Friday, December 16, 2011

Mitigating Executive Compensation

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. Boards with significant stock ownership of the company may also be more likely to act like owners (rather than the CEO's friends) when determining compensation levels. 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.

Information on how to find the company's compensation practices is available here.

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

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