Why Has Exec Pay Grown So Much? | BTalk Australia

(Episode 297; 15 minutes 07) US executive rewards have increased by 50 per cent in real terms since 1995 and by a factor of about six since 1980. Why is this happening?

Research by Peter Swan and Jaeyoung Sung, studying the pay for S&P 1500 CEOs over the period, 1994-2006, has shown how a talented CEO can add value to a firm of any size, just as a poor performer can destroy a firm. So does that mean senior executives are getting paid what they’re worth?

Today on BTalk Australia Phil Dobbie talks to Peter Swan, a professor of Finance at the Australian School of Business at the University of New South Wales, about the study. What factors influence how much a CEO gets paid?

Add your thoughts in the Talkback section at the end of this post.

See also:
Why Pay More to Execs Who Fail? | BTalk Australia
Are We Paying Our Bosses Too Much? | BTalk Australia

Subscribe to BTalk Australia on iTunes.

View all BTalk Australia podcasts here.

• Transcript

Phil Dobbie: Hello I’m Phil Dobbie, welcome to BTalk Australia and today, how much we pay our top executives. Is it too much, just right or not enough?

It was a political hot potato not so long ago, wasn’t it, in fact still is. Are CEO’s being paid too much when times are tough, profits are down, budgets are cut, I guess it’s only human nature that we look at where the money is being spent and the CEO’s salary is normally a fairly sizable number on the spreadsheet. So are they paid too much? Peter Swan is a professor of finance at the Australian School of Business at the University of New South Wales. He’s co-authored a study on executive pay, asking why has CEO pay grown so much. So Peter, is there a relationship between how much an executive is paid and the influence that they do have on the success of a business?

Swan: Yes there is. The most successful CEO’s are paid a very large sum of money but because of their high talent, high pay is usually associated with high talent, they actually create so much wealth for shareholders that their pay fades into insignificance.

Dobbie: In terms of the wealth they generate for the business and for the shareholders?

Swan: That’s right

Dobbie: So you mentioned talent, it seems like a subjective term. How are you defining the talent of an individual? Is it just his ability to produce those results?

Swan: Yes, his talent is estimated from the performance of the company, how much they have generated for shareholders. And it takes into account their incentives, their talent, the volatility that they create and a whole host of other factors. And after we’ve accounted for all of these things then what’s left is their talent.

Dobbie: OK, what about the rest of the management team. Are you counting the performance of the rest of the management team? Are you saying that’s really determined by the CEO because he can pick and choose who sits in that management team?

Swan: I tend to feel that the CEO is responsible for the management team and therefore ultimately it goes back to the CEO and you can see this with respect to some of the top CEO’s most talented managers that the study identifies over the last few years, people like Steve Jobs of Apple who actually doesn’t take a single cent in salary, Michael Dell, Larry Ellison, the fourth richest man in the world who basically created Oracle. So these sorts of people I think are responsible for the wealth that’s generated. I mean it would be silly to say that you could have had Dell computers without Michael Dell, for example. Or even the success of Apple without Steve Jobs.

Dobbie: In the Steve Jobs case and also the Michael Dell case, here you’ve got a couple of people who founded businesses and obviously it’s their baby, they want to see them succeed. So do you think there’s an element of passion creeping in with these CEO’s because they’re founders that perhaps don’t exist with other CEO’s?

Swan: Yes definitely, I think passion and also because of their high shareholdings they have a very strong pecuniary interest, which I think is an important aspect. One of the things that this study shows is that it’s too narrow just to focus on the pay of the CEO, meaning what shareholders or boards determine they should receive. Because the real pay or the real income consists of two things: what they receive directly from the paycheques or their option grants and their shareholdings so even the worst performing managers who may seem to be get massively overpaid get so off the performance of the companies. In so far as they’ve got shareholders, they still suffer considerable losses.

Dobbie: Well giving a CEO a large at risk component, I think it’s a no-brainer, isn’t it really because it forces them to take a more long-term view of the company’s value rather than just look at their own pay packet.

Swan: It certainly does and one of the remarkable things we find is that at any one time one third of all companies are actually generating negative wealth for their owners, the shareholders. Moreover the CEO’s of these failing companies aren’t penalised in terms of their direct paycheques. And this is, we believe, because the shareholders want to encourage these guys to take risks and if they didn’t encourage them to take risks these companies would never succeed in the first place.

Dobbie: So you’re saying they need to have, obviously an adequate base pay to provide the standard of living that they’ve grown accustomed to but really anything extra should fall into that at risk component?

Swan: That’s right and the reason for this is because it’s clearly the human capital of these CEO’s which is at risk and that’s tied to the success of the company. With your mortal shareholders, we can diversify across dozens or hundreds of different companies so our success as investors is not dependent on the success of any one company whereas the CEO whose life or reputation or share ownership is all tied up in the one company, it’s a very different state of affairs. So if boards were to reward CEO’s like shareholders and give them options with a zero strike price shares, they wouldn’t in fact act like shareholders. They would act very, very conservatively, wouldn’t take risks at all. And these companies, I think, would never succeed.

Dobbie: Right so you can see you’ve got to take a balance, you’ve got to make sure that there is that base salary so that they can take the risks. I understand what you’re saying. So what about capping pay? There’s been talk about capping executive pay; there are some extraordinary salaries. If everybody was capped I guess the playing field would be level and we’d just be paying everyone less. Is that a good idea?

Swan: Talking about capping is just a pile of bologna in my view. Because the salaries of all of these CEO’s, including the ones that have gone bankrupt, Mr Ford and all the rest, Lehman Brothers, have all effectively been capped because some years ago the US Government set a limit of 1 million dollars as the maximum pay that could be made and still get a tax deduction for it unless there was an incentive component. So really what happened was the fixed pay was set at a million dollars and they used bonuses and other methods, which emotionally at least some performance component to pay them in many cases hundreds of millions of dollars more. So for every barrier you set up in terms of limit, they could, should and will find ways around it.

Dobbie: Yes, there’s always a way, isn’t there? Now what about companies where they need somebody to turn the company around so they get a hired gun and pay a big salary because they want to see immediate results and those people are going to add more than the CEO, for example, who might consistently turn good results for a company, only that they’ve just been employed in that company for a long time, shown loyalty and haven’t moved on. Isn’t that an unfair situation that the hired gun, the person who is moving around, is seeing his salary increase while the other one isn’t?

Swan: We found that CEO’s who hire from outside tend to, particularly in that turnaround situation, were paid a lot more than the internally promoted CEO’s who’ve been with the company a long time. In fact there’s a very strong negative association between tenure with the company prior to the appointment of the CEO and the CEO pay. And that makes sense because you need to attract high fliers and they have a lot more reason to come in and take over a potentially damaged brand or potentially damaged firm.

But what we did find was that the CEO’s, particularly say CEO’s who might have a board role as chairman of the board and CEO that these guys not only got paid very well if the company was one of these two thirds of companies which are highly performing that their pay went up quite substantially each year. Whereas the failing companies, the one generating negative wealth for shareholders, these apparently powerful CEO’s who could, according to many critics, can dictate their own salaries are also chairmen of the board, they didn’t pay themselves well at all, moreover they didn’t give themselves increments. It does suggest it’s not failure of corporate governments here that’s leading to the pay of non-performers, it’s this risk aversion property.

Dobbie: Yes and actually it’s a good argument, isn’t it, for actually having the CEO and chairman of the board as being one in the same person, whereas often it’s argued that that’s a bad thing.

Swan: Yes it’s often seen as a very bad thing, so much so in Australia that any company that dares do that now gets shouted down in the media. But there are many successful companies in the US particularly that do have this role. There’s something to be said for having someone who actually knows and understands the business as the chairman, often these chairmen are the ex-CEO’s, once again who know and understand the business.

Dobbie: Right, now in a free market, obviously the demand for CEO’s and the salaries they attract is not influenced by the government in any way, but governments are starting to influence more now. We’ve already talked about salary caps but also the governments in the US have been bailing out companies that have failed. So is that mucking up your model, I guess.

Swan: It’s not mucking up the model but it’s certainly narrowing the difference between the United States and the failed Soviet Union. If, for example, you know Mr Obama was to guarantee that every CEO failed would be bailed out, then we would in affect be back with the Soviet Union style of model and I would see a very poor future for capitalism. This weeding out process through failure is a necessary part of our society, without these collapses, without these shocks to the system, people like Madoff would be going on ripping off hundreds of billions of dollars from the public purse.

Now should Mr Madoff have been bailed out? Well obviously not, but what’s the distinction between some of these failed companies who are effectively running pyramid schemes based around usually government incentives to promote home ownership. So the government was really behind the subprime bubble, if the subprime bubble was not an indication of government failure. Well the indication of government success, its policies to promote home ownership worked very well and they worked too well in fact. So it’s a necessary failure and bailing out the failed CEO’s, the failed shareholders is just a recipe for seeing these disasters magnified 50 times again in future.

Dobbie: So really the upshot of your research is showing that it is all about transparency, isn’t it really? Seeking out talent that’s shown that they can deliver or return to their shareholders, which is many times magnified what you might be paying them in terms of their executive salary. And at the end of the day it’s a very simple argument, isn’t it? You pay what you get, no one’s getting paid peanuts here but the argument, you pay peanuts, you get monkeys, applies that’s for sure.

Swan: The model is based around the learning of their talent of the manager so there’s updating of reputation of the model and there’s market clearing and so the CEO’s who are successful with track records get their pay beat up by this market process. But you’re quite right about transparency, transparency is crucial. And in fact we’ve done another study on transparency showing that when in Canada the pay of CEO’s was made transparent, there was a massive improvement in their incentives and as a consequence a massive improvement in the performance of Canadian companies and it drove the income of Canadian CEOs towards their brethren across the border. So the pay went up not because their salaries went up but because their performance from incentives went up.

Dobbie: Alright well Peter Swan, I do appreciate your time today. Thanks very much.

Swan: Thank you, Phil, bye bye.