The Government Wants to Set Your Pay

As the federal government contemplates broad, new regulations for the financial services sector, compensation is high on the agenda. The impact of such regulations will be significant. Human resource strategy is a key driver of value in any company; it is arguably the most critical driver for a company whose chief assets walk in and out of the front door every day.

Why does the government care so much about pay?

The nominal reason for interest in executive compensation is its importance for corporate governance. Compensation strategy is used to attract capable managers, and to align their interests with those of the shareholders. Most observers agree that perverse incentives contributed to the recent demise of many financial institutions, arguably contributing to the resulting financial crisis. Regulators are understandably anxious to prevent a recurrence.

Unfortunately, the government also has a very different, and in many ways much more compelling reason to care about executive pay—popular sentiment. Policy makers are following the headlines in proposing legislation because that’s where the votes are. The resulting laws use the language of governance, but they mostly impose substantive restrictions that closely reflect general opinion about what is wrong with Wall Street pay.

For better or worse, we can’t disentangle governance and populist rationales for regulation of compensation. To the extent that they are aligned, popular anger can be a useful club for imposing needed governance reforms. Unfortunately, history shows that mob psychology generally contributes no more to governance than it does to government. Past regulations have caused many more problems than they solved. It’s frankly difficult to expect better results going forward.

A brief history of compensation regulation

In 1980, the average multiple of CEO pay to that of the average worker was about 40 times. Compensation structures were fairly simple—a base salary plus a bonus opportunity that typically represented from 10 percent to 50 percent of salary. The main reform being touted by the good governance crowd was an increase in the proportion of pay at risk, i.e., more from bonus, and less from salary. Governance mavens were also advocating equity awards to improve the alignment of managers.

By the late 1980s, the burgeoning market for corporate control created a premium for better leaders. It also made the CEO’s job riskier, leading to the wide adoption of golden parachutes. Every now and then, it became a value-creating proposition to basically bribe entrenched managers to surrender their poorly run companies. But “pay for failure” outraged ordinary citizens, so the tax on golden parachutes was born.

By 1990, pay for a growing number of Fortune 100 CEOs began to top $1 million. Something about crossing the $1 million threshold captivated the press and ticked off the public. “Who could be worth $1 million a year?” people asked, especially as the economy began to slow down. So in 1992, the government’s experiment in containing executive pay began in earnest. That year, it imposed enhanced disclosure rules for the five highest paid executives. The theory was that such disclosure would force a spotlight on this spending, and thus keep a lid on it. The next year, as CEO pay went up again, Congress passed a limit on the tax-deductibility of salaries over $1 million.

These rules were intended to slow the growth of CEO pay. Their effect was exactly the opposite. Enhanced disclosure made the market for high-end talent more transparent, and the competition for that talent more efficient. The limit on the deductibility of salary simply accelerated the shift of senior executive compensation toward variable pay, especially stock options, which benefitted from peculiarly favorable accounting rules. These elements happened to come together at the onset of one of the biggest bull markets in history. Some would say the newly souped-up incentives had something to do with that. In any case, CEO pay went through the roof.

True to the historical pattern, the burst of the dot-com bubble and ensuing economic difficulties landed the spotlight once again on the richest CEOs. The excesses of titans like Dennis Kozlowski, Bernie Ebbers, and even successful CEOs like Jack Welch rankled the populace. Additional changes in accounting, tax, and disclosure rules soon followed.

These accumulating compensation rules contributed to another bane of governance critics—increasingly complex pay plans. Like squeezing a balloon, as soon as a rule to clamp down on one perceived source of excess was implemented, new pay popped up in another place. The clampdown on salaries led to higher bonuses and more equity. The spotlight on bonuses and options led to more perks. The jam on perks led to greater deferred compensation and sweetened pension-related rewards. Every time the policy makers thought they were closing the loopholes, the market found another way. By 2000, the multiple of CEO pay versus the average worker climbed to 400 times.

Why did regulation fail so badly?

So, if a patient gets treated for a condition, and still exhibits symptoms, one can suggest that the treatment didn’t take for any number of reasons. If a patient gets treated multiple ways for an ailment, across years or decades, and the symptoms get worse, one should at least begin to question the original diagnosis. One diagnosis stood behind every one of the government’s failed attempts to limit CEO pay, the diagnosis to which they unquestioningly cling to this day: managerial power.

According to this thesis, CEOs take advantage of their influence over boards to get what they want, regardless of performance. Critics see directors as the CEO’s golfing buddies unable to say “no” to any proposal the boss floats regarding his or her pay. Or directors are clueless codgers, able to be hoodwinked into giving the CEO much more than they realized, until after the contracts are signed and the money is out the door. Or, worst of all, the board is perceived as actively conspiring with the CEO in a mutual back-scratching exercise, where CEOs on the board of one company vote for higher pay in the expectation that other CEOs on their board will increase their own pay in a kind of web of privilege.

Managerial power is a real phenomenon. There is, in fact, plenty of empirical as well as anecdotal evidence linking managerial influence and CEO pay. The problem is that, 20 years later, all of this evidence undermines the managerial power thesis of growing CEO pay. Even the most strident corporate critics acknowledge that, since the early 1990s, boards have become far more independent, more vocal, and otherwise less willing to tolerate an imperial CEO. So, if managerial influence is such an important driver of pay, why hasn’t CEO pay declined, or at least grown more moderately, as power has unquestionably shifted from the CEO to the board?

A less conspiratorial framework

Occam’s razor provides us with a much simpler explanation than managerial power. This explanation doesn’t assume, against actual experience with real boards, that directors are systematically lazy, stupid, or corrupt: rather, that the effective demand for executive talent has sharply increased, largely as a result of the complexities and risks of the job, some of which is government-created.

Belief that executive pay is driven by supply and demand or risk and reward factors doesn’t deny that some CEOs are “imperial” and some boards are “captured.” It certainly doesn’t suppose that the market for talent works perfectly. But it neatly explains the rise of CEO pay in a way that managerial power can’t, based on all the available evidence, especially for those willing to accept that a buyer of executive talent can tell the difference between a $2 million executive and a $10 million executive as surely as a real estate buyer can tell the difference between a $2 million building and a $10 million building.

It also suggests an economic framework upon which to better understand the dynamics of executive compensation, and to propose remedies more likely to improve governance. In particular, compensation policy involves trading off three corporate governance requirements:

• Attracting and retaining necessary talent,
• Aligning managerial interests with those of the shareholders, and
• Obtaining retention and alignment benefits at a reasonable cost to the company.

As with any trade-offs, you generally can’t get more of all three at the same time. The best way to increase alignment is to make pay more variable, deferred or conditional, all of which reduce the value of compensation to the employee. At that point, a firm must either accept a greater risk of losing their talent to alternative employment, or increase the total compensation opportunity. There is no point arguing that CEO X is overpaid in the absence of specific knowledge regarding the original retention and alignment trade-offs contemplated by the board at the time the plan was conceived.

This is the first in a two-part series on executive compensation and financial service regulation. Part two examines the current crop of executive pay proposals with a view to their likely effectiveness in regulation reform.

Author bio

Marc Hodak is Managing Director of Hodak Value Advisors, a firm specializing in the finance and compensation issues of corporate governance. Marc teaches corporate governance at New York University’s Leonard N. Stern School of Business. He can be reached at mailto:mhodak@hodakvalue.com