The Wall Street Journal was in no doubt. Under the headline “Option Opulence”, it reported how the “bull market is bringing huge ‘paper’ profits to executives” of companies granting options. The New York Times was able to disclose that several inquiries were under way into the “untimely bounteousness” that had created a “new and resplendent class of workers whose emoluments exceeded those of most great owners”.
The quaint turn of phrase gives the game away. Those two articles, the first from 1955 and the second from 1933, show that public disquiet — outrage even — about bosses’ earnings is as old as the executive dining room.
The most recent great paroxysm in America was in the early 1990s, at the time when Graef Crystal published his book “In Search of Excess”. It produced a law that tried to cap the chief executive’s salary at $1m, using the tax system. The law caused some bloodletting, but proved a sensational failure: the $1m ceiling in effect became a floor as companies raised their managers’ basic pay to the threshold. Christopher Cox, chairman of the Securities and Exchange Commission, last year told the Senate banking committee that the law “deserves pride of place in the museum of unintended consequences”.
Just as misgivings about pay seem to crop up in every generation, so they crop up in just about every economy, too. Even Norway, which has one of the world’s most compressed pay scales, has introduced laws on disclosure and votes on remuneration (as indeed have most other European countries).
That people everywhere are perpetually irritated by the boss’s pay is a good reason to hesitate before drawing conclusions from the latest fuss. It is hard to say, for instance, whether people last year were more annoyed by Lee Raymond, the long-serving head of Exxon Mobil, getting a parting pay packet of some $400m or by the rise in the petrol price to $3 a gallon.
The public debate on pay draws heavily on individual examples. Such anecdotes make an impression partly because they are so dramatic and partly because there is no way of offsetting them by examples of people who have been paid just the right amount.
What the anecdotes show is that chief executives sometimes abuse their position and that boards sometimes pay them too much. That may be wrong, but it is not surprising. After all, the shift from imperial chief executive to options-rich manager is founded on the idea that companies are run not by philosopher-kings pursuing the common good but by people made of flesh and blood and with a keen sense of self-interest. Similarly, pay packages are complex contracts that may be drawn up in one set of economic circumstances and enacted in another. Any market will produce examples of people who overpay at the peak of a boom, say, and live to regret it when the bubble has burst. The question is what all these particular stories reveal about governance in general, and about its part in explaining the rapid increase in executive pay.
Wrong Time, Wrong Place
The main weakness of the governance explanation of excessive pay is that the conduct of boards and the market for chief executives have both been improving in recent years. Pay took off at a time when executives were under more scrutiny than in the 1950s and 1960s, a period of restraint in spite of a bull market for equities. It is hard to explain by weak governance why powerful executives back then should have passed up the chance for higher pay that their less powerful successors were later able to seize with both hands. Similarly, flaws in the system of hiring executives can explain rapidly increasing pay only if the market had failed sensationally in the 1980s and 1990s. Instead, the market for executives has grown steadily. Certainly it is imperfect, but it is less imperfect than it used to be.
The pattern of pay over the past few years is also hard to explain in terms of governance. Thanks to new listing rules adopted by the New York Stock Exchange in 2003, chief executives are no longer on the nomination committee for directors, they cannot receive loans from directors, directors are more independent, and pay consultants work directly for the compensation committee rather than reporting to managers. Moreover, after the controversy over pay and the scandals following the collapse of the internet bubble, boards can be in no doubt that the chief executive’s pay will now be subjected to minute scrutiny.
David Nadler of Mercer Delta, a change consultancy, describes all this as a fundamental change in the authority of the board. “For 20 years you didn’t need to know about the board,” he says. In the bad old days board members used to fall asleep and drink too much. When people were unprepared for board meetings, everyone would laugh, “give ’em lunch and send ’em home.” These days boards are monitoring their own performance and seeking advice on how to cope with splits and conflict. Boards must routinely meet in “executive session”, that is, without the chief executive present. That encourages directors to talk frankly and raise questions without seeming to confront managers or undermine their authority. Executives “used to talk about ‘my board’ in the imperial sense”, Mr Nadler says. “Now managers are employed by the board.”
If excessive pay were chiefly the result of poor governance, such improvements might have been expected to bring about a large and permanent downward adjustment in executives’ remuneration. After the stockmarket bubble burst, median pay did indeed fall a little, and the arithmetic mean much more. Some, if not most, of the fall can be put down to the decline in the stockmarket. After all, executives are paid partly in shares, a currency that had just suffered a big devaluation. But the effect was relatively small and temporary. By 2004 pay in the largest companies was again growing much faster than average workers’ wages. By 2005, according to Mercer, the total pay of the chief executives of 350 large companies had easily surpassed its level in 2002 (see chart 1 in “In the Money“). Better governance may have lowered pay, but not by much.
In fact, the argument that powerful incumbent chief executives use their influence to wring extra money out of weak boards is hard to square with what has happened in the market for outside executives. In the 1990s, when incumbent executives were extracting more money than ever before from their particular firm, a record number of managers voluntarily gave up this advantage by leaving for new companies, where they would typically start off with less influence. Moreover, executives were able to keep their salary high when they changed firms. The fat pay packet which according to the theory depended on managers’ power over their old board turned out to be transferable to other jobs where the managers had to negotiate with strangers on the new board. That looks like a market at work, not a rigged game.
The third main complaint about governance in the 1990s was that executives were granted too many options on easy terms. Yet, on closer inspection, this accusation also needs qualifying. It is clear that a sort of mania took hold in the 1990s and that boards were extravagant with options. This makes options a failure of governance, but not one that fits the common view that top managers were exploiting investors. Brian Hall of Harvard University and Kevin Murphy of the University of Southern California have established that top executives received under 10% of the options handed out at that time. The rest went to other employees — in some companies to all employees. Such generosity was not restricted to Silicon Valley. In 2000, for instance, “old-economy” companies gave employees below the top five an average of $2,559 each in options.
Dishing out options to the office cleaners makes no sense. Options are an expensive way to pay employees: they are worth less to workers than they cost the company to issue. This is because options cannot be freely traded, and workers may feel that if they already depend on their firm for their job, investing in the business as well means having too many eggs in one basket. For such people, cash is much more valuable. For companies, one reason for issuing them was to inspire loyalty and provide an incentive to stay on. But option grants outside management have fallen steeply since 2004 and will, consultants predict, eventually disappear altogether.
Governance critics also saw something sinister in the easy terms of options packages. In the 1990s these were almost always “plain vanilla”, granted at the current share price, with a vesting period of three years and without any performance hurdles. Executives got them just for turning up to work (“pay for pulse”) as they waited for the bull market to lift the share price.
That design was hardly demanding, but it was encouraged by America’s accounting rules rather than by greedy executives. Contrary to both economic logic and the principles of accounting, options granted at or above the day’s share price did not count as an expense in the accounts and eventually delivered a tax credit to the company. On the other hand, options “in the money”, ie, below that day’s share price, or with performance hurdles attached, were charged as a cost. Advocates of governance reform argued, reasonably enough, that “expensing” options should not affect a company’s stockmarket value, as it would not affect its cashflow. The failure to attach hurdles to options was a failure of governance.
However, such advocates underestimated people’s enslavement to accounting conventions. In the past two years there has been a flowering of long-term incentive plans of a different kind. According to Scott Olsen, a pay expert at PricewaterhouseCoopers, performance hurdles are now common. There are longer vesting periods and holding periods after the options have been exercised. Worried about dilution, investors have successfully pressed companies to issue “restricted” shares which their owners cannot sell freely. The shift from standard options was prompted by an accounting change that came into force in America in 2005, requiring options of all sorts to be expensed. The performance hurdles are mostly based on internal measurements, because market-based tests still receive less favourable accounting treatment.
Everybody’s Doing It
International pay patterns add to the evidence that American pay was determined chiefly by the market. National pay cultures vary, with long-term incentives playing a far more important part in America than anywhere else (see chart 5). Options for executives were first adopted in continental Europe about ten years ago and grew rapidly almost everywhere. According to Harm van Esch of Russell Reynolds, an executive-search firm, industries that are particularly exposed to international competition, such as the technology sector, have changed faster than more local ones such as construction.
Piia Pilv, of Mercer’s pay consultancy, has noticed a similar pattern in eastern Europe and the Middle East. At first clients were interested only in getting hold of international pay data, but soon afterwards they started looking at the design of long-term incentive plans. Multinationals that are grappling with different pay schemes in different markets lead the way, along with industries that employ lots of foreign executives. In the Middle East, says Ms Pilv, private companies are rapidly raising pay towards international norms, but the state-owned sector is slower. Whereas Japan is a laggard, Chinese companies are embracing long-term equity incentives. Early government approval was given in 2006 and now some 100 firms, such as ZTE, a telecoms-equipment group, are planning to use long-term incentives to motivate managers.
Pay-consultancy services offered by firms such as Mercer, Frederic W. Cook, Watson Wyatt and PricewaterhouseCoopers have themselves proved controversial. Critics complain that the data they provide help to ratchet up pay because almost all companies seem to want to pay their executives at or above the average (a statistical impossibility), and that the consultants suffer from conflicts of interest. In the past they reported to the chief executive rather than to the board. That arrangement has been outlawed by the New York Stock Exchange, but sometimes the consultancies have other large contracts with the company which are in the gift of the very executive whose salary they are helping to set.
It is feeble of boards and managers to blame the consultants for everything. Directors were always free to decide whose advice to take and whose to ignore. And companies have good reason to follow the crowd in pay because good packages are difficult to design. Bengt Holmstrom, a professor at MIT, points out that some of the most astounding pay packets were offered by companies such as Apple and Oracle whose boards adopted unusual structures or turned their backs on comparative data.
Accusations of conflict have more substance. Quietly, a few consultants will admit that in the 1990s the standard of advice sometimes fell short — though of course only at other consultancies. But the consultants’ job has changed since they stopped working for executives and took up with the board instead, and they themselves seem happier to work that way.
How to Cut Severance Pay
Even the most controversial elements of pay may have a market logic. Krishna Palepu of Harvard Business School observes that companies preach the rhetoric of pay for performance but go on to guarantee the payout, using devices such as severance payments. Perhaps that is because a company cannot go on piling risk onto its executives. Imagine a board replacing an executive’s standard options with a type that pays out only if the company’s share price beats an index of its competitors. Such an option, recommended by some advocates of governance reform, has the advantage for the company of rewarding the executive for doing better than his peers but not for a piece of luck that affects everyone equally. But it is a riskier proposition for the executive. Messrs Hall and Murphy calculate that a standard option has a probability of 80% of paying out at the end of ten years, compared with less than 50% for an indexed option.
In Britain investors sought to tighten long-term incentives so that they paid out only for companies that had done better than average. One device was to award restricted shares based on share-price performance and dividends that outclass similar companies. According to PricewaterhouseCoopers, the trouble with such plans is that they do not pay out often enough. That is bad for the companies as well as for their executives, because a scheme that frequently fails to pay out soon loses its motivating power. Companies have responded by easing the rules for other incentive schemes, such as the annual bonus.
Boards could do away with severance payments and the like, but at the cost of making executives’ jobs even riskier. That holds two worries for companies. First, a riskier job would attract a different kind of applicant, so companies might find it harder to lure an executive from a secure perch at a successful public company. Second, those applicants who were not put off by the extra risk might well expect extra compensation for it. So the reforms advocated by governance activists would sometimes result in even higher pay than they do now.