Tuesday, December 15, 2009

What Is The CEO Worth?

Wage disparity between executives and workers has been on the increase for several decades. In 1982, the average CEO of large US firms made 42 times the wage of the average worker. By 2001, that number increased to a staggering 531 times *. Opponents of this disparity will argue that intervention is needed to force companies to have higher parity within their wage structures. Others argue that executives are worth every bit of their salaries or companies would not pay them.

Unfortunately, it's difficult to know what a CEO is actually worth. In theory, letting the market decide what to pay executives should establish reasonable ranges, as companies which pay their executives too much will suffer from lower profits than firms with better compensation practices. In practice, however, the market makes plenty of mistakes. When investors investigate the pay structures of executives in companies in which they are interested, there are several important items to look out for.

The first is whether the compensation package rewards a manager only for what he can control. For example, the profit performance of an oil producer is directly related to the price of oil, which is rather volatile. But the oil company's CEO has no control of that price. If bonuses and options are not indexed to the price of oil, the manager's compensation is unrelated to his skill and effort.

Compensation also appears to be sticky on the way down. While bonuses and salaries rise as a company does well, they do not decline when a company does poorly. This not only exacerbates the first point above, but it results in an incentive structure which is asymmetric (heads, I win big...tails, I don't lose) leading to excessive risk-taking. Golden parachutes also protect managers even following poor performance.

Finally, managers have company-specific knowledge that the rest of us don't, and so they are able to take advantage of situations with their superior information. For example, they can sell shares or even retire when expectations are at their peak relative to fundamentals.

The above issues can be counterbalanced. Restricted stock (when restricted until long after the end of a manager's employment), structures which are aligned with what an executive can control, and symmetric rewards/punishments are examples of how enlightened boards are ensuring they are getting a good deal for their money. Investors can protect themselves from falling victim to excesses in executive compensation by ensuring the companies in which they invest have sound practices where shareholder interests are maintained.

* McKinsey study: A New Era in Governance, McKinsey Quarterly 2, 2004

1 comment:

Biology said...

I do agree with the comments posted by Observero0 but I'm not that concerned about CEO pay in privately-owned companies that run their businesses effectively. We should all be rewarded by a job well done. It's those clueless fat cats sucking off the government teat that I despise. From the moment a company - any company - takes a single dollar in government money to right the wrongs the company has made, that is no longer a private company. It's a company owned by our government. We need to put a stop to our corporate welfare system that makes billionaires out of crooks, thieves, and swindlers. And idiots. As a government-owned entity, rules and regulations - and limitations - kick in the moment the government cash is accepted. And there is no reason for rewarding bad or stupid behavior - yours, mine, anybody's. I read elsewhere today some AIG execs are threatening to leave because their paychecks are going to reflect the piss-poor job they've done lately.

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