As always happens in the spring, companies reported the pay of their chief executive officers and other top leaders. And, as usual, the press and activists complained that CEOs are paid more and more, without regard for performance, and that boards aren't doing their jobs.
But there's a twist this year. The Say-on-Pay rules in the Dodd-Frank legislation required for the first time that shareholders vote on executive-pay packages. And to the surprise of many, those votes have been overwhelmingly positive. The pay policies at more than 98 percent of the companies in the Standard & Poor's 500 Index received majority shareholder support. Almost 90 percent of those companies received favorable votes exceeding 70 percent.
What gives? How can CEOs who are so consistently criticized by the press and activists garner such shareholder support? The answer is that this backing makes complete sense. Contrary to popular opinion, average CEO pay has decreased over the last 10 years, CEOs are paid for performance, and boards are aggressive in firing CEOs who don't meet the standards. In other words, the pay process isn't broken, and boards are doing a good job.
In 2000, S&P 500 boards paid their CEOs an average of almost $17 million (in inflation-adjusted dollars). Board-awarded pay includes salary, bonus, restricted stock, and the expected value of options. In 2009, the average was less than $8.5 million, a decline of almost 50 percent from 2000.
These results have come as a surprise when I have presented them to audiences that included business people, directors, finance academics, and, shockingly, the head of corporate governance at Institutional Shareholder Services, a major consultant on these issues.
That's because this kind of data is rarely reported by critics. While average CEO pay increased in 2010 (the final comparable numbers aren't yet available), the increases were on the order of 20 percent. This would mean that average pay in the S&P 500 is down 40 percent since 2000.
Nevertheless, critics will point out that $8.5 million is a lot of money, particularly relative to the wages of the average worker. True, but it is important to note that many other high earners have done at least as well as CEOs since 2000 (and even since 1994).
For example, the average top 50 law firm saw profit per partner increase 34 percent in 2009, to more than $1.6 million, compared with $1.2 million in 2000. Those profits increased again in 2010. Also in 2009, the average top 25 hedge-fund manager earned more than $1 billion. That means the top 25 hedge fund investors earned more than $25 billion, about six times the amount earned by all S&P 500 CEOs combined.
Clearly, CEOs aren't in a class of their own. Their high pay appears to be part of (not the cause of) the increase in income inequality over the last 30 years. Market forces -- particularly globalization, technology and economies of scale -– are the true drivers of these increases, and tt seems likely that boards have responded to these same market forces in determining how much to pay CEOs. The Say-on-Pay results suggest that shareholders agree with the assessments of boards.
It also turns out that CEOs are, indeed, paid for performance. In measuring this, it is important to look at realized pay -- the amount a CEO actually takes home -- rather than the amount the board estimates it is giving that executive. Realized pay differs from estimated pay by substituting the value of exercised options for the estimated value of options granted. (Estimated pay is a better measure of what the board expects the CEO to receive, while realized pay is a better measure of what the CEO actually gets.)
My colleague Josh Rauh and I looked at realized pay of CEOS in a given year. Firms with top executives in the top decile of realized pay earned stock returns that were 90 percent greater than those of other firms in their industries over the preceding five years. Companies with CEOs in the bottom decile of realized pay had stock returns that underperformed their industries by almost 40 percent in the previous five years. The results are qualitatively similar for performance over three years or even one year.
This correlation is borne out when one examines pay for performance year by year. In 2008, the year of the financial crisis, companies performed poorly as a group. Average realized pay for S&P 500 CEOs declined almost 30 percent. In 2010, as the economy recovered, so did many companies. Accordingly, CEO pay increased for that year.
These results should also make clear that boards aren't the puppets of CEOs they are sometimes portrayed to be, and that they do penalize executives for poor performance. In a recent study, Dirk Jenter and Katharina Lewellen found a strong relation between CEO turnover and performance. Fewer than 20 percent of chief executives with strong stock performance (in the top 20 percent) lost their jobs over a five-year period. By contrast, almost 60 percent of those with weak stock performance (in the bottom 20 percent) lost their jobs over that same period.
U.S. companies, particularly the non-financials, have performed very well in the last two years, recording historically high profit margins and cash balances. If anything, these results and the Say-on-Pay votes suggest there is room for boards to pay CEOs more.
(Steven N. Kaplan is professor of entrepreneurship and finance at the University of Chicago Booth School of Business. The opinions expressed are his own.)
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