The Real Story Behind Executive Pay

The Myth of Crony Capitalism

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Room with a view: businessmen watching the Occupy Wall Street Protests, May 2012. (Mike Segar / Courtesy Reuters)

As the share of income taken home by top earners in the United States has risen over the past few decades, so, too, has popular concern about economic inequality -- something the Occupy Wall Street movement loudly reminded Americans about in 2011. Much of the outrage has centered on the compensation of the United States’ top corporate executives, who are said to be taking home ever-fatter paychecks, while the incomes of lower-level employees have stagnated. “American workers are having to make do with less,” an AFL-CIO official complained to The New York Times last year, “while C.E.O.s have never had it better.” (Europeans have also gotten worked up over these issues, with the EU proposing rules that would cap bankers’ bonuses.)

Part of the problem, allegedly, is that the corporate boards that determine CEOs’ pay packages have severed the link between salary and achievement. Lucian Bebchuk and Jesse Fried, authors of the 2004 book Pay Without Performance, conclude that “flawed compensation arrangements have not been limited to a small number of ‘bad apples’; they have been widespread, persistent, and systemic.” Mihir Desai of Harvard Business School has claimed that skewed incentives for executives have fueled “the twin crises of modern American capitalism: repeated governance failures . . . and rising income inequality.”

Economists such as these argue that although CEOs are in theory beholden to the boards that hire and fire them, often the reverse is true, with directors striking sweetheart deals to stay in the good graces of powerful executives. If only corporate boards broke free from their executive captors, the logic goes, CEOs would get a taste of accountability, their pay would return to earth, and the growing gap between the rich and the poor could begin to narrow.

But the reality of executive compensation reveals a far different picture from this caricature of skyrocketing pay packages and crony capitalism. In fact, although their incomes rose dramatically over the twentieth century, U.S. CEOs of public companies have seen their pay fall, not rise, for the past ten-plus years. Moreover, they are penalized for bad results, with their pay tracking their companies’ stock performance. And boards do monitor performance; executives of companies with sliding stock prices now face a much greater risk of getting fired than they did in years past.

It is impossible to deny that the United States’ corporate executives are paid handsomely. And there have been high-profile examples of overly generous boards. Yet the idea that CEOs’ high incomes are primarily the product of failures of corporate governance is a myth. Rather, CEOs of public companies have benefited from an increasingly remunerative market for top talent. As technology has improved and companies have grown larger and more efficient, incomes among the country’s other top earners -- private-company executives, corporate lawyers, hedge fund managers, and investors -- have also risen. In other words, high incomes in the United States, and the accompanying inequality, stem from broader market forces, not from quirks or imperfections in the U.S. corporate governance system. Attempts to reduce top executive pay through additional regulation will only risk driving skilled public-company executives to apply their talents elsewhere.

THE COMPENSATION MYTH

From 1936 to 2000, the CEOs of large public companies saw their average inflation-adjusted pay increase almost 19-fold. I recently asked a group of chief financial officers for public companies, a group of large institutional investors in public companies, and a group of corporate governance academics what they thought had happened to average CEO pay since 2000. Over 60 percent of each group said that pay had continued to go up, and less than 30 percent said that it had stayed flat. Less than ten percent of each group believed that pay had declined.

Yet it had. As the figure on page 22 shows, from 2000 to 2010, the boards of S&P 500 companies -- the largest publicly traded U.S. corporations -- decreased the average amount they awarded their CEOs by 46 percent. Over the same period, average pay converged with median pay, which stayed roughly flat -- up eight percent from 2000, but down seven percent from 2001. (These figures represent “estimated” pay, which includes the hypothetical value of the stock options issued to the CEOs at the time they were granted. In other words, they measure how much a board intended to compensate its chief executive.) The story is similar outside the S&P 500. Average CEO pay among more than 1,000 smaller public companies also increased in the 1990s and declined in the decade afterward, likewise falling closer in line with median pay.

The convergence between mean and median pay suggests that since 2000, boards have become far less likely to award unusually large pay packages. Some executives do earn gargantuan sums; in 2010, for example, three CEOs of S&P 500 companies -- Philippe Dauman of Viacom, Larry Ellison of Oracle, and Leslie Moonves of CBS -- received over $50 million each. But these cases are the exception rather than the rule.

That said, although CEO pay has recently fallen, it remains very high in an absolute sense. In 2010, the average S&P 500 CEO took home more than $10 million, roughly 200 times the income of a typical U.S. household. Especially since the 1990s, CEOs have done extremely well for themselves. The important question is, why?

The most compelling answer involves market forces, not corrupt corporate boards. Specifically, improvements in technology and the growth in the size of firms and the scale of finance have allowed more talented people to increase their productivity relative to others. The larger the company, the greater the returns to hiring a productive CEO. And as firms have become more valuable, boards have responded by spending more to attract talent that can affect that value.

That story checks out when comparing companies’ market value to the pay their CEOs receive. Ever since the late 1970s, the ratio between the average pay of CEOs of large public companies to the average market value of those companies has stayed relatively constant: CEO pay has grown hand in hand with corporations.

THE RISE OF THE REST

For further proof of this theory of market-driven CEO compensation, consider what has happened to the incomes of other well-paid people. If a broken corporate governance system were to blame for the long-term rise in executives’ pay, then one would expect the pay for all top earners -- the vast majority of whom are not public-company CEOs and thus do not necessarily have their incomes determined by boards -- to have grown more slowly than that of public-company CEOs.

Yet over the past 30 years, incomes for that broader group have also risen, meaning that the CEOs of the biggest companies have seen little change in their pay relative to that of other top earners. In 2010, the average S&P 500 CEO made about twice as much as the average person in the top 0.1 percent of U.S. taxpayers -- about the same ratio as in 1994. CEOs of smaller public companies, for their part, have actually done worse over time, earning less relative to the top 0.1 percent than they did in the early 1990s. Looking even further back in time, the same pattern of stable relative incomes holds true. In 2007, CEOs of large public companies were making roughly the same amount relative to the top 0.1 percent as they were in the late 1930s, when the problems of corporate governance said to drive CEO pay today were presumably less acute.

A comparison of private- and public-company CEOs offers more evidence that overly generous boards are not to blame for high pay packages. Executives of private companies should possess similar skills and come from similar pools as executives of public companies, yet they are different in one important way: because private companies are controlled by large shareholders, the boards that pay their CEOs have a greater stake in the companies’ success. Thus, they should be less subject to any skewed incentives that supposedly inflate CEO pay when it is determined by public-company boards, the directors of which may own some, but not much, stock. Yet the incomes of private-company executives have actually risen faster than those of public-company executives.

Lawyers at top law firms offer another useful comparison group. Much of the work they perform is for corporate clients, and because the general counsels of large public companies are often former law partners, there is some overlap in the market for talent between top executives and top lawyers. Law firms are partnerships, and their fees are negotiated with outside clients, so partner pay is undoubtedly market-based; there is no captive board of directors that can be blamed for it. Yet like CEO pay, the average profits per partner at the top 50 law firms increased markedly from 1994 to 2010, from $0.7 million (in 2010 dollars) to almost $1.6 million. In fact, over the same period, the pay for top law partners rose faster than did that for public-company CEOs.

Hedge fund managers compose another highly paid group. Since 2001, Institutional Investor’s Alpha magazine has published an annual list of the 25 highest-paid hedge fund managers, estimating how much they earned from fees and from the capital they invested in their funds. Although the inclusion of their investment income causes the figures to overstate how much of these managers’ income derived from their employment per se, the trends are striking. Their average income (in 2010 dollars) grew from $134 million in 2002 to a peak of over $1 billion in 2007 -- roughly a hundred times as much as that of the average S&P 500 CEO.

The point of these comparisons is to show that although public-company CEOs earn a great deal, they are far from unique. Members of other groups with similar backgrounds and skills, in fields where a competitive market for talent exists and where the mechanics of awarding pay are different, have also experienced substantial pay increases. If one points to higher CEO pay as evidence that executives have captured boards, then one must also explain why other professional groups are getting paid more, too. Instead, the more likely story is that market forces affecting the broader corporate world are at work. Technological advances have allowed lawyers to do more work faster and on bigger deals, investors to trade large amounts more efficiently, and CEOs to better manage large global organizations. And as firms have grown larger, so, too, have the returns for leading them.

PAYING FOR PERFORMANCE

Another popular myth alleges that not only do CEOs receive exorbitant pay, but they do so even when they are failing. According to this story, corporate boards are again to blame, overpaying and underfiring. Once again, however, the evidence fails to support this notion.

To test whether public-company CEOs are paid for performance, the economist Joshua Rauh and I asked whether chief executives who run companies that perform better relative to their industry peers earn more than those whose companies perform worse. (We looked at “realized” pay, which includes actual option gains, not theoretical ones. This measure is more appropriate here because a firm’s actual performance determines the value of the options.) Analyzing some 1,700 firms, we found that compensation was highly related to performance: the companies that paid their CEOs the most saw their stocks do the best, and those that paid the least saw their stocks do the worst.

Performance-based payment also explains why U.S. CEOs earn about twice as much as their foreign counterparts. Some critics of CEO pay have pointed to that gap as evidence of the United States’ failed corporate governance system, but it is more properly understood as the product of the country’s greater reliance on equity-based pay. A comparative study by Nuno Fernandes, Miguel Ferreira, Pedro Matos, and Kevin Murphy concluded that, controlling for individual firm characteristics, “the U.S. pay premium is economically modest and primarily reflects the performance-based pay demanded by institutional shareholders and independent boards.”

Boards also hold CEOs accountable in another way: by firing them. In fact, research shows they are resorting to this punishment more frequently. Before 1998, the average S&P 500 CEO could expect to stay on the job for roughly eight years; since then, the number has dropped to six. The job of CEO has become riskier over time, in other words -- a change that offsets some of the benefits of higher pay. Thus, the true increase in CEO pay since the early 1990s is arguably smaller than compensation figures alone imply, since CEOs are earning that money over shorter time spans.

Moreover, CEO turnover has become increasingly tied to poor stock performance, suggesting that U.S. corporations have gotten better at monitoring their executives. The economists Dirk Jenter and Katharina Lewellen examined CEO turnover from 1992 to 2004. They found that in the first five years of their tenure, CEOs whose companies performed in the bottom quintile among their industry peers were almost four times as likely to lose their jobs as CEOs whose companies performed in the top quintile. Among companies with especially independent boards and directors who had greater stock ownership, CEOs whose companies performed in the bottom quintile were eight times as likely to lose their jobs. As the authors concluded, “Boards aggressively fire CEOs for poor performance.”

It would be worth knowing whether shareholders think CEOs are unjustly rewarded. Fortunately, the Dodd-Frank Act of 2010 mandated that most publicly traded firms hold nonbinding shareholder votes on the compensation of their top five executives. Supporters of this “say on pay” provision contended that the votes would act as a check against outrageous pay and hold CEOs more accountable. The act thus set up a useful test, pitting the view that compensation is largely determined by market forces against the view that it is a function of boards’ outsized generosity.

The results? Shareholders have overwhelmingly backed existing pay policies. In 2012, an impressive 97 percent of the companies required to hold these votes received the support of over 50 percent of their shareholders, and 72 percent received above 90 percent support. If executive compensation were the product of captured boards, then one would expect far more investor outrage.

It should not be surprising that shareholders tend to approve of the pay packages that their executives receive: corporate America has weathered the recession well. Although the S&P 500 index has only recently begun to near its peak of 1,576 in 2007, after falling precipitously in 2008, the median operating margins of S&P 500 companies have actually grown since then. Nonfinancial companies in the S&P 500 have done even better, and nationwide, corporate profits as a fraction of GDP have reached historically high levels. In other words, at the same time that CEOs’ compensation has fallen, the average operating performance of their companies has actually improved -- the opposite of what one would expect in a world of boards gone wild.

COMPETING FOR TALENT

Judging by the perceptions of the media, investors, and even experts on corporate governance, one might naturally assume that the United States’ public-company executives are getting large and undeserved raises. But as a careful parsing of the available data suggests, the opposite appears to be true: over the past decade, they have seen their pay slip in real terms, and they are increasingly rewarded for good performance and penalized for poor performance.

Regardless of their resemblance to reality, however, the misperceptions matter. Because executives earn far, far more than the median household, and because there have been some egregious cases of poor corporate governance, boards now face intense political and popular pressure to reduce the amount they pay their CEOs -- especially given that the economy is still moving sluggishly. The upside of this scrutiny is that it will likely further reduce outliers and further increase pay for performance.

At the same time, the market for executive talent is putting ever more pressure on boards to attract and retain their top employees with competitive pay packages. Boards are caught in the middle, forced to choose between soothing public outrage and holding on to the people responsible for the success of their companies. To the extent that boards choose not to respond to market pressures, the better public-company executives are likely to move to private companies, particularly those funded by private equity investors, who are happy to pay for talent when talent adds value.

Americans are understandably worried about economic inequality, but CEOs’ salaries have not been the driver of that inequality. Rather, they have been buoyed by the same forces that have increased pay for others. Policymakers who want to narrow the gap between the rich and the poor by regulating corporations are likely to be disappointed and could even do unintended damage by undermining the ability of top public companies -- important engines of the American economy -- to attract and retain the best people.

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