Goldilocks in the Corner Office

In the eyes of the public, this criminal lineup is a particularly sordid one.

No, they haven't scammed grandmothers out of their savings, nor sold babies over the Internet. They are robbers of a sort, though impeccably dressed ones. Truth be told, they are not actual criminals (well, maybe a few are), but their actions are considered criminal in the figurative if not literal sense.

The group: chief executive officers. Their crime: getting paychecks that are simply too big. In the court of public opinion, it's a slam-dunk case: guilty. A thousand—no, make that several million—times, guilty.

The anecdotes of seemingly ludicrous CEO pay almost never stop; every year produces a fresh batch of fat cats to parade as examples of capitalism run amok. But the matter of CEO compensation is more complicated than some normative sense of what the public considers fair. Even if cool-headed economists might agree that CEO pay appears out of whack, they can step back and search for reasons why current compensation levels may be perfectly logical in a market sense.

What comes out in the end is something of a hung jury: Anecdotes aside, a multitude of factors make it difficult to see if CEO compensation is systemically biased and inefficient, and for whom or to what consequence. Indeed, if the matter were so straightforward, there would be no controversy.

Recent research has made some strong theoretical arguments that CEO pay is above what efficient markets would confer. But some fundamental unknowns cast doubt on whether that theory holds up in practice, none of them more critical than the fact that there has been no solid evidence of systematic overpayment—only anecdotes, even if numerous.

Some evidence even suggests—put down those tomatoes—that current CEO pay levels are fair, or at least reasonably so.

Show me more money

Probably no topic in popular economics provides more fodder for critics than CEO compensation. Just when people think the apocalypse has occurred in CEO pay, a sequel follows.

For example, a Forbes magazine analysis of CEO pay among America's 500 largest firms finds that it rose by 54 percent in 2004 alone. Three CEOs cracked the $100 million mark, mostly thanks to the exercise of stock options in a strong market that year. Last year, CEO pay rose a more modest 6 percent, to an average of $11 million; five took home nine-digit paychecks, and 13 cracked the $50 million mark.

CEO compensation has several components—salary, noncash incentives like stock options, pension and retirement contributions, perquisites—some of which are obtusely disclosed in Securities and Exchange Commission (SEC) filings. As a result, surveys on CEO pay don't often agree with each other, though they tend to all lean in the same direction. The nonprofit Corporate Library, for example, reports that median CEO compensation for more than 500 of the nation's largest firms rose 11 percent in 2005, compared to 30 percent in 2004, 15 percent in 2003 and more than 9 percent in 2002.

Critics of CEO compensation point to steep differences between head-office pay in the United States and in other countries as prima facie evidence of off-kilter U.S. CEO compensation. For example, CEOs here make 35 percent to 80 percent more (depending on study) than their British counterparts. The top earning CEO in Europe in 2005 was Lindsay Owen-Jones, then at French cosmetics giant L'Oréal. Her $32 million would not even have cracked the U.S. top 25 that year, according to Forbes rankings. The number two European CEO came in at $20 million, good for 59th place.

The contrast might be even starker than rankings suggest. Researchers like Lucian Bebchuk of Harvard University have uncovered ballooning retirement packages, which are not typically included in annual compensation surveys. Last year, Bebchuk and Robert Jackson, also from Harvard, looked at CEO pension plans among Standard & Poor's 500 firms and found a median actuarial value of $15 million. That might not be much for a Jack Welch-type CEO who sat behind the mahogany desk at General Electric for 20 years. But average CEO tenure is somewhere around a half-dozen years, and dropping. That means many S&P 500 CEOs are getting several million dollars annually just in retirement benefits. According to Bebchuk and Jackson, retirement packages had the effect of pumping up total "salary-like payments" to CEOs by 15 percent to 39 percent.

As in the case of someone caught after a crime spree, the evidence of soaring CEO pay just keeps piling up. CEOs now command signing bonuses (dubbed "golden hellos") as well as generous severances if they are booted out the door (golden handshakes) or the firm is bought out (golden parachutes). In a study earlier this year, Tjomme Rusticus at the University of Pennsylvania looked at a representative sample of CEOs at S&P's 1,500 firms. He finds that from 1994 to 1999, half of the sample's 375 firms had some form of severance agreement with the CEO. The median level was two years worth of cash compensation. David Yermack of New York University also finds that about half of the 179 CEOs that exited Fortune 500 firms between 1996 and 2002 left with severance and received an average amount of $5.4 million.

Where CEO pay is not appalling in sheer dollars, it can offend in principle. For example, compensation contracts are packed with perquisites. A 2005 report on CEO compensation by Pearl Meyer & Partners finds that "other compensation"—non-income perks, mostly—went up almost 14 percent in 2005 to $188,000. This area of compensation is the smallest, but to many the most egregious, because it covers things that proverbial cake-eaters have to pay out of their own pocket: generous allowances for housing and vehicles, for instance, and continued access to company planes and other assets upon retirement. It's not uncommon for CEOs to receive additional payments for things like insurance premiums, financial management services and even help covering a growing tax bill, implying that a CEO's wealth has become a burden that the firm should help manage.

Public and investor outrage over such compensation tends to be muted when everyone is sharing in the wealth accumulation, like during the 1990s bull market. But average returns this decade have been comparatively paltry, as have wage gains for many rank-and-file workers. As a result, scrutiny of CEO pay has magnified considerably. Now a slew of CEO-pay rankings have sprung up across the country; many regional business publications tabulate and rank CEO pay in their metro area or state, often comparing pay to the firm's performance. In California, there is a survey just for bosses of tech firms. The New York Times and Wall Street Journal, among other national media, have recently been devoting significant space to the minutiae of executive compensation.

The added publicity and visibility, along with the continued rise in CEO pay, is making for some grumpy folks. A Bloomberg poll in March found that more than 80 percent of Americans believed CEOs make too much, and both the well-off and those making less than $100,000 held that view. A survey late last year by Watson Wyatt, a global human resource and financial management firm, asked 55 pension fund managers overseeing some $800 billion in assets about CEO compensations, and 90 percent "think the current executive compensation system has overpaid executives, and 85 percent say it has hurt corporate America's image."

Even pro-business magazines like Fortune and Forbes have been openly critical of the trend in CEO pay. Says one Forbes article, "What's at stake, in short, is nothing less than the public trust essential to a thriving free-market economy."

Obscene, but OK?

Regardless of whether CEO pay offends people's sense of fairness, even to the point of outrage, that doesn't mean it automatically violates any rules of market efficiency. But at these stratospheric levels, could current CEO pay possibly be efficient?

That's a question receiving much attention from economists and other scholars. In a 1999 paper, Kevin J. Murphy of the University of Southern California notes that research before 1985 consisted of a few papers a year. By 1995, the number had grown to about 60 papers a year. No literature tally has since been made (or at least none could be found), possibly because executive compensation has become its own research field, with pockets of research on incentives, governance, accounting, law and other subtopics.

But at its core, research on CEO compensation is rooted in principal-agent theory, which examines how a manager (the agent) operates a firm on behalf of the owner (the principal). In the case of CEOs, the common dilemma is getting the CEO to act in the best interests of the shareholders when he or she has inherently different interests and motivation, and holds a significant advantage in information and leverage over shareholders.

CEO compensation should therefore be designed to mitigate this principal-agent problem, providing both incentives and a monitoring effect to better align a CEO's self-interest with that of shareholders: Compensation incentives motivate a CEO to take the actions necessary to improve company performance; improved performance will result in higher stock prices; stock price appreciation will trigger the incentives that boost the CEO's pay. Rinse and repeat annually.

Whether CEO compensation actually accomplishes that goal is a hotly debated question. Virtually no one is arguing that CEOs are underpaid. The controversy revolves around whether they are appropriately or overly compensated. Answering this question typically involves uncovering whether shareholders have prospered as much as CEOs. In decades past, CEOs were often compensated largely through cash salaries. But over time, added focus on this principal-agent problem slowly shifted compensation schemes toward a greater use of incentives, whereby the CEO would profit when—and hypothetically, only when—shareholders did.

Compensation schemes veered hard toward pay-for-performance in the 1980s with the replacement of restricted stock (which has a vesting period) with stock options, which typically can be cashed in at the discretion of the recipient. This seemingly subtle shift shortened the performance time frame, and when a company's stock appreciated in the short term, big stock-option paydays got the attention of CEOs and compensation committees. The matter received a further boost in 1993 when President Bill Clinton signed into law a tax-deductibility cap of $1 million in compensation for a firm's top five executives in an effort to slow down what was perceived at the time to be flagrant pay. Prior to this, all CEO compensation was tax deductible, like any other employee salary. With a leash on cash compensation, firms saw noncash incentives as a perfect fill-in.

What's not quite clear, however, is the degree to which rising CEO pay is actually linked to greater firm performance. Chamu Sundaramurthy, Dawna Rhoades and Paula Rechner, in a 2005 Journal of Managerial Issues article, say empirical evidence regarding executive compensation and firm performance "is quite mixed." Their own results indicate that there is "no substantive relationship between ownership and firm performance."

Some research does show a correlation between aggregate CEO pay and overall market performance. Pearl Meyer & Partners, a compensation consultancy, reports that 2005 CEO pay rose 13 percent (to $10 million) at 179 major U.S. companies investigated. During the period studied, this group of companies saw average increases of 33 percent in net income and 20 percent in shareholder return. Notably, all 179 firms had the same CEO from 2003 through 2005.

Research looking at longer time frames has produced similar results. For example, Brian Hall and Jeffrey Liebman, in a 1998 article in the Quarterly Journal of Economics, look at a 15-year data panel of the largest public U.S. firms and document "a strong relationship between firm performance and CEO compensation," which they credit to greater CEO ownership through the introduction of stock options.

According to a National Bureau of Economic Research working paper by Xavier Gabaix and Augustin Landier, published this summer, "The sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the sixfold increase in market capitalization of large U.S. companies during that period. ... The size of large firms explains many of the patterns in CEO pay, across firms, over time and between countries."

In a 2003 NBER working paper on corporate governance and CEO pay, Bengt Holmstrom and Steven Kaplan suggest that the U.S. compensation system "is well above average" compared to elsewhere. They acknowledge that some CEOs might be paid more than necessary and that the system of prevailing incentives might be improved. But, they add, "[t]he fact that the shareholders of U.S. companies earned higher returns even after payments to management does not support the claim that the U.S. executive pay system is designed inefficiently; if anything, shareholders appear better off with the U.S. system of executive pay than with the systems that prevail in other countries."

The shark and the sucker

But a simple correlation between aggregate CEO pay and stock market returns falls well short of a causal effect—that high CEO pay is responsible for better company performance and, thus, higher stock prices. Bebchuk, from Harvard, has been the general in a small army poking holes in the notion that CEO compensation is truly based on performance. In the past several years, he has published a sizable list of papers on the subject with a variety of cohorts, along with one well-received book, Pay Without Performance (2004), with Jesse Fried of the University of California, Berkeley.

The thrust of their argument is that CEOs hold managerial power—simply put, leverage—over the boards that set their compensation. The leverage starts at the board nomination process—typically controlled by the CEO—and is reinforced by the information advantage the CEO has over the board in terms of the company's performance and his or her role in it. It persists because board members are generally reluctant to rock the boat and are somewhat toothless to do much given their limited time commitments as directors.

As a result, company boards cannot negotiate CEO pay at arm's length, a critical factor in aligning a CEO's interest with that of shareholders. What happens in its place is a pseudo-negotiation in which the CEO holds most of the cards. In poker parlay, that means the board—playing the shareholder's hand—is the sucker at the table. By playing their hand well, CEOs can extract pay that exceeds fair market value (what economists call "rent").

In some cases, the design of the compensation process makes matters worse. Boards tend to benchmark pay in terms of what the competition offers. When this happens, boards inevitably approve above-average pay packages because they don't want to send the message that their CEO is average, or worse. Call it the Lake Wobegon mentality, because all CEOs become above average. That's where Bebchuk and others scream foul, because no such arrangement would come from an arm's-length negotiation.

In a 2005 discussion paper, Bebchuk and Yaniv Grinstein, from Cornell University, show that executive pay from 1993 to 2003 "has grown much beyond the increase that could be explained by firm size performance and industry classification." Had the relationship of these three variables remained constant, mean compensation would have been about half its actual size in 2003. The authors find that the ratio of compensation to company earnings for the top five executives rose from about 5 percent to more than 10 percent during this time.

Bebchuk and his various co-authors have no particular gripe about the nominal level of CEO pay. But they chafe over the pay-padding they believe results from managerial manipulation of board compensation decisions. They also object to what they call "windfall compensation"—big executive payouts from stock appreciation that stem more from an industry or marketwide surge than from judicious moves by the CEO.

Oil and other energy firms are a good example: Rising stock prices in that industry have been due as much to political conflict, natural disasters and even serendipity than to the particular activities or visions of the CEO. Rising energy prices have lifted virtually all stocks in this sector, which creates windfall compensation for CEOs despite the fact that their company's stock performance was not unique within the sector.

Bebchuk and Fried suggest that performance benchmarks use indexed options that compare a company's stock price appreciation to a basket of competitors, and offer compensation to the degree that the company beats the competition in stock price appreciation and is the result of firm-specific performance. That is a more onerous metric, to be sure, but it does a better job of making sure compensation is due to a CEO's steering of the boat and not by virtue of the CEO merely being in the boat as the tide comes in. The idea has reportedly been slowly winning some board converts.

Bebchuk and others have also zeroed in on other, growing forms of compensation—golden hellos, goodbyes, perks and especially retirement packages—that typically have little to do with company performance.

Bebchuk calls such pay "stealth compensation," because it is rarely disclosed, or obscurely so when required, and so flies under the radar of investors, the public, even boards themselves. For example, the SEC requires disclosure of pensions and other retirement pay, but does not require firms to include monetary values. That might sound innocuous enough, but pension formulas mean little without cumulative dollar amounts. Some boards do not even know the full value of these packages—leading to what some have called the "holy cow" calculation, as when the board of the New York Stock Exchange got caught with a surprised look on its face upon discovering that it had signed off on a $140 million retirement package for departing CEO Dick Grasso (though a recent court ruling has ordered he give back $100 million, a decision he is appealing).

Shadow boxing

To a certain degree, both sides are swinging at shadows. That is, neither has the weight of hard evidence on its side. The critics of current CEO compensation levels point mostly to theory and to seemingly obvious design flaws, and the weight of anecdote can be pretty compelling. But they typically fail to demonstrate the "so what" factor: namely, that high CEO pay has had a systematically detrimental effect on shareholder value.

Indeed, if CEOs are overpaid, then it would seem logical that the crush of recent research might have calculated, even hypothesized about, the amount of rent being extracted by CEOs. But you'll find no such estimates in the literature. Despite their extensive—and widely heralded—critique of executive pay, Bebchuk and Fried make no estimates of the booty seized by way of managerial power, despite insisting repeatedly that it exists and making numerous reform proposals to constrain its growth.

In an e-mail response to questions from the Region, Bebchuk said the focus of his research "is on the structure of compensation, not on the level." He added that it's hard to determine exactly what CEO pay would look like with arm's-length contracting. "The absence of arm's-length contracting is likely to lead to pay exceeding the arm's-length benchmark," Bebchuk said. So, while their argument is intuitive, logical, even seductive, it adds up to something of a "trust us."

A lengthy review of Pay Without Performance in last year's Michigan Law Review by John Core and Wayne Guay, both from the University of Pennsylvania, and Randall Thomas of Vanderbilt, puts it this way: "It is correct that U.S. CEO incentives and pay are large both by recent historical standards and relative to other countries, and that they have grown during the 1990s. However, there is very little if any empirical evidence that shows that U.S. CEO pay, or its growth, is suboptimal. ... [Bebchuk and Fried] have provided some interesting examples of bad apples, but have not offered evidence to show that the entire barrel is bad."

The managerial power argument also struggles to account for the fact that CEOs have likely been trying to extract rent since the invention of the corporation. For this to occur, a CEO must rely on board members who are connected to the firm and have some allegiance to the CEO to help carry the water. But over time, and especially of late, boards have become more—not less—independent.

On the other side, defenders of CEO pay might want to simply plead the Fifth. Though some studies have found correlations between CEO pay and firm performance (specifically stock prices), there is little evidence to suggest a cause and effect—that is, that high stock market returns are the direct result of CEO performance (and related CEO pay).

There are plenty of examples of highly paid CEOs running poorly performing companies, as well as modestly paid CEOs at the helm of high-performing companies. Business publications today are stuffed with these sorts of annual lists—the best and worst CEOs and the highest- and lowest-paid CEOs. But many analyses of CEO pay never get past the aggregate level—say, CEO pay versus stock price appreciation among all S&P 500 firms-glossing over other, more careful investigations, such as CEO pay trends among high- versus low-performing S&P firms.

So too are there plenty of examples of pay-for-performance incentives going awry, where CEOs either fudge the books or focus exclusively on enhancing short-term stock prices to the long-term detriment of the company. According to a 2003 study by the New York Office of the State Comptroller, the number of earnings restatements by U.S. corporations listed on the New York Stock Exchange increased steadily from 48 in 1996 to about 240 in 2002, which the study attributes in part to the trend in tying pay to earnings. With the passage in 2002 of Sarbanes-Oxley (a financial reporting and oversight law stemming from the collapse of Enron), restatements reached almost 1,200 last year, according to the research firm Glass, Lewis & Co.

The shenanigans don't stop there. In October, the heads of United Healthcare, McAfee and CNET Networks stepped down after allegations of stock-option abuse—and they were just a few of 130 companies nationwide being investigated at the time by the federal government or internal auditors for back-dating and other questionable stock-option practices.

Other theories

So if there is no clear link between CEO pay and firm performance, but also no real firm notion of what a "rentless" CEO market might command in pay, might there be other market-based explanations for why CEO pay continues to rise? Possibly, but none of them extends much beyond speculation.

For example, economic theory would suggest that the passage of Sarbanes-Oxley has helped raise CEO pay, if only to a small degree. The law—mostly derided by Corporate America—makes CEOs liable for erroneous financial statements, which represents a risk factor that would logically lead to higher insurance-based payments for any prospective CEO.

Supply and demand idiosyncrasies also influence CEO pay. For example, there is a growing trend toward hiring CEOs from outside the firm, rather than the more traditional method of promoting from within. In a 2004 paper, Kevin J. Murphy and Ján Zábojník, both from USC, find that outside hires accounted for 15 percent of CEO replacements in the 1970s; by the 1990s, it was 26 percent. Anecdotal evidence suggests it is higher still today and that firms tend to pay more to attract CEOs from outside the firm.

Rakesh Khurana at Harvard has expressed this as the "Super CEO" syndrome—the desire for a charismatic CEO savior. Such a standard artificially narrows the candidate field to existing CEOs or recently retired ones, eliminating many otherwise-qualified candidates.

At the same time, CEO turnover has been accelerating—evidence, some argue, of greater board independence and stricter pay-for-performance demands by these boards. In 2000, 57 of the nation's largest 1,000 firms had new CEOs, growing steadily to 129 in 2005, according to public relations firm Burson-Marsteller. The trend also is hitting firms of all sizes. According to Challenger, Grey & Christmas, an executive outplacement firm, total CEO departures in 2005 doubled from the preceding year, to about 1,300. Another record appears to be in the offing this year, with 960 through August.

With CEOs having shorter expected tenure, more demands for performance, greater demand for their services and higher personal liability for a firm's financial statements, economic theory suggests that reservation wages—the level at which a person chooses work over leisure—for CEOs should also be going up.

Clearing the smoke-filled boardroom

Ultimately, any change in the trend of CEO pay likely will have to come through a changing mindset among boards, which feeds back to much of Bebchuk's arguments. Some research has begun to recast the principal-agent problem farther upstream between shareholders and a firm's board, looking at whether incentives are in place for boards to properly govern and lead firms, including the setting of CEO pay at proper levels.

As one might hope, there appears to be a solid correlation between good governance and shareholder return, though research to date is limited. A 2005 report on corporate governance by the Bureau of National Affairs says that "an increasing body of evidence suggests that enhanced governance equals enhanced performance. ... [C]orporate boards that are more concerned about shareholder rights are also better guardians of shareholder money. Simply put, good corporate governance does, in fact, pay."

A white paper last year by Institutional Shareholder Services, a corporate governance consultancy, looks at 16 performance metrics from 2002 to 2004 for 5,200 U.S. firms. It concludes that companies with better corporate governance "have lower risk, better profitability and higher valuation. More specifically, these well-run companies outperform poorly governed firms in return on investment, annual dividend yield, net profit margin, and price-to-earnings ratio." Such findings, the authors note, "are generally consistent with the limited academic research that has been done in this area."

Better governance doesn't come free, however, and like CEO pay, incentives matter for directors as well. Director compensation has been on the rise, according to separate surveys by the Conference Board, Korn-Ferry and Aon Consulting. Annual compensation runs between $50,000 and $100,000, depending on the sector and firm, with annual increases of late running up to 20 percent or more.

A 2005 study by Paula Silva in the Journal of Managerial Issues finds that boards compensated with equity ownership tend to use a more quantified, verifiable approach to CEO performance. Those boards without stock ownership tend to use more qualitative approaches to CEO evaluation. She also finds that poorly performing firms have boards that use qualitative evaluations of CEOs.

The moral of the story is that current CEO pay levels, whether deemed too low, too high or just right, haven't happened by chance, but by design. And in the future, better design is likely to come about through better corporate governance. That might or might not lead to changes in CEO pay levels, but it would better ensure that CEO pay—whatever its level—is more surely attached to performance.