The debate over executive compensation, once muted, has reemerged with a distinctly populist ring. While executives of major companies have been paid outsize salaries for years, the recent spate of bonuses for employees of bailed out firms has drawn the ire of the public and politicians alike. The AIG debacle merely presaged a wider sense of indignation. Now even companies freed from their debts to the federal government have become subject to public scrutiny over executive pay.
Simple math can partially explain the public’s frustration. The average CEO of a Standard & Poors 500 company is paid approximately 3.75 times their weight in gold per year (total compensation averaged $10.9 million in 2009). Half of all executives made 104 times more than the average American worker in 2005, up from a low in 1970 of 25 times more. With numbers like these, many argue that heads of the world’s largest firms are simply paid too much. But others claim the benefits of a good chief executive more than outweigh the costs. So are CEOs paid too much?
“It’s a tough question to answer,” said professor of finance Camelia Kuhnen. Many boards of directors, she said, feel high-power chief executives deserve the large sums if they can steer their companies to success. But on the other hand, she noted, CEOs in the United States often have a hand in setting their salary and compensation, with many serving as chairmen of their own board.
Researchers studying executive compensation have attempted to clarify these two alternative explanations. One theory, according to Kuhnen, says firms need to pay high-ability executives big money to retain their services, otherwise he or she may leave for another company. For many boards, the cost is well worth it. “When you match a really high ability guy with a really large firm, there’s a huge amount of output” Kuhnen said.
“But this model doesn’t preclude the idea that was championed by people like Lucian Bebchuk that says CEOs make a lot of money not because they deserve it, but because they can. CEOs have control over the board and they can dictate their own pay.”
“Which of these two views is right?” Kuhnen asked rhetorically. “We will never know.”
The public as the great moderator
Despite the murkiness of the theory, outrage over CEO pay is very concrete. Public discontent has forced the government to limit pay at companies receiving bailout funding, a result that Kuhnen thinks may be appropriate since taxpayers are now shareholders—it is their right and responsibility to determine the CEO’s pay. But for companies that have skirted public assistance, she does not think regulation is necessary. “Firms have the incentive on their own to not look ridiculous in front of the public,” she said. “Look at Goldman Sachs—the first page of the Financial Times had an article that said Goldman will not pay very high bonuses this year because they are concerned about making the public even more angry.”
Goldman’s response echoes what Kuhnen has found in her own research (pdf). She and her co-author Alexandra Niessen discovered a significant correlation between public opinion of CEO pay and actual executive compensation. “When the public is very negative about CEO pay, in the following year on average in the U.S. we see that CEO pay will drop.” Furthermore, executives are generally paid less in states like Iowa, Utah, and Minnesota that are more sensitive to income inequality. (New York and Nevada, by contrast, are two of the most insensitive.)
Still, Kuhnen is uncertain about what has driven executive compensation levels up at such a dramatic pace. “Many things could be going on. Some of them are about governance, some of them may be about talent—you have to pay a really talented guy a lot of money for him to run your firm—and some could be about norms.”
“It could be in this country it’s been OK for the past 30 years for CEOs to make more and more money—nobody cared,” Kuhnen said. “But now maybe the norms are changing. Public opinion is very negative, and so we’ll see.”