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Executive Pay: How Much Is Too Much?
Growing pay disparity between top executives and average workers threatens morale

By Stephen Miller, CEBS  10/2/2012
 

During the 1970s, the late management theorist Peter Drucker recommended that 20 times average worker pay was an appropriate upside ceiling for top executive compensation. Today, CEOs at S&P 500 firms are more likely to be paid more than 200 times what a typical worker earns, according to compensation specialists addressing the issue Is It Time to Reform Executive Compensation?, at the Brookings Institute in Washington, D.C. on Sept 27, 2012.

One consequence of increasing disparities between executive compensation and average worker pay is lower morale, said Eleanor Bloxham, founder and CEO of the Value Alliance, a board and senior executive advisory firm.

At the largest U.S. firms, "People feel disconnected from the CEO. They are not willing to share with management what could be fixed or improved. The people on the ground don't feel that top management understands them," she said.

Big pay disparities also impact the effectiveness of the CEOs themselves, because "they become disconnected, not understanding what their employees have to deal with or what their customers are going through. They're in a protective bubble," she noted.

Bloxham was critical of the use of both stock options and restricted stock shares as a large portion of executive compensation packages. Rather than tying pay more closely to executive performance, as they are intended to do, she argued, "You have managers cutting costs to increases the stock price because their pay is tied to stock. And then they cut costs some more. That's what we're experiencing now."

Explosive Growth, Then Stabilization

However, Donald Delves, founder and president of The Delves Group, an executive pay consultancy, contended that, "Today, I do not think that executive compensation is out of control. It's just high, and there's a difference."

CEO pay skyrocketed by 400 to 600 percent during the 1990s, Delves admitted, driven to a large extent by "an explosion in the granting of stock options." Fortune 500 CEOs now make $9 million to $12 million a year, but CEO pay has not gone up dramatically since 2001, Delves said. "In fact, it came down a little bit, and it has fluctuated in a range since then."

He pointed to reforms instituted under the 2002 Sarbanes-Oxley Act, which barred CEOs from serving on board compensation and audit committees, and, under the 2011 Dodd-Frank Act, new nonbinding "say on pay" shareholder votes.  Also, beginning in 2006, the Financial Accounting Standards Board began requiring that granted stock options be recorded as an expense on corporate balance sheets, fueling a decrease in stock options and an increase in time-based or performance-based restricted stock shares, which Delves (unlike Bloxham) believes are more effective than stock options in tying pay to performance.

"The end result is that executive pay actually does move up and down with performance," Delves said. "CEO pay went down during the recession, and as corporate profits came back up, CEO pay went back up. But what do you say to the typical factory worker whose pay has not increased in real terms for 20 years? What do you say to the family whose average household income has actually gone down? That is a very serious societal problem."

"What do you say to the typical factory worker
whose pay has not increased in
real terms for 20 years?"

In Delves' experience with corporate boards, "most compensation committee members want to do the right thing, and they're not trying to just line the CEO's pocket. They are trying very hard to tie pay to performance."

The problem is not that executive pay is high, "it's that average worker pay is so low and that it has not increased," Delves reiterated. "In the 1980s we spent a lot of time implementing gainsharing and Scanlon plans, and other efforts designed to help employees improve the productivity and performance of their company, factory or business unit by sharing in the gains. I haven't seen much of that in a long time."

Instead, "There is an enormous amount of effort and research that goes into figuring out how to pay and motivate the top five, 10 or 15 people in the company. We don't spend enough time talking about how we've going to structure pay to improve the productivity of the rest of the employees. I'm not saying we need to pay less attention to executive pay, but we need to pay a lot more attention to worker pay, and that's where boards of directors can focus more of their attention."

The 'Say on Pay' Sea Change

Holly Gregory, a corporate partner with the law firm Weil, Gotshal, & Manges LLP, agreed that regulation has transformed how compensation committees operate, including new Securities and Exchange Commission (SEC) rules issued in 2012 to increase the independence of compensation consultants and compensation committee members from the top executives whose pay they are charged with setting.

Gregory called shareholder say on pay votes "a sea change in compensation," noting that "even though the vote is advisory and nonbinding, it certainly has been coercive."

In the year following the first say on pay votes in 2011, companies had to disclose in their proxy statements whether they had considered the shareholders’ vote in setting executive pay, and if so, how that had impacted compensation policies going forward.

While only a small percentage of public companies received a shareholder vote of "no" in 2011 and 2012, negative recommendations by shareholder advisory firms can adversely affect how a company's governance is perceived, Gregory said. "The institutional investors received advice from professional proxy advisers on how to vote, and those proxy advisors have voted against compensation at a greater rate this year than last year, and it's something to watch carefully," she said.

Those cases where shareholders voted against the executive pay package "mostly have to do with a perceived disconnect between pay and performance," Gregory added. "Large institutional investors don't seem that concerned about pay levels, but they are concerned about pay in relationship to performance and how that tracks."

In addition, there are certain pay practices that now are sure to get a negative vote on compensation, "which is why we're seeing far more reasonable perquisites, far less reliance on tax gross ups, the disappearance of option repricing. Boards know that those practices are a key way to get ISS, the largest shareholder advisory firm, to issue a negative recommendation," she remarked.

Say on pay also is driving increased efforts by companies to communicate decisions around compensation in much clearer way, Gregory said, and is driving efforts to engage much more closely with large institutional shareholders, to try to understand their concerns and communicate how the board and the company are looking at governance issues.

Coming up, she noted, Dodd-Frank requires that public companies disclose the ratio of the CEO's pay to the median salary of company workers. The statute did not include a deadline and no rules have yet been issued by the SEC, but once it is required, compensation committees will have to rationalize CEO pay not just as a total amount, but in terms of its relationship with what workers generally earn.

Disclosing Relative Performance

The final speaker, David Walker, a professor of law at Boston University, also pointed to performance-vested restricted stock shares as a means to better tie executive pay to company performance. "When we talk about executive pay today, we're talking about stock, not stock options," he said. “With performance-vested restricted stock, not only do you have to meet the time requirement, but the firm has to hit an earnings target or another benchmark in order for the stock to vest."

Walker noted that in 2000, stock options represented over 60 percent of the average compensation mix of S&P 500 senior executives, and restricted stock represented about 10 percent of pay. In 2011, those figures had largely reversed, with stock options representing less than 20 percent of pay and restricted shares more than 40 percent.

All told, "If you look at the history of our regulation of compensation, particularly equity compensation, it's been abysmal," Walker said. "Limits on deductibility of nonperformance-based pay certainly didn't reduce pay. It might have contributed to the shift into options."

Rather than increased regulation, he recommended further disclosure, including making transparent the average pay period for holding restricted shares before they vest, as compared to a company's direct competitors.

Walker also advocated not tying pay simply to whether the company's stock price rises or falls, since CEO performance can't control the broad movement of the stock market. Instead, he argued, pay should be based on the company's stock price movement in relation to competitors, along with other metrics that are comparable among industry peers.

Stephen Miller, CEBS, is an online editor/manager for SHRM.

Related SHRM Video:

Rosie Steeves Tie Compensation to Engagement. Executive compensation should be tied to employee engagement, not short-term financial goals, argues Rosie Steeves, principal at The Refinery Leadership Partners.

Related SHRM Articles: 

CEO Salaries at Biggest Firms Pass $1 Million Mark, SHRM Online Compensation, August 2012

Viewpoint: Making Executive Pay Work, SHRM Online Compensation, June 2012

The Evolving Say on Dodd-Frank’s ‘Say on Pay,’ SHRM Online Compensation, May 2012

Above-Peer CEO Pay Decreased Shareholder Support, SHRM Online Compensation Discipline, March 2012

Executive Pay Programs Stabilize, Reflecting Best Practices, SHRM Online Compensation Discipline, March 2012

Fewer Companies Offer CEOs Perks and Incentives, SHRM Online Compensation Discipline, February 2012 

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