It is the time of the year when stories about CEO compensation are the news of the day, and investors and onlookers alike get to ask whether a CEO can really be worth tens or even hundreds of millions of dollars, in annual compensation. Before I join the crowd, it behooves me to list my biases to start, because it will allow you to make a judgment on whether I am letting these biases color my conclusions. First, I believe that in some companies, CEOs not only add very little in value to the company but may actively be value destroyers, and that in many companies, what CEOs get paid is out of sync with the value that is created by them. Second, before you put me in the economic populist camp, I also believe the only group that should have a role in deciding how much a CEO gets paid in a publicly traded company is its stockholders, and that politicians, regulators and societal nannies should not get involved. Third, if you, as a stockholder, are disconcerted by the disconnect between CEO pay at your company, and CEO value added, you should be cheering on activist investors and pushing for more power to stockholders, rather than less.
CEO Compensation: The Landscape
Companies in the United States are required to break out and report what they pay their CEOs in summary compensation tables, filed with the Securities Exchange Commission (SEC). The numbers are still trickling in from 2014, but here is what we have learned so far:
- The early returns suggest that CEOs were paid more this year than they were last year, with collective pay increasing about 12.1% at the largest companies.
- The portion of that compensation that was in cash increased to 37% from 35% in the prior year, with the bulk of the the remaining coming from stock grants (31%) and options (23%); pension gains (6%) and perks (2%) rounded out the rest.
- The highest paid CEO in 2014 was Nick Woodman, CEO of GoPro, who was granted 4.5 million restricted stock units, valued at $284.5 million.
It is true, as many others have pointed out, that CEO pay has been increasing at rates far higher than pay for those lower in the pay scale, for much of the last three decades. In the graph below, I look at the evolution of average CEO pay since 1992, broken down broadly by sector:
Since 1992, the annual compounded increase in CEO pay of 7.64% has been higher than the growth in revenues, earnings or other profitability measures. Of all the drivers of CEO pay changes over time, none seems to be as powerful as stock market performance, as is clear in this graph going back further to 1965:
For those clamoring for legislative restrictions on CEO pay, note that it was a law designed to restrict executive compensation, passed by Congress in 1993, that set in motion an explosion of stock-based compensation that we have seen since. If you break down CEO compensation by its component parts (salary, bonus, equity-based compensation and other), you can see the shift towards equity-based compensation over time:
While there has been much talk about the ratio of CEO pay to that of an average employee, and that ratio has indisputably jumped over the last three decades, I found this ratio of how much a CEO gets paid, relative to the next highest paid employee in the company, for S&P 500 companies, using 2012-2014 data to be a more useful statistic.
The median CEO is paid 2.30 times the next highest-paid employee at an S&P 500 company, which raises the follow up question of whether he or she adds that much more in value. While we can debate that question, the bottom line is that CEO compensation is large, rising and increasingly equity-based, that the growth in pay has accelerated in the last 20 years, and more so in the United States than in the rest of the world.
Determinants of CEO Pay
Not only is CEO pay high, but it varies across time and across companies. There are three broad theories, not mutually exclusive, as to why you see that variance.
- Reward for performance: If a CEO is paid to run a company, it stands to reason that he or she should do well when the company does well, though you can measure “doing well” on three dimensions. The first is profitability, with higher profits (and growth in those profits) translating into higher pay. The second is the quality of the profitability, where the focus is on profit margins and returns on invested capital, with higher numbers on either measure resulting in bigger payoffs for CEOs. The third is to use a market measure of performance, by looking at stock price movements, with CEOs who deliver superior returns (either in absolute terms or relative to the market or the sector) getting fatter paychecks.
- CEO Market: If you start off with the presumption that it takes a unique skill set to become a CEO and that there is a market for CEOs, the compensation package that the company negotiates with a CEO will be determined by how the market prices his or her skills.
- CEO Power: If a CEO is powerful, he or she may be able to get a pay package (from a captive board) that is at odds with performance and much higher than what the market price would have been. There are multiple factors that determine CEO power, starting with his or her stock ownership. CEOs who own controlling stakes (and control does not require 50%+) in companies will be more powerful than CEOs that do not. The second is corporate governance, with all of the inputs that determine whether it is strong or weak; companies with weak or compliant boards of directors and little accountability to shareholders will be more likely to over pay their CEOs. The third is CEO tenure, since there is evidence that the longer a CEO stays in place, the more likely it is that the board will be moulded to meet his or her needs.
This excellent survey article on the topic summarizes the evidence, and it is both supportive and inconsistent with each of these theories. Xavier Gabaix, my colleague at the Stern School of business, finds that dominant variable explaining changes in CEO pay over the last three decades has been changes in market value, with CEO pay increasing as market value increases. However, that theory in inconsistent with what happened in the 1950s and 1960s, when US stock market capitalization increased with no dramatic jump in CEO pay. There is some evidence that