The Real Problem With CEO Pay
The Securities and Exchange Commission did as it was told more than five years ago and issued a pay-ratio rule today. It says public companies must disclose how their chief executive officers' compensation compares with their median workers' pay.
Unions and liberal advocacy groups like the rule as much as corporations dislike it. For the same reason, too: The point is public shaming. Once the world knows that a CEO makes hundreds of times more than an employee, the thinking goes, CEOs will look grasping and greedy. And then, voila! Red-faced corporate boards will have no choice but to cut pay for bosses or raise it for workers.
Don't believe it. Sure, the comparisons -- which won't appear until 2017 -- will get a great deal of notice. Best and worst lists will appear. And CEO pay will keep going up.
Instead of obsessing about how much CEOs earn, it would make sense to focus on how their pay is determined. CEO pay is almost always tied to how well a company's shares are doing. These days, most bonuses come in the form of shares that vest over the years. Even more detailed performance metrics, such as total shareholder return (share-price appreciation plus dividends over time), that determine how much of a CEO's potential bonus will be paid out, are based largely on how well the stock is doing.
Equity-based compensation, however, doesn't necessarily measure how well or poorly a CEO has managed a company. Shares rise and fall with the broader economy, bringing most companies' stock along for the ride. Shares can jump because of a rival company's merger deal. That rewards a CEO for being lucky.
Equity-based pay also can give CEOs an incentive to take on risk. If stock returns dip, for example, it's only natural that chief executives will start to worry about their portfolios. An acquisition or share buyback financed with borrowed money can nudge the shares upward. But the company's long-term prospects may suffer if there's too much debt, or if an acquisition loses money.
A falling share price, on the other hand, isn't always an indicator of poor performance. It can reflect a determined CEO's attempt to refocus a company by selling poorly performing assets and investing profits (rather than returning them to shareholders) in new products or new markets that may not pay off for several years.
Why not consider alternative forms of payment and performance measurements? Sallie Krawcheck, a former Bank of America and Citigroup executive, has joined several academics suggesting paying executives with corporate bonds, which would give executives reasons to borrow less, take fewer risks and manage for the longer term. (This would be especially appropriate for banks.)
They're onto something. Consider the subprime lending crisis, in which the equity-based bonus system encouraged financial companies to originate home loans that had little hope of being repaid. That didn't matter to the mortgage bankers making the loans, whose stock-based bonuses depended on the volume of loans they made and whose future liability (once those loans imploded) was limited.
But if those mortgage bankers had been paid in debt -- either directly with corporate bonds or debt-like instruments (defined-benefit pensions or deferred compensation) or indirectly by linking bonuses to the price of their company's 10-year bonds or its credit rating -- they would have had to stand in line with other creditors to get their money out.
American International Group, whose bonus-eager executives sold billions worth of insurance on mortgage bonds that AIG couldn't make good on once the housing bubble burst, likes the debt compensation approach. In 2010, it said that 80 percent of executive bonuses will depend on company bond prices, and only 20 percent on the share price.
Other academics suggest replacing total shareholder return as the main performance measurement -- about 60 percent of company boards use it now --- with a "market-value added" gauge. One way to do this is to base compensation on the difference between the market value of a company's debt and equity and the amount of capital invested. Instead of basing pay on the financial market's expectations, market-value added depends on a company's absolute performance.
As Harvard professor Jay Lorsch has written, stratospheric pay has caused the public to think of CEOs as "self-interested free agents ready to make tracks out of their companies and to sacrifice the long term for immediate gain." Paying CEOs for underlying performance would go a long way toward changing this perception. It might even result in some CEOs being paid less.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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Paula Dwyer at firstname.lastname@example.org
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