The Economics Of Ceos Pay

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MANAGEMENT &STRATEGY

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BUSINESS AT OXFORD

The economics of a CEO’s pay

The great CEO compensation debate, and how it will impact an emerging economy such as India

EXCLUSIVE

B Y T HOMAS N OE ······················ s any reader of the business press knows, CEO compensation has become the subject of intense debate. The debate started in the US, it has reached the UK (as evidenced in the imposition of “say on pay” regulations) and, with the rise in continental CEO salaries, is spreading across Europe. How will this debate affect India—by far the largest emerging market economy with Anglo-Saxon legal and financial institutions, exactly the sort of institutions that birthed the CEO compensation debate? I will try to answer this question by looking beyond the outrage of critics and the rationalizations of boards, focusing instead on the underlying economics of CEO compensation. The attack on CEO compensation comes from two directions. Some argue that CEO compensation is too high, exceeding the level CEOs would obtain in arm’s length transactions; others argue that CEO compensation is too low-powered, that is, too insensitive to firm performance. The problem with the “too high” argument is that it is not easy to find an absolute threshold beyond which CEO compensation becomes unreasonable. At a company such as

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Walt Disney Co., with around $3 billion (around Rs12,945 crore) in after-tax profits, a CEO capable of boosting profits by a modest 5% could—even if we capitalize earnings at a modest price-earnings multiple of 5—raise corporate value by $750 million. In this context, the “outrageous” salary earned by Disney’s ex-CEO, Michael Eisner, of around $100 million does not seem so outrageous. • Because it is difficult for critics of CEO compensation to measure either the scope for CEO value creation or the diffusion of star talent across the population of CEOs, critics for the most part attack the level of CEO compensation through comparisons, either by comparing the CEO of today with the CEO of yesteryear or by making cross-country comparisons. Lucian Bebchuk and Yaniv Grinstein (2005), for example, show that US CEOs’ compensation relative to corporate profits has grown substantially between 1993 and 2003. Martin J. Conyon and Kevin J. Murphy show that in 1997, CEO compensation in the US was more than double CEO compensation in the UK. • At first glance, these observations seem to support the idea that, at least in the US, lowering CEO compensation would be in shareholders’ interest.

However, upon further inspection, the case is less clear. Much depends on how compensation is measured. Carola Frydman and Raven Saks (2007) show that relative to assets, the increase in US CEOs’ compensation is very modest. Moreover, the increase over the 1990s compensated for a decrease in normalized compensation in the preceding 10 years. Comparisons of CEO compensation across countries are also fraught with problems because CEO compensation is part of a larger system of corporate control that includes law, accounting, board design, and institutional investors. As my research with Michael Rebello and Ramana Sonti shows, the marginal contribution of each of these checks on opportunism varies with the strength of the other checks. Thus, perhaps in the UK, where the legal system imposes fewer constraints than the US on direct intervention by institutional shareholders, the marginal value of high CEO compensation packages is lower. The relevant question for a firm’s compensation committee is not how much the firm’s CEO should be paid in an ideal world, but how much the CEO should be paid in the actual business world in which the firm operates. • The indictment of CEO compensation that is based on “low performance sensitivity” is also less than air-tight. The argument is that “high-powered” CEO compensation, which deals out very high rewards on average but concentrates these rewards at the top end of firm performance, is

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the ideal way to incentivize managers. This rests on the assumption that a board’s problem of designing incentives for the CEO is qualitatively similar to the standard problem of inducing effort from an employee. However, the CEO’s position relative to shareholders is fundamentally different from a worker’s position relative to his boss. The CEO has a huge information advantage over the board and enormous discretion. In this environment, CEOs need incentives to do the right thing, even when their firm is sailing through rough seas and very ambitious performance targets are out of sight. • Moreover, a weak relation between the CEO’s current performance and current compensation does not imply a weak relation between long-run performance and the CEO’s long-run compensation. In a dynamic world, rewards for performance need not be meted out at the same time as performance. My research with Rebello shows that optimal CEO compensation can lead to a very weak relation of current CEO pay and current firm performance and yet produce a very strong link between the long-term value of the CEO’s position and firm performance. The empirical research of John F. Boschen and Kimberly Smith (1994) shows that a weak current but strong long-term link is typical of US firms. • How will the great debate on CEO compensation, thus far conducted mostly in the developed economies, play out in emerging market

economies such as India? Lacking a crystal ball, but armed with humility, I will venture the following predictions: In India, the growing mobility of human capital, combined with economic growth, will lead to sharp increases in CEO compensation and management compensation generally. Because of higher CEO turnover, the timing of CEO rewards will become more closely synchronized with firm performance, leading to a stronger measured pay-to-performance relation. The weakness of institutional investor monitoring will lead boards, even if they are concerned with outside shareholder welfare, to grant CEOs fairly generous bonus plans for meeting modest performance targets. The increase in compensation will be decried by some in the business press, while others will praise the strengthened pay-to-performance relation. Send your comments to businessatoxford @livemint.com

Thomas Noe is Ernest Butten professor of management studies at the Saïd Business School, University of Oxford.