Why Restraining Executive Pay Makes No Sense – III Sunday, May 13 2007 

Business and Corporate Life and Executive Pay buscom 11:17 am

The third reason why society might want to intervene in CEO compensation is simply to obtain a specific outcome for policy reasons. Governments may prefer that CEOs be paid less if that is what voters seem to want. If my argument in the previous posting is correct, one can move CEOs down the line of intersection of the demand and supply curves with impunity. It is very rare that interference in markets will result in such limited fallout. Intervention will not really distort the market and will not cause CEOs suddenly to quit in protest. What is the problem with doing this? Well, the first point is that the burden of proof is on those supporting interference. Why adjust the compensation of CEOs and not go after golfers, football players or any highly-paid person? There is the perception that CEOs in particular “don’t deserve it”, while a sports celebrity does. This can only be based on the conclusion that the process of choosing CEOs is not based solely on ability and merit, which may well be the case, but this is surely the fault of shareholders and their boards. For reasons of equity it isn’t clear why one can justify meddling in one person’s pay but not another’s. Certainly some of them deserve to be in their current roles. If Tiger Woods’ compensation were to be reduced by fiat to half its current level – a modest $50m or whatever – he would still play golf, presumably equally well, and nobody would live their lives much differently. Nevertheless ,there is no moral justification for doing so, and the attempt would be met with protests from lovers of the game who feel that Mr. Woods deserves whatever he earns. Regulation of pay is something you do to everyone or no-one.

If attempts to protect shareholders are unwarranted and efforts to “correct the market” are counter-productive, and if it is not morally or economically valid to try to direct CEO compensation towards a particular outcome, then the effort should be abandoned entirely.

 

Why Restraining Executive Pay Makes No Sense – II Saturday, May 12 2007 

Executive Pay buscom 6:10 am

As I wrote yesterday, there are several reasons why society might want to try to limit compensation for the corner office. One possible justification for intervention would be to correct market failures, either of collusion or lack of information. The market for top executive talent is probably not a very well-functioning one, but for reasons other than collusion and lack of transparency. Further, the very individual characteristics of this market mean that exchange of information, while well-intentioned, may make the problem worse. The market functions poorly because the supply and demand curves are very idiosyncratic.

For a normal market, economists generally assume that the market price and quantity exchanged are determined by intersecting supply and demand curves. See below. One can debate the exact shape of these curves, but most people agree that supply goes up with price and demand goes down.

sd1.png

 

The market for CEOs doesn’t work so neatly. The demand for CEOs is, think about it, largely fixed. It goes up and down due to corporate organization changes, and, over the long-term, the creation of start-ups, but it has little to do with price. CEO compensation may involve huge sums of money to an individual but to large corporations the numbers are negligible and scarcely influence demand. If the price goes up, within reasonable limits there is no decrease in demand – limits well above the packages we are talking about. Similarly if price goes down, companies don’t start to add additional CEOs to the payroll. The demand curve is vertical with a bend at the top where costs become huge.

Similarly, supply is determined by other than monetary issues, for the most part. A large number of people want to be CEOs and would do so, even if the rewards were more modest. At some low level, presumably, people would decline the job. The demand curve is therefore basically vertical with a bend at the bottom.

sd2.png

If we assume that the curves intersect then they do so at the vertical section, where many different prices could apply, but the amount of CEOs is fixed. This is largely why the price of CEOs varies largely, while the price of a worker at McDonalds is pretty consistent.

Every CEO wants to be at the top, and so publication of competing salary information may, in fact, far from protecting the shareholders, provide CEOs with the data to drive up the vertical intersection as far as he or she can. Information may therefore be quite counter-productive to the objective of furthering market efficiency.

 

Why Restraining Executive Pay Makes no Sense – I Friday, May 11 2007 

Business and Corporate Life and Executive Pay buscom 7:12 pm

I have been considering executive pay for a while, and my conclusions run counter to the current orthodoxy. I believe that attempts to limit top executive compensation are ill-considered and ineffective, and it is time we faced up to this. To put my cards on the table, I am in a senior position but I am not in the category that we are speaking of. My compensation package, sadly, is fully deductible under corporate taxation regulations and will remain so for a long time! (i.e. less than $1M). Although I probably am somewhat in sympathy with the people in the corner office, I find many pay packages offered to this privileged class as distasteful as anyone else does. I don’t support effort to rein these in, and I question the thinking and motives of anyone who does.

There are really only three possible reasons for trying to influence executive compensation, and I will address each one in a separate posting. The first justification might be to protect shareholders from profligate insiders effectively stealing assets. A single proprietor will control the compensation policies within an organization, and it is hard to understand why this becomes so difficult when there are multiple shareholders involved. Certainly, as we know, there need to be mechanisms put in place to ensure that the full cost of compensation is made clear, but shareholders should be able to decide whether or not they want to look after their own money. In many cases, of course, shareholders don’t express much interest in managing executive pay, for two reasons. Firstly, the sum of money involved, although often very large in absolute terms, is very small in the context of financing a large corporation. Executive compensation for a $30m company can loom large as a percentage of profits, but for a $30bn corporation with the same profitability the sum is minuscule.

The second reason that shareholders don’t manage compensation closely is because they are very concerned to get the most capable person, correctly realizing that a bad CEO can be a disaster even over a short period of time. They are prepared to risk overpaying, provided they get someone good. Obviously they don’t want to get an expensive idiot, but the error of not attracting the top potential talent is a worrying one, and the sums to be saved by miserliness are very modest.

Shareholders could have additional reasons for avoiding unseemly packages. They might be concerned about the impact on the other employees, or trickle-down increases (which could be very expensive), but they seem oblivious to these. Given that shareholders don’t appear to want to reduce the cost of CEO compensation for a variety of reasons, why does it become the government’s role to intervene to protect their interests?

There may be other motivations for society to get involved and I will discuss these tomorrow.