The Executive Pay Conundrum

What? You're taking away my company Porsche? And the boat too??

The issue of how to remunerate executives has been hotly debated, at least as far back as Berle and Means’ The Modern Corporation and Private Property (1932), that first stressed the separation of ownership and control and the emergence of a powerful class of professional managers. But for a long time the debate had been largely restricted to academic seminars and practitioners’ discussions until the turmoil of the current financial crisis brought the issue into the limelight of public debate.

This went so far that, shortly after taking office, President Obama announced in early 2009 that executives of companies receiving federal bailout money will have their pay capped at $500 000 under a revised financial compensation plan. He defended this measure by stating that 2008’s handout of $18 billion in Wall Street bonuses was ‘exactly the kind of disregard for the costs and consequences of their actions that brought about this crisis: a culture of narrow self-interest and short-term gain at the expense of everything else’.

In July 2008, well before the financial crisis reached its peak, the workshop on ‘Executive Pay’ of the CESifo Venice Summer Institute, organized by Florian Englmaier, Gerhard Illing, and Efraim Sadka, brought together international experts on the topic of managerial compensation at Venice International University on the small island of San Servolo to discuss this issue. This special issue of CESifo Economic Studies collects the papers by Eugene Kandel, Ian Dew-Becker, Carola Frydman, Daniel Ferreira, Robert A. Miller, and Peter Katuscak presented at this workshop.

For a long time the focus of the debate about executive pay was set on the right structure of the compensation schemes, stressing, like Jensen and Murphy (1990) the low pay-performance sensitivity of executive pay. Jensen and Murphy (1990) showed for a panel data set of CEOs in the largest, publicly traded US companies from 1974 to 1986 that, on average, CEO wealth changes by only $3.25 per $1000 of shareholder value, i.e. managers could buy corporate jets with a 99.7% discount. Furthermore, they pointed out that managerial ownership had declined over the previous 50 years which caused this low level of pay–performance sensitivity.

Gibbons and Murphy (1992), for a sample from 1971 to 1989, argued that the presence of substantial career incentives could account for these low-powered explicit incentives. However, using a panel from 1980 to 1994, Hall and Liebman (1998) showed that CEOs are in fact not paid like bureaucrats but that there is a strong relationship between firm performance and CEO compensation. This relationship is generated almost entirely by changes in the value of CEO holdings of stock and stock options. Furthermore, they show that both the level of CEO compensation and the sensitivity of compensation to firm performance had risen dramatically since 1980, largely because of increases in stock  option grants.

In light of this dramatic increase in executive compensation, from 1970 to 2005 average executive compensation increased eight-fold, there was a shift in the discussion away from the structure of pay more towards trying to explain this change in levels. Bebchuk and Fried (2004) gained a lot of popularity by arguing in their book Pay without Performance that strong executives with control over weak company boards expropriate shareholders by effectively granting themselves excessively generous pay packages. This behavior, they argue, is only restrained by outrage that excessive packages cause in the general public, and hence firms try to hide the true level of compensation by issuing stock options or offering large pension packages (Bebchuk and Jackson, 2005) that are not as readily observable to outsiders. However, if anything, boards have become stronger over the last 20 years, so the Bebchuk and Fried argument has a hard time explaining the time trend. In contrast, for example, Murphy and Zabojnik (2004) employ a more neo-classical approach and describe compensation as the result of an increasingly competitive labor market for executives.

Recently another explanation has gained popularity—the so-called firm size approach. Baker and Hall (2004) and, in particular, Terviö (2008) and Gabaix and Landier (2008) 35 argue that the drastic increase in average CEO pay can be largely explained by the increase in average firm size measured by market capitalization that boosted the marginal return to CEO talent. The papers at the workshop addressed various issues related to these debates and pointing at directions for future research.