Sunday, January 24, 2010

CEOs' compensation needs overhaul

By Vijay K. Mathur

Published in Standard-Examiner, Ogden, Utah, Jan 9, 2010

Most people are aware of complaints by politicians and general public about corporate CEOs' outrageous compensation, especially in large corporations. Economist Arantxa Jarque reports in his paper in the Richmond Fed's Economic Quarterly, Summer, 2008, that the average compensation of CEOs in the top 500 corporations in the U.S. was $15 million in 2007. That was 300 times the average pay of workers. Even the severest recession in recent memory and the dismal managerial performance in the financial sector have not prevented companies from awarding large bonuses to executives.

There are no standard benchmarks which can be used to evaluate the performance of executives. The concern is with compensation (salary, bonus with stock options, stock grants, retirement benefits, severance payments and other deferred payments) for executives in large companies. According to a study by C. Frydman and R. Saks, median CEO pay rose 54 percent from 1970-79 to 1980-89, but it jumped to 125 percent from 1990-99 to 2000-2005.

The question therefore is what determines the compensation of CEOs in large corporations? Various determinants have been investigated to explain CEOs' compensation, for example, sizes of the corporations, rates of return on stocks (dividends and change in stock prices as a percent of stock prices), market values of the companies (values of assets and stocks), and competition companies face in the market. But, aside from measurement problems, there is no unambiguous agreement on uniform standards of performance to base compensations.

CEOs are principal agents (hired managers) who represent shareholders' (owners') interests. Therefore, part of their compensation is for managerial and organizational abilities. However, there is one problem. CEOs, possessing critical information, may have different interests than the interests of shareholders. Hence they may not disclose complete and accurate information to shareholders in order for them to make important decisions good for the health of the corporations. Hence the problem shareholders face is to design a compensation package which provides the incentive to CEOs to maximize shareholders' value.

In the current system there is conflict of interest when CEOs are involved in recommending members to the board of directors, consultants to the compensation committees who decide CEOs' compensation. The Wall Street Journal reported on Dec. 15,2009, that in addition to the widening salary gap, the gap is also widening in pension plans of executives and employees.

The claim that bonuses and stock options are meant to compensate CEOs for the risk they take in maximizing shareholders value has not produced desired results. In fact, we have recently witnessed awards of large bonuses despite the financial meltdown in the banking and financial sector and enormous losses suffered by employees and shareholders. Stock option grants, where CEOs benefit from the spread between the granting price of the stock and market price, have been manipulated and misused.

Shareholders must take an active interest in the decision making process of corporations. In Europe stock holders are already taking an active role in many of the decisions of corporations, especially mergers and acquisitions -- one of the strategies CEOs use to maximize their own compensation and power.
However, most mergers fail and/or are unprofitable. Professor Dennis Mueller found in his major study on profits in 1980s that the more diversified a company, greater is the difference between "actual and potential recorded profits."

Thus the question arises, what is the best standard for CEOs' compensation? Professor Henry Mintzberg of McGill University argues in his opinion piece in WSJ of Nov. 30, 2009, that CEOs should not be paid bonuses in the form of stocks and options. They should get competitive salaries and be entitled to the same benefits, commensurate with their salaries, as other employees.

I propose the following:

* (1) CEOs' compensation should be based upon competition for talent in the international market place, because large corporations compete globally and the average worker in those corporations is subjected to international competition. At present American CEOs' compensation on average is way above the compensation of CEOs in other advanced countries.
* (2) Stock grants, vested in five years, should be a greater proportion of total compensation and be redeemable at prevailing market prices.
* (3) Retirement plans should be the same for all employees and no golden parachutes for CEOs.
* (4) CEOs should have no role in the choice of directors and/or consultants which determine their compensation.
* (5) Boards of directors, who are supposed to monitor CEOs' performance for shareholders, must also be stakeholders in the corporations they serve.
* (6) Shareholders must have a limited role in the decisions on CEOs' compensation.
Legislation will not solve this problem. Ultimately, corporate structure's survival and success depends upon the emergence of responsible corporate leaders who look beyond their narrow self-interest and work for the interest of their shareholders and employees.

As Professor Mintzberg states, "all this compensation madness is not about markets or talents or incentives, but rather about insiders hijacking established institutions for their personal benefit."

Mathur is former chairman of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He is also adjunct professor of economics at Weber State University. He resides in Ogden.

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