When it comes to the pay packets of chief executives, how much money is too much?
The issue is likely to be the focus of increased attention in the coming weeks and months, when each publicly traded US corporation will, for the first time, report how much its CEO is paid relative to the median company worker.
Executive pay has taken off since the early 1980s, when American CEOs were paid about 40 times more than the average worker. Today, most estimates suggest the ratio is comfortably more than 300-to-1, with the typical CEO of an S&P 500 company taking home more than $11 million (€8.8 million) annually. Elevated pay ratios have long been justified by the notion that you have to pay for top talent. In football, the Lionel Messis and the Cristiano Ronaldos of this world are paid more than their less gifted counterparts and the argument goes that the same applies to the corporate world.
That argument took a beating during the global financial crisis, however, when top banking executives were widely lambasted for having taken reckless, short-term decisions that ultimately catalysed the deepest recession since the 1930s.
Publishing pay ratios
Reflecting this unease, the Dodd-Frank Act, introduced in the aftermath of the banking crash in 2010, mandated that public companies disclose their pay ratios to investors. Dogged resistance from companies has delayed implementation, but the ratios are now finally being published.
Some policymakers want to go further. For example, in Portland, Oregon, companies have to pay a 10 per cent surcharge on gross earnings if their CEO earns more than 100 times more than rank-and-file workers. Similar rules are being proposed in San Francisco as well as in a number of US states.
Nor is the pressure coming solely from policymakers and regulators. Last year, the world’s largest investor, Blackrock, warned it would vote “systematically” against corporate pay packages that did not meet its criteria.
CEO pay ratios are much less elevated outside the US. German CEOs earn roughly half as much as their American counterparts. Ratios are lower still in the UK, where the average FTSE 100 CEO earns 129 times that of the median worker.
Among Irish-listed companies, average CEO pay (including bonuses) comes in at almost €2.1 million, according to a recent Irish Congress of Trade Unions (Ictu) report. Companies are especially frugal in Japan, where CEOs are paid about one tenth of what American executives get. The one constant, however, is that people all over the world routinely view CEOs as overpaid. That's according to the authors of a 2014 Harvard study, How Much (More) Should CEOs Make? A Universal Desire for More Equal Pay, which used survey data from more than 55,000 people across 40 countries.
Respondents everywhere dramatically underestimated the size of the pay gap. In the US, for example, people estimated CEOs earned just 30 times that of the median worker, while the "ideal" ratio was deemed to be just 7:1. The desire for a smaller pay gap was "strikingly consistent" across countries, which may explain why even apparently conservative politicians like UK prime minister Theresa May have proposed the publication of pay ratios in listed companies.
Pay for talent?
Supporters of such measures, like the late management guru Peter Drucker, who believed the CEO-to-worker pay ratio should not exceed 20:1, argue that extreme pay gaps "increase employee resentment and decrease morale".
The counter-argument is that corporate talent is increasingly mobile in a globalised world and that the scope of a CEO is far greater than it was in the past. Ice-cream maker Ben & Jerry's implemented a 5:1 ratio for 16 years but was forced to abandon the policy in 1995 as it was unable to find a CEO willing to accept the pay cap. Not only that, a CEO's actions are scalable, says Alex Edmans, a professor of finance at London Business School, who has published a number of studies regarding the question of CEO pay. A CEO who improves corporate culture can roll out firm-wide reforms, says Edmans. Accordingly, if the head of a $100 billion company company helps increase its value by 1 per cent, he will have created $1 billion in value. It follows that it makes sense that the biggest companies pay the biggest bucks – music to the ears of the likes of CRH chief Albert Manifold, who earned almost €10 million in 2016, or Microsoft's Satya Nadella, who received a pay package worth $84 million (€67.7 million) when he became CEO in 2014. Still, opponents suggest this argument can only be taken so far. Apple is worth almost $1 trillion, but no one is proposing that CEO Tim Cook be paid in billions as opposed to millions.
And while Edmans cites some studies indicating that high CEO ratios are economically justified, many other studies indicate the link between CEO pay and performance is a tenuous one. For example, an MSCI study of 429 large US companies from 2006 to 2015 asked if CEO pay reflected long-term stock performance. “In a word, no,” it bluntly concluded. Companies that had below median pay levels outperformed their higher-paid counterparts by as much as 39 per cent, the study found.
Many other studies have reached similar conclusions while high stock incentives have also been linked to increased earnings manipulation and product safety problems. Additionally, a company’s stock price performance is dependent on many factors outside the CEO’s control, such as interest rates, macroeconomic developments and stock market cycles.
It is a "one-way ecosystem, in which CEOs reap credit while rarely getting blame", complained money manager Barry Ritholtz in a recent Bloomberg column. "It's a terrible waste of shareholder dollars. We can and should be able to do better".
Edmans agrees the system is flawed, but argues the focus on pay ratios is misplaced. Firstly, disclosing pay ratios may have unintended consequences, he suggests. Companies may outsource low-paid jobs to lower the ratio, or even raise workers’ salaries while slashing other benefits such as on-the-job training, promotion opportunities and flexible working conditions.
Short-termism
Secondly, Edmans argues the real problem is one of short-termism rather than the level of executive remuneration. In a study published last month, he reported that stock option packages granted to CEOs encourage them to focus on temporarily pumping up the share price just prior to encashment. The more stock that executives have vesting in a given quarter, the more likely they are to cut investment and to instead announce share buybacks and mergers and acquisitions (M&A). This leads to higher short-term returns but significantly lower long-term returns.
Buybacks and M&A are both justifiable in certain circumstances, Edmans writes in a Harvard Business Review article summarising his research, but they tend to have "destructive long-term consequences" when they are motivated by short-term share price considerations. In other words, the horizon of pay is more important than the level of pay. "Cutting pay in half will win more headlines than extending the vesting horizon from, say, three to five years," says Edmans, "but the latter is likely to be much more important".
