In many companies, remuneration of high level executives, such as Chief Executive officers (CEOs) and Chief Financial Officers (CFOs), are based on the performance of their companies as well as the market pay for similar positions. In a good economy, companies are fighting for high performance CEOs and CFOs, the pay levels and performance bonus are extremely high. There has been a lot of debate over this pay and benefits policy, especially after the recent financial crisis. This paper will examine the how the financial crisis has affected executive pay and examine the pros and cons of imposing limits on executive pay. Debates over the limits on executive pay and proposed capping methods in the United States, the United Kingdom and other parts of the world were reviewed.
Executives in firms refer to senior and managerial employee within a firm. They are usually paid differently from the general employees. They normally get a base salary and on-top receive a performance linked bonus. For example, the pay of a CEO in a retailing firm might be based on a basic salary plus sales performance related bonuses. These bonuses are seen as short term incentives, since the executives only have to perform well in a particular period to get the bonus.
Executives may also be compensated by other methods such as the grant of stock option and equity shares. Stock option and equity shares are long term incentives for the executives. These options allow the owner to exercise based on the strike price. Executives only make profits if the share price is greater the strike price of the option. To maintain a high stock price, i.e. keep the option profitable, the executives have to align their interests with other shareholders, hence, to achieve good performance over a long period. Though stock option compensation might bring long term incentives, there are criticisms that the executives might decide to sell off firm's long-term wealth in order to drive up the stock price and exercise the option.
Other compensations to executives might include retirement plans, housing and car allowances, health insurances, children benefits, club benefits, etc.
In a perfect competition, executives' pay should be equal to their marginal product. In equilibrium, these executives should be paid as much as the revenue they contributed to the firm. In a perfect competition, where all agents have perfect information, paying less or more to executives cannot occur. Firms overpaying executives will be undercut by competitors, while firms paying less, these executives will look for jobs elsewhere. In such a model, no one will be overpaid or underpaid. Executives receive high compensations only because of their high productivity and contributions to firms, not a sign of overpaying. Former US Treasury Secretary John Snow said, “in an aggregate sense...(CEO pay)....reflects the marginal productivity of CEOs...Until we can find a better way to compensate CEOs, I'm going to trust the marketplace.” (Greg Ip, 2006).
If we are in a perfectly competitive world, we can truly trust the marketplace that resources are allocated perfectly. There is no need to discuss whether executives are overpaid as market will self-correct. We can argue that the upwards trend of executives paid was led by the increasing competition in markets. Nowadays, managing a company requires more skills as CEOs face more competition. In this model, CEOs are worth getting huge amount of compensations.
However, we are not living in a perfectly competitive world. In an imperfect competitive market, we face imperfect information, where we don't know the marginal product of CEOs. Former Porsche Chief Executive Wendielin Wiedeking has been Europe's highest paid CEO, with a salary of more than $100m (David Stevenson, 2009). We do not know whether Wiedeking marginal product equals his pay as we do not have perfect information. Moreover, many people blame him for acquiring huge amount of debts and driving share price down after failing to takeover Volkswagen. Is he truly worth $100m? Since we are unable to observe any individual value of marginal product, we cannot tell whether these high earners are being overpaid or not.
According to a recent study, the ratio of CEO pay in the United State, including bonuses and stock options, to that of an average employee has gone up from about 25-40 in 1970s to as high as 344 in recent years. The ratio in Europe remained around 20-40 and 10-15 in Japan (Venkat Venkatasubramanian, 2009).
Figure 1 illustrated median CEO pay at the 350 largest publicly-held companies in the US in the period of 1995 to 2005. From the figure, we can see an upward trend, especially the 35% rose in 2001. However, we can see from the figure that executives' pay does not always go up. In 2001, the dot com bubble went burst, the stock market declined significantly and had led to large fell in CEOs' pay.
Source:Mercer Human Resources Consulting
CEOs in the United States not only being paid significantly more than their average domestic employees, they also receive significantly more than CEOs around the World. A study conducted by Martin Conyon, John Core and Wayne Guay in 2006 found that CEOs in the US were being paid 1.3 times of UK CEOs. Research on Japanese executives paid found that, they only received about a third of pay of the US counterparts while holding firms size constant (Minoru Nakazato, Mark Ramseyer and Eric Bennett, 2006).
The recent financial crisis has drawn many tax payers and politicians' attention to the big pay package of many senior executives in companies that have requested government help and federal subsidy.
Debates on putting a limit to the executive pay have disclosed many areas of controversies and concerns.
Overpaying executives have raised a number of concerns from the public and governing bodies such as the following areas:
As stated earlier, executives are being paid significantly higher than median workers. The increasing gap between top tier workers and front line workers will result in bigger inequalities problem, which can then lead to other social problems. Workers might think that their contribution to the firms is not rewarding, or they might not have benefited from the growth of the economy or the firm. In many past stories, we see firms growing, executives being paid at high rate, but at the same time laying-off labour.
Data on the top 10 highest paid CEOs in United State is shown in Table 1.
From the Table, we can see that the highest paid CEOs receive more than 10 million US dollars. The amount these CEOs received is massive and many employees could not make this amount of money in their life-time.
If the executives receive compensations that are greater than their value of marginal product, i.e. greater than their contribution to the firm, shareholder return may be stolen. A study compared the total pay given to the top five executives relative to corporate earnings at Standard & Poor 1500 firms between 1993-1995 and 2001-2003 has shown that the ratio of executives pay to aggregate corporate earnings doubled between the periods (Lucian Bebchuk and Yaniv Grinstein, 2005). However, another study states that the elasticity of CEO pay with respect to the rate of return to shareholders is very small. A 10% increase in rate of return to shareholders only lead to a 1% increase to CEOs' pay (Michael Jensen, Kevin Murphy, 1990). We might argue that the correlation between shareholders' return and CEOs' pay are too small to motivate CEOs to work for the firms' best interests. Also, by increasing this correlation will improve the firms' profitability by encouraging the CEOs.
If the CEOs are being overpaid, and greater than their marginal product, this might due to the board losing control, which can then lead to further problems. Chairman Barney Frank of the House Financial Services Committee in the United State said in 2006, “I do not think the boards of directors' work as effective independent checks. They are not the fox guarding the hen house. They are hens guarding the rooster. And I think the time has come to say we need the shareholders to do this...” Former US President, George Bush, had asked American corporate boards to take up the responsibilities to control excessive executives' pay. He said in 2007, “America's corporate boardrooms must step up to their responsibilities. You need to pay attention to the executive compensation packages that you approve. You need to show the world that American businesses are a model of transparency and good corporate governance”.
Occurrences of corporate scandals are largely because of executives being compensated by stock option. These scandals include accounting fraud and earnings manipulation. Executives can maximise personal interests by manipulating. An example of such a scandal is Xerox Corporation. In 2002, the Securities and Exchange Commission in the US accused the company of a massive manipulation of earnings over a number of years. “The SEC said that accounting scheme helped keep Xerox's stock price artificially high in the late 1990s, so that executives could cash in $5 million in performance-based compensation and more than $30 million from stock sales. Xerox's stock rose to more than $60 in mid-1999, the heart of the period in which the SEC says executives manufactured profits, before tumbling to less than $4 a share in later 2000” (Bandler and Hechinger, 2002). These manipulations of profit can mislead investors but share holders might still be benefiting from rising share price, though this is not the initial goal of the firm.
The above concerns have logically led to the conclusion that executives' pay need to be controlled and cannot be excessive. However, there remains the questions that should we impose a maximum cap on the executive pay.
The financial crisis in 2008-2009 was a quick and unpredicted one. Many financial institutions and banks, especially investment banks went bankrupt or into difficulties. Governments all over the world had different rescue plans. In the United States, one of the biggest investment banks, Lehman Brother, went bankrupt; American International Group suffered liquidity crisis. In the United Kingdom, Northern Rock was nationalised; Royal Bank of Scotland and Lloyds TSB together received ₤40 billion direct aid from government to prevent collapsing. Many financial institutions received government grant in order to survive.
Many countries have shown signs of moving out of recession. Investors are starting to enjoy the bull market with increasing stock prices. But, has the recession made a difference on paying culture? Are executives still being paid excessively?
In the United Kingdom, “The boardroom bonus culture is still booming” says the Guardian's Simon Bowers (David Stevenson). We still see executives being paid numerously after the recession. Lord Myners said the culture needed to be reformed as without government aids, bank would otherwise have collapsed a year ago (Jill Treanor, 2009). He warned that if banks do not self-discipline, government will take appropriate actions.
In the United State, financial institutions and investment bank still pay executives very high bonuses as these companies make a lot of profit with tax payers money in the stock market. In October 2009, the US government announced ways to limit executives' pay. The Treasury Department decided to order the seven companies that have not repaid bailout money to cut their executives' pay by half. This will result in the top executives pay limited in most cases to $500,000. The Federal Reserve takes another method. They proposed to monitor the paying packages at thousands of banks, including those who never receive aid from government. These actions taken by the government have two main objectives. Firstly, the government tries to push the executives' pay down to construct a fairer society with less inequalities and inefficient allocation of resources. The second reason to set-up these policies, is to limit risk-taking by banks. If banks, or bankers, are trying to risk in the stock market to earn high bonuses, they might lose out again. Discouraging reckless gambles can slow down or eliminate the development of a stock market bubble.
However, experts think that neither plan is expected to kill Wall Street's culture of lavish pay (Martin Crutsinger and Stevenson Jacobs, 2009). People argue that Federal Reserve's proposal does not set a specific limit; hence, the usefulness of the policy is still uncertain. The Treasury's plans only cover a limited number of executives. Also, this is not a long term policy, as if these companies pay-off their bailout fund, they are no longer being restricted and they can pay executives as much as they want.
We see a lot of problems associated with huge executives' pay, which include inequalities, accounting scandals and earning manipulation.
If executives are being paid more than the marginal product, then yes, capping of executives' pay is needed. However, how can we observe an individual marginal product? How to cap and at what level are tough questions. It is also difficult to ensure executive performance when the pay incentives are taken away. It is also difficult to administer an equitable pay cap to executives of forms in different industries.
If capping is implemented in one country, but not another, the highly skilled CEOs might just work in the country without the cap in order to earn more. As a result, the country as a whole may lose the competitive advantage because of brain drain.
Capping seems to be a socially desirable policy in an economic crisis situation. However, it violates the principle of free economy which will be based purely on supply and demand. In addition, the capping policy will be seriously challenged in a good economy. Human resources specialists will also challenge this policy as it will limit a firm's ability to compete for the best talents in the labour market (Cheung, 2009). In a recent article in the Middle-East, Richard Lamptey of Mercer, an executive search firm, also warned the employers that the competition for high performance CEOs will drive up the executive pay (Richard Lamptey, 2009).
It appears that the capping policy will result in interference in the market and could lead to inefficient allocation of resources. To resolve the problems associated with executive pay such as over paying the companies executives leading to unfair return to shareholders; short term or unethical actions by executives to drive up share price and inequalities in distribution of wealth in society, one should consider using appropriate action to rectify the situation. Corporate governance practice and audit by independent Board Members are important measures to ensure proper Executive Pay policies. Progressive tax system on executive pay will help to redistribute wealth. These could be more effective measures than to cap executives' pay in such a model.
In a perfectly competitive market, there is no need to intervene as the market will self-correct and reach equilibrium where executives or any individual employee are being paid according to their marginal product. However, we are living in an imperfect competitive market where we have imperfect information. Control is needed when these executives are being paid more than their contributions to the firm. It is consider more appropriate to ask for good corporate governance practice to manage this situation than to use Federal law to regulate private activities.
If this essay isn't quite what you're looking for, why not order your own custom Economics essay, dissertation or piece of coursework that answers your exact question? There are UK writers just like me on hand, waiting to help you. Each of us is qualified to a high level in our area of expertise, and we can write you a fully researched, fully referenced complete original answer to your essay question. Just complete our simple order form and you could have your customised Economics work in your email box, in as little as 3 hours.
This Economics essay was submitted to us by a student in order to help you with your studies.
This page has approximately words.
If you use part of this page in your own work, you need to provide a citation, as follows:
Essay UK, Executives pay and compensation. Available from: <http://doghouse.net/free-essays/economics/executives-pay-and-compensation.php> [21-02-19].
If you are the original author of this content and no longer wish to have it published on our website then please click on the link below to request removal: