent to shareholders ahead of annual meetings -- which for most companies will be in early 2018. The rule, however, is among those the Securities and Exchange Commission is likely to reconsider under its new chairman, Jay Clayton, chosen by President Donald Trump. U.S. shareholders typically get to weigh in on executive compensation at annual meetings, although the vote isn't binding. In the U.K., Prime Minister Theresa May is taking more of a reformist stand. Shareholders in its companies now get an advisory vote on pay; she wants it to be binding, similar to Switzerland's law. Parliament is also considering a government report that calls for disclosure of CEO versus employee pay ratios. Such reforms are part of national efforts to reduce -- or to be seen addressing -- income inequality. The CEOs of S&P 500 companies made 347 times more than their employees in 2016, up from a ratio of 46-to-1 in 1983, according to the AFL-CIO. That’s more than twice the gap in Switzerland and Germany, and about 10 times bigger than in Austria. In Japan, CEOs make about 67 times more than workers, and eight of the ten highest-paid executives there are from other countries. A global Harvard Business School survey found that most people think pay gaps are far smaller than they are. That was particularly true in the U.S., where survey respondents thought the ratio of CEO to average worker pay was 30 to 1; they put the ideal ratio at 7 to 1.
Management guru Peter Drucker wrote in 1977 that a CEO shouldn’t make more than 25 times the average salary at his company. He narrowed his ratio to 20-to-1 in 1984. He thought wider gaps bring “resentment and falling morale.” In 1993, the U.S. Congress required pay above $1 million to be “performance-based” to qualify for corporate tax deductions. Meant to curb executive pay, the law did the opposite: Instead of raising salaries, companies granted stock options and tied cash bonuses and equity awards to specific goals, such as share-price increases. These awards have increased pay gaps in the U.S. and elsewhere, according to the Organization for Economic Cooperation and Development. A cottage industry of consultants has sprung up to advise corporate boards on what performance measures to use, how to divide pay between cash and equity, and which competitors to regard as peers for pay comparisons. Proxy advisory firms advise shareholders whether to vote for or against compensation plans in non-binding “say on pay” votes. In 2016, the average support for company pay practices was 93 percent, and only 1 percent of companies failed to get majority support, according to data compiled by Bloomberg.
In executive compensation, everything is up for debate, even how to tally the “say on pay” votes. When it comes to gauging performance, some commonly used measures have been criticized for rewarding managers for things they don’t control, such as market swings. There’s scant evidence that higher pay improves stock performance anyway. Stock options, which gain in value when the share price rises, were once believed to align executives with shareholders but are now derided for encouraging short-term financial engineering at the expense of long-term planning. These awards also dilute the value of outstanding shares. Another closely watched metric, earnings per share, can be easily manipulated through accounting changes and share repurchases. Economic profit, or net income minus capital costs, has been touted as encouraging long-term investment while measuring only those things executives can control, but companies that tie pay to it don’t outperform their peers. For those tired of figuring it all out, there’s a radical solution: a maximum wage.
The Reference Shelf
- A Bloomberg News article says America's highest-paid female executives lead technology companies.
- The AFL-CIO tracks corporate compensation at its Executive PayWatch website.
- William Lazonick, an economist, criticized pay-boosting stock buybacks in a 2014 Harvard Business Review article.
- A 2006 BusinessWeek article recounted how U.S. President Bill Clinton’s 1993 plan to curb CEO pay went awry.
- Steve Denning, a management consultant, faulted the practice of tracking performance against stock returns on Forbes.com.
- A Bloomberg News article discusses pay-for-performance metrics, including economic profit.
First published March 25, 2015
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