Is CEO compensation rational?

July 16, 2016 08:00 PM

When asked at the 2016 SALT Conference about the eye-popping $55 million severance package that Yahoo (YHOO) CEO Marissa Mayer could receive should she be forced out of the firm, Starboard Value founder Jeffrey Smith dismissed such payment as “Just math. It’s just contractual.”

In Smith’s eyes, Mayer, whom the hedge fund manager had called on to resign just months earlier, had bungled Yahoo’s finances during her tenure. With her departure, $55 million was considered a drop in the bucket compared to the billions more in value they saw in Yahoo’s assets. 

In the high-stakes world of corporate board room battles, Sachem Head Capital’s Scott Ferguson summed it up best during the panel on activism: “Money is a great way to effectuate things.” 

That said, the figure is considered irrational in a nation where the median household income is roughly $52,000 – according to the Bureau of Labor Statistics (BLS). This golden parachute would take that household more than 1,000 years to earn. Hard to imagine Mayer would receive this if she were to be forced out by the sale of the company. But then, the CEO compensation game is highly inefficient, highly irrational, and devoid of traditional metrics one might use to award employees for performance.

The Equilar/Associated Press S&P 500 CEO Pay Study 2016 offers some broad insight into rising pay and corporate leadership. According to the report, the median total pay package of an S&P 500 CEO hit roughly $10.8 million, in 2015 a 4.5% increase from the previous year. Although just 17 women appeared on the list of 341 executives in the study, the median female CEO earned $18 million. The median for 324 male executives was $10.5 million. 

Overall, the average CEO pay is more than 300 times that of the average worker, although the number varies depending on the source. The Economic Policy Institute says that the ratio sat at 303.4 to 1 in 2014 (see “It’s good to be the 1%,” below).

When one evaluates the CEO’s pay against that of the firm’s average worker, the numbers are similar. PayScale maintains a CEO to worker pay ratio list, marking CVS Health Corp.’s (CVS) Larry Merlo as the holder of the largest ratio of 422 to 1. Two pills of different size depict the difference in scale. The others in the top five are Richard Kramer of Goodyear (GT) at 323 to 1, Bob Iger of Disney (DIS) at 283 to 1, Rupert Murdoch of 21ST Century Fox (FOXA) at 268 to 1 and David Cote of Honeywell (HON) at 211 to 1.

Like so many other CEOs, Mayer has already been handsomely compensated for her time. In 2014, Mayer made $42.1 million, up 69% from 2013. That year, she was the S&P 500’s highest paid female CEO. In 2015, despite the earnings slump, she took home another $36 million. 

That’s before the golden parachute.

Starboard sees value in the parts of a struggling tech icon; a core business with $4 billion in value, a 
$30 billion stake in Alibaba (BABA), $9 billion of Yahoo Japan (TYO), cash and a wealth of patents. “When you add it all together, it’s worth more than the market capitalization of the company,” Smith said in early May.

Fast forward to mid-June, and Yahoo is currently accepting bids from Verizon Communications (VZ) and AT&T (T) for the core business, with offers reportedly above the $4 billion estimate. It is seeking bids above $1 billion for its patent portfolio. And Alibaba stock is showing new signs of life.

Meanwhile, criticism of Mayer, who joined Yahoo from Google (GOOG) in 2012, has centered on her tenure. The firm had operating losses in all four quarters of 2015. Its Tumblr acquisition didn’t go anywhere. The company hired, then let go of COO Henrique de Castro – a decision that cost the company roughly $108 million in salary and severance. And while the stock may be up 120% during her tenure, shareholders can thank the IPO of Alibaba Group Holding for the bump.

Now, the idea of $55 million just to walk away is an issue that has rubbed many analysts, advocates, pundits, politicians, and most of all shareholders, the wrong way. 

When it comes to Mayer’s potential golden parachute, the numbers fluctuate depending on what regulatory filing one reads. In 2014, a severance package could have been worth $157.9 million, according to USA Today. In May 2016, the severance pay hit $54.9 million should Mayer be terminated without cause, and the parachute was guaranteed should there be a “Change of control” or sale of the firm, a Securities and Exchange Commission (SEC) filing reads. 

With “math” like this, one must wonder how such figures are even possible, and how the corporate compensation game has triggered this explosion in inequality and economic divergence. More importantly, in an election year when politics typically trumps economics, will this trend ever reverse itself? This story dives deeper into the inefficiencies of corporate compensation and explores the so-called “math” that drives change and leadership at the corporate level.

Is CEO compensation earned?

It’s easy to debate the morality of paying someone more in one day than what the average worker earns in a year. On this topic, everyone one is a pundit. Every pundit is an expert. And every expert has an argument.

New York University finance professor Roy C. Smith argued in a Washington Post op-ed titled “What Size is Your Parachute” that a large exit compensation is subject to the basic reality that many CEOs will never get another shot and want to ensure they get the best rate. “The best chief executives have proven track records demonstrating management ability in large, complex corporate situations. Such people are always in demand,” Smith wrote. “But most get only one shot at being a CEO, and they want to make the most of it…If things go wrong, their contracts may be all they have to hang on to, so they negotiate the best ones they can going in. No doubt you’d do the same.”

AFL-CIO President Richard Trumka calls the growing wage gap in the United States “a disgrace,” while his organization claims that executive pay has been driven by a culture where CEOs outsource work abroad, benefit from “tax avoidance” and profit from the reduction in U.S. based employment.

Forbes contributor Tim Worstall writes: “The real reason CEOs are paid large amounts is that a good one is worth a lot to a company and its shareholders and a bad one can destroy a lot of value.”

Robert Reich at the University of California says that “Today’s CEOs don’t rake in 300 times the pay of average workers because they’re worth it. They get these humongous pay packages because they appoint the compensation committees on their boards that decide executive pay.”

J. Scott Armstrong of the Wharton School and Philippe Jacquart of France’s EMLYON says CEOs aren’t worth what they receive and conclude that large compensation packages can reduce performance and that excessive incentives can cloud an executives’ judgment and thus ability to achieve certain goals.

Bang Dang Nguyen of the University of Cambridge and Kasper Meisner Nielsen of the Hong Kong University of Science measure the value of a CEO’s pay on one key event: His or her death. In a paper in Management Science, the two authors argue that in 149 cases where CEOs died on the job, a shift in market price to the news indicated that the majority of executives are not overpaid.

But not enough people ask how we got here and why compensation  continues to climb. This question isn’t aimed at addressing the broad social and political arguments. Rather, it explores the economic arguments and the data to reach a structured conclusion worthy of greater discussion.

Many factors influence executive pay, but at its core, two fundamental issues go ignored quite often: Supply and demand.

Size, scale, supply & demand

Peter Crist has spent nearly 40 years in the high-stakes world of executive recruiting. Chairman of the Chicago-based firm Crist Kolder, Crist was named one of the “50 Most Influential Search Consultants in the World” by BusinessWeek in 2008. He has led countless searches at the CEO, COO and CFO level. 

As Crist explains, the executive recruiting industry is a highly irrational, highly illiquid market with no true pricing mechanism to fully determine a right or logical payment schedule. 

“The world I live in is an extraordinarily inefficient marketplace,” he says. “For 40 years, my firm has been recruiting CEOs and CFOs, and we live in this very inefficient market where the average tenure of a public company’s CEO is about six years. That’s the volatility we see. Identifying and retaining talent is really hard to do. I wouldn’t exist without the inefficiency of this human capital game.”

Crist offers a deeper dive into how searches are conducted and the process by which compensation is determined at this level. 

“[The] CEO compensation game is probably one of the last [bastions] of capitalism that you can truly point to because it is truly the capitalist’s game,” he says. “Jamie Dimon will not leave the CEO chair of JPMorgan unless you make some highly attractive proposition to him. Let’s say a CEO makes $50 million a year. You’re not going to get them to leave for $25 million a year. So the bid/ask in the market place that I live in is ‘where is the talent, and how do you acquire that talent at the best price for the buyer.’”

He highlights three primary drivers of board compensation: CEO volatility, company size and scale and board protectionism.

First, volatility. Each year, Crist Kolder releases its annual Volatility Report, which provides insight into key metrics surrounding executive compensation and recruiting. The most interesting number is the average tenure of CEOs (see “Get it while you can,” below).

“If you combine S&P 500 [and], Fortune 500, that’s about 750 companies. The average tenure for the CEO of those companies is about six years. That’s very different than [the average of 10] 15 years ago. Every time that chair moves, every time there’s somebody coming in and going out, there’s an upward motion on the compensation. So if you paid Joe $100 to be in the chair, you’re going to pay Suzie $110 to be in the chair next.”

Second, size and scale. “You have to consider [the] size of [the] enterprise, which is very important talking about CEO compensation. Whether it’s market cap or revenue, again that drives an inflationary mindset about compensation. You’re not going to pay Jamie Dimon the same compensation as you’re going pay a small community bank CEO.”

Academic research backs that sentiment. In a 2007 paper in the Quarterly Journal of Economics, Xavier Gabaix and Augustin Landier explored CEO pay from 1980 to 2003 and found strong evidence that “the six-fold increase of U.S. CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large companies during that period.”

The third component, according to Crist, is what he refers to as board protectionism. 

“A board is very risk averse. The last thing a board wants to deal with is a CEO walking out the door, or, just as much, a CFO walking out the door. They make sure the person has been paid well. They do so by comparing compensation against their peers.”

Compensation committees regularly review compensation of the top five named executive officers (NEOs) and compare them with their peers. “They’re comparing them to other companies that are peers, Crist says. “So, let’s say there’s 15 peers in the proxy and any company public proxy you pick up, you’ll see this. And then you go to the other end of the dialogue, where you’re trying to attract talent. You’re trying to recruit talent. You’re trying to change a company, make a company better. And that dialogue, there has to be some incentive for someone to move, or they’re not going to move.”

Crist explains the process of recruiting at the executive level. The corporate search process typically takes five months. Over the first 30 days, his team conducts research to determine which people are capable of actually running an organization. In this example, we hypothetically explore Exxon. 

The next month, the firm calls people who could run Exxon to determine their interest in a conversation. The next 30 focuses on client introductions. By that point, three months have already been knocked out of the schedule. During the final 60 days, candidates meet with many different people in different scenarios before the board reaches a final decision. The firm is also in the process of assessing internal candidates as well (see “Where CEOs come from,” below). 

“Every big search has an insider or two,” he says. “Usually we assess internal candidates around day 60. The internal candidates are very important people worthy of consideration. The board wouldn’t suggest we interview them if they didn’t feel they were valuable.”

The other popular executive search exercise is a process called mapping. Companies assign Crist with the task of locating several candidates who might be able to replace someone planning to retire in one or two years. However, the firm doesn’t want a search. They don’t want phone calls. They want the answer to one thing: Who are the people who could run their company if called upon and would likely accept an offer. In Crist’s observation, only a select number of people have the qualifications to run a specific organization.

So how many people could replace Exxon CEO Rex Tillerson right now?

Crist’s answer: “Two to four, not 10.”

Or Yahoo if CEO Marissa Mayer were to suddenly resign? 

“About 30. They don’t need a chemical engineering degree [like the Exxon candidates].”

Both numbers may be larger to some other recruiters. But one thing is clear: Top talent is rare and getting them to come to a company requires a lot of money, time and screening. Crist soon begins the process of determining if any of these candidates would be available, and what sort of compensation would be required. The big one, of course, is determining severance packages.

“[Severance pay and golden parachutes are] negotiated in advance. In most cases, we represent a company that wants a number two to become a number one.Hypothetically, we’d be trying to attract the number two person of IBM to become the number one person of HP.”

When that person is chosen, it is time to explore company proxy statements. In most cases, information is disclosed about compensation. Long before the dialogue begins with the prospective target, the clients are well-informed of the equity value that a person holds in another firm.

“If someone is sitting on $50 million dollars of equity value, he or she is not just going walk away. In this case, they might create a $50 million value pool nested over three or four years, so they wouldn’t have access to it right away. But it would still sit there. And contractually, it would be guaranteed depending upon certain circumstances. So, all that is front-end loaded, well before one says, ‘Yes, I’m coming.’ And if not, the candidate just folds his or her hand.”

That figure is typically called a “make whole” award: A payment to compensate someone for stock she left behind. 

In the case of Marissa Mayer, she left a significant amount of stock behind when she left Google. 

According to Mayer’s offer letter, she receives three different payments over her five-year term. Each one is based on Yahoo’s stock price from Nov. 29, 2012. 

The payments include a $12 million annual equity award, a $14 million make-whole payment and a $30 million one-time retention award over her entire term. 

The source of excess

What truly fueled the meteoric rise of corporate compensation — salary, options, exit packages and pensions — during the last 25 years? The best evidence points to the hall of economic unintended consequences — or the U.S. Congress. 

Recently, ProPublica explored the ramifications of a 1992 decision to incentivize companies to limit corporate compensation through the tax code or to draw shame to a firm’s pay scale. At the time, outrage exploded on the campaign trail as the average CEO was earning more than 100 times the average employee, according to the Economic Policy Institute. As a result, Congressional leaders pushed through Section 162(m) of the tax code that limited salaries as a business expense to $1 million, while encouraging greater ties between company performance and executive compensation.

Author Allan Sloan writes that compensation consultant Bud Crystal told then-candidate Bill Clinton in 1991 that the idea of capping compensation deductions would backfire — two years before it entered the U.S. tax code.

“Crystal said he told Clinton that the proposal not only wouldn’t hold down executive pay, but would hurt shareholders by increasing the after-tax cost of CEO pay packages,” wrote Sloan. Not only did it fail to limit executive compensation, but it also incentivized changes to how compensation was paid. 

David Owen of the New Yorker dove into this IRS rule in October 2009. The author had spoken to Nell Minow — a  co-founder of a research firm called The Corporate Library. “The last time we tried to fix corporate pay through the tax code was 1992, and that essentially created the mess that we’re in now,” Minow told Owen.

Minow explained the deduction limit became an excuse to hike all salaries at or close to $1 million, and executives expanded a strategy to receive more compensation. “In the museum of unintended consequences, this is Exhibit A,” Minow told Owen. “The first thing that happened was that everybody got a raise to a million dollars. The second was that companies started issuing bazillions of options.”

That sentiment has been echoed by Cornell Law School professor Lynn Stout. “If you want to know why executive pay is skyrocketing, it’s not because of lack of shame, it’s because of this change in the tax code,” Stout told The Atlantic last August. (Propublica explains that the deduction issue wasn’t even a big deal to companies, as executive salaries still rocketed past the limits.) 

But perhaps the biggest reason why the entire tax deduction failed was that it had been watered down significantly from its original proposal. Former Minnesota Congressman Martin Sabo had originally pitched a rule that would have eliminated the tax deduction if any worker’s pay exceeded a 25 times multiple of a firm’s lowest paid workers – not just its top executives. When the idea was first proposed in a 1991 bill, Former Democratic Congressman Tom Downey said a lot of his “friends in Hollywood” attacked it, and the Income Equity Act died. Sloan notes that even though the rule change failed to ever work – and helped fuel a boom in options related compensation — it still remains on the books. 

Is more regulation the answer?

From Congress to shrinking union halls, many want Washington to do something about income inequality. But aside from scope and scale, board protectionism and CEO volatility, the spike in executive compensation draws clear influence from the Clinton-era tax rule that capped limits on deductions.

Some new efforts started under the 2010 Dodd Frank Act. The financial reform bill demands public firms allow shareholders to vote on executive pay every three years. So far, it is gaining traction. According to a new report by Meridian Compensation Partners, roughly 65% of companies have worked with institutional shareholders and/or proxy advisory firms to prepare for votes tied to compensation.

Meanwhile, the latest fiat rule comes from the SEC. A new SEC rule makes companies explain pay packages for their firms, with language that dissects the breakdown between pay and stock performance. But it’s unclear how this information is useful.

Do they plan on forcing companies to print on the label of their products the CEO to worker pay difference? How will they account for financial companies where the average pay is higher than in the retail sector? Right now, 40% of firms have started calculating the pay ratio between CEOs and the median employee, according to Meridian.

Other influencers have pitched ideas to reduce the gap between CEO pay and median worker pay. For example, Stout – who raised concerns about the tax code – offered one plan to The Atlantic: A federal rule that pegs executive compensation to a figure no higher than 100 times the national minimum wage. 

“It will finally give the business roundtable a disincentive to fight increases in the minimum wage,” she says.

Perhaps one of the most radical, yet simplest solutions has been offered by Dallas Mavericks owner and tech influencer Mark Cuban, who explains that today’s stock compensation isn’t taken from money that could have been paid to a firm’s employees. The money is taken from the pockets of a company’s shareholders, a distinction missed by the SEC ratio rule. 

“I’ve always been an advocate of paying CEOs in cash,” says Cuban. “It would be enough cash to allow CEOs to buy stock [and options] if they wish, rather than diluting shareholders.” 

Cuban has been a critic of Yahoo’s corporate culture for more than a decade. Having sold to Yahoo in 1999, he said the company operates on a culture of consensus, which has limited its ability to compete. Though he says he isn’t familiar with Mayer or her leadership, he is quite astute on the nature of the pay packages given to outside executives and their impact. 

“As far as the issue of relative cash compensation I’m not so concerned about how much CEOs get paid in cash. The issue is how much are employees at the bottom getting paid.”

Cuban worries about whether employees are receiving enough compensation to avoid government support services, and advocates for a study on how companies receive in indirect subsidies due to their employees’ reliance on welfare support programs. 

“We also have a problem of shareholders rewarding profitable companies for cutting employees in cost cutting maneuvers to drive up stock prices,” he says. 

Cuban also sees two other important things to reduce the pay boom – both that do not require Washington’s influence: First shareholders need to take greater role in shaping the company.

“If shareholders viewed themselves as true owners, maybe they would influence management to manage for a bigger picture,” Cuban says. 

Second: Improve the internal succession plan in order to reduce large jumps in compensation due to upward bidding on outside executives. 

“There should be at least three to five executives being groomed for those jobs in each company,” Cuban says. “They don’t turn over annually. They turn over after a decade or more in most cases, with Yahoo being an exception.”

In the end 

Corporate compensation will continue to evolve a key political debate in the 2016 election – assuming that neither frontrunner completely implodes within the next five months. With executive compensation ballooning, and golden parachutes generating significant attention over the past two decades, one must wonder how both corporate America and political leaders are set to respond. The irrational marketplace likely isn’t going to reduce compensation any time soon, and Congressional action or regulatory fiat could end up creating a whole new set of unintended consequences. 

It will likely be up to investors to answer the question: Are you happy with your CEO’s pay and the board’s succession plan?

About the Author

Garrett Baldwin is the Managing Editor of the Alpha Pages and the Features Editor of Modern Trader. An author and Baltimore native, he earned a BS in journalism from the Medill School at Northwestern University, an MA in Economic Policy (Security Studies) from The Johns Hopkins University, an MS in Agricultural Economics from Purdue University.