It’s the best of times and the worst of times — to be an American CEO. On the one hand, the top 500 CEOs took a 30 percent pay cut this year, according to Forbes. On the other hand, 17 banks paid $1.6 billion in bonuses while begging for federal bailout funds. Executives might believe they’re sharing the pain, but to many an unemployed worker, “chief executive officer” is a synonym for “greed.”
When it comes to executive compensation, what is the line between fair pay and greed? Two McCombs School of Business professors offer two different perspectives. But they agree on this: The structure of CEO pay might have helped to bring on the Great Recession.
Both see a link between the lure of big bonuses and the making of chancy business decisions, particularly at financial services firms. The central problem, they say, is a misalignment between pay and performance.
Pay and performance have been out of whack for a long time, says James Fredrickson, McCombs management department chairman. “For most executives, other than the people who founded the companies, you cannot justify the scale of their pay based on their contributions to the company.”
Outsized CEO earnings, he says, might actually hurt a company’s performance. In a new study of pay dispersion — the gap between a CEO and other top brass — he found that as dispersion went up, a company’s return on assets tended to go down.
“Where you need a team effort, you’re much better off having similar pay,” Fredrickson speculates. “People are more likely to undermine one another if they’re paid differently.”
To Jay Hartzell, executive director of the Real Estate Finance and Investment Center at McCombs, the problem is not how richly CEOs get rewarded, but what they get rewarded for. “Some of the problems we’ve had the past few years are driven by poor incentives,” he says, “not by oversized amounts of pay.”
Twenty years ago, he explains, it became popular to pay executives less in salary and more in stock options. If an option was priced at $5 a share, and the stock had soared to $10 a share, the CEO could exercise the option and pocket the difference. The strategy was to align the executive’s self-interest with the firm’s stock price, making money for both himself and stockholders.
As it turned out, options also encouraged executives to make riskier decisions, says Hartzell. A CEO made money if a risk paid off, but didn’t lose it if the stock went down. Even when stocks declined, many boards perversely rewarded their CEOs. They went back and lowered option prices, so their executives could cash in anyway.
“Lots of those structures work quite well when things are healthy,” says Hartzell. “But when the market goes bad, they blow up.”
Today, with most firms allergic to risk, the pay pendulum is swinging from options to stock, says Hartzell. Options will still have a place. But a CEO’s self-interest will be to take smaller risks if he knows his stock might drop.
Fredrickson recommends making executives wait longer before they can cash in their stock. “The obvious issue is short-term versus long-term gains,” he says. “You can’t give somebody a big bonus at the end of this year because the stock price went up this year. I would say the waiting period should be a minimum of five years.
“It’s still under the guise of pay for performance. It just depends on what criteria you use to judge performance, and what and how much you’re going to pay.”