Executive Compensation in American Business

Before feeling too sorry for executives opting out of a regular salary, it is important to understand why foregoing a salary often doesn’t hurt their long-term position.  The bulk of executive compensation is paid in the form of option grants and long-term incentive plans (Kuepper, Undated).  These types of compensation are essentially rights to purchase company stock at a price lower than the current market trading price or direct grants of company stock, often restricted such that the executive must hold the stock for some time.  This type of compensation is most commonly tied to the financial performance of the company, meaning that in years that the corporation’s share price, revenue or other targets exceed expectations, top executives can expect huge payouts of this kind (Gayle & Miller, 2009).

It is important to understand that while option grants and stock awards are often valued in the tens, if not hundreds, of millions of dollars, executives often cannot cash out this type of pay for some time, meaning the company, and market in general, must continue to perform well for this type of compensation to reach full value.  This creates significant personal risk for top executives, but also creates incentive for them to ensure the long-term appreciation of their organization’s stock price (Burd, 2009).

Retirement and severance packages often contain a mix of both cash, stock, options and other perks and are much maligned in the press, often referred to as “golden parachutes.”  Part of the reason for public outrage is that this type of compensation often results when a top executive is forced out, either for poor performance, ethical misdeed, or shift in attitudes of the board.  Take for example the pay package of former HP CEO and current candidate for the US Senate in California, Carli Fiorina.  She received approximately $21 million in severance compensation after essentially being fired (Garofoli, 2010) by the board.  Public outrage was high, especially since she was responsible for the elimination of nearly 30,000 as part of the HP-Compaq merger.

However, during her tenure the company underwent key transformations that really positioned HP in a manner that has enabled it to compete more effectively in the market place, returning much more than the value of Fiorina’s severance to shareholders and employees.  And while HP has recently seen the departure of her successor, Mark Hurd, under scandal and with yet another generous severance package, the overall increase in value to the firm pales in comparison to the payout.  

Many executives negotiate these severance packages for two key reasons.  First, their employment is really conditional on the outcome of many high-risk gambles and decisions often made with very little information.  The average tenure of American CEOs in only 3.2 years, indicating the highly fickle nature of boards and investors and their reluctance to instill long-term leaders.  Second, as highlighted in the case of Hurd and his attempt to move to Oracle, many executives are bound by very strict non-compete agreements that can essentially sideline them for several years should they be booted out the door.  While golden parachutes may seem unfair on the surface, a deeper look shows that they are a key insurance package negotiated by shrewd executives who understand their future is more uncertain than most.

The last component of executive compensation, executive perks, such as the use of corporate jets, personal assistance, and even lawn care service, seems excessive to the average American.  However, as a study points out, the position of CEO for a public company is considered one of the most stressful and demanding jobs in America, second only to firefighters.  Individuals in top management positions often forfeit personal time with family, work an average of 65 hours per week, and often travel non-stop.  In order to attract top leaders to what amounts to pretty unattractive work, companies often add VIP perks to pay packages to make working conditions more bearable, particularly if the company is struggling and the value of its stock depressed such that options and stock grants will lead to little compensation in the short term.

With a more comprehensive understanding of the types of executive compensation, it becomes clear why pay for top executives is so highly correlated with strong company performance.  Indeed as Burd summarizes, research has strongly indicated that the relationship between executive pay and company performance is critical to the long term success of organizations.  This trend is important for two reasons.  First, it illustrates how corporations, owned by shareholders who are generally not present, are able to resolve the principle-agent problem and entrust management of the company to executives who would otherwise have no stake in seeing the company succeed (Gayle & Miller, 2009).  Second, it illustrates how this type of compensation is a key corporate strategy, enabling organizations to attract and retain the best talent to drive results and ultimately returns for investors.

Despite this clear correlation, there is still a major push underway to transform executive pay.  From the financial sector and auto industry bailouts to recent financial regulation legislation, there are a number of very aggressive attempts by government to regulate executive pay, eliminating large option bonuses and restrict the value of severance and retirement packages.  These measures are in reaction to much public outrage as executives at companies that were faltering received large checks as investors saw an unprecedented decline in market value.  This has lead many in government to characterize executives as greedy and overpaid, compensating themselves before considering employees or investors.

However, as the research of Gayle and Miller illustrates, the growth of executive compensation has not greatly exceeded overall salary growth rates, especially when adjusted for the risk many of these executives carry by having such a large percentage of their income tied directly to company stock performance, which can often be beyond their control.  This general misconception about executive pay has led policy makers to push for changes and caps on executive compensation to appease the public.  What these individuals fail to understand is the risk that is inherent in not only executive compensation, but also in a competitive free market.  While it would appear failure is highly rewarded, with executives leaving companies decimated by excessive risk taking yet still receiving large payments, these executives have often only fared only moderately in comparison to their successful counterparts and often struggle to find further employment.  The market, as a reaction to failure, punishes both the company and the executive.  This risk-reward system is a key driver in free markets.

Nevertheless, many still want to alter the pay structure to make it more “fair” in the minds of average consumers and investors.  Those taking this position should heed the warning found in the research of Gayle and Miller:

“Policymakers and citizens making the case to eliminate such compensation should carefully consider the consequences to ensure that government actions don’t inadvertently diminish the worth of U.S. corporations, a recipe for disaster in the current economic climate.”

Essentially, the US market requires substantial rewards for successful risk-taking and is naturally punitive for those that fail or try to take advantage of the system.  While some oversight is necessary to protect investors in their attempt to manage the principal-agent problem, this market balance is what drives growth in companies and the market and is ultimately a critical component of the success of the US economy.

Works Cited

Burd, M. D. (2009, July 16). Curbing Executive Pay Incentives Would Devastate Shareholder Equity, Indicates Carnegie Mellon Research. Retrieved September 17, 2010, from News Detail: Tepper School of Business at Carnegie Mellon: http://www.tepper.cmu.edu/news-multimedia/news/news-detail/index.aspx?nid=388

Garofoli, J. (2010, September 2). Climate, jobs split Boxer, Fiorina. The San Francisco Chronicle , p. A1.

Gayle, G.-L., & Miller, R. A. (2009). Has Moral Hazzard Become a More Important Factor in Managerial Compensation. American Economic Review , 1740-1769.

Kuepper, J. (Undated). Evaluating Executive Compensation . Retrieved September 12, 2010, from Investopedia: http://www.investopedia.com/articles/stocks/07/executive_compensation.asp