A rigidity-based theory of executive compensation

by on April 14, 2014 at 4:37 am in Economics, Uncategorized | Permalink

There is a new paper by Kelly Shue and Richard Townsend (pdf), it is quite intriguing though note it is preliminary work. I am not linking to it but the authors appear to have distributed the abstract on the internet:

We explore a rigidity-based explanation of the dramatic and off-trend growth in US executive compensation during the late 1990s and early 2000s. We show that executive option and stock grants are rigid in the number of shares granted. In addition, salary and bonus exhibit downward nominal rigidity. Rigidity implies that the value of executive pay will grow with firm equity returns, which averaged 30% annually during the Tech Boom. Rigidity also explains the increased dispersion in pay across firms, the difference in growth rates between the US and other countries, and the increased correlation between pay and firm-specific equity returns. Regulatory changes requiring the disclosure of the value of option grants help explain the moderation in executive pay in the late 2000s. Finally, we find suggestive evidence that number-rigidity in executive pay is generated by money illusion and reference-dependent motivation, the same behavioral biases that may underlie downward nominal wage rigidity among rank and file workers.

For the pointer I thank Robert J. Shiller.

Addendum: The authors recommend this link to a new version of the paper.

Steve Sailer April 14, 2014 at 4:38 am

Heads I win, tails I don’t lose. Repeat as often as necessary.

dearieme April 14, 2014 at 5:16 am

My own theory is that the senior executives are essentially in charge of their own pay and seize the opportunity to express their warm self-regard. All that’s left to explain is why it was less like this a couple of generations ago. Better upbringing?

Steve Sailer April 14, 2014 at 5:23 am

A sense of shame?

Rahul April 14, 2014 at 6:28 am

They’ve managed to convince people that top executives can improve a company’s future to an extent far greater than they actually can.

Also, in the past, were top executives more likely to be in-house groomed? Is the spike in executive compensation correlated with the rise in outside hires?

Steve Sailer April 14, 2014 at 5:30 am

My vague impression from living through the 1980s was that, more than anybody else, Michael Milken rewrote the rules of the corporate game. He seems like a fascinating figure who deserves scholarly attention: was he the truly historic figure that he seems in my recollection?

Steve Sailer April 14, 2014 at 5:46 am

To ramble on about Milken, I may be overestimating his importance because he’s a fellow Valley Dude. But, he seems like the man who, more than anybody else, spread the gospel that the logic of wealth maximization should be exploited unrestrained by custom, morals, or good taste. Sure, a lot of buccaneers in the past had followed that path individually, but Milken created a machine for replicating that kind of CEO.

The funny thing is that Milken portrayed himself at the time as the enemy of ensconced CEOs, but of course the subsequent Milken Generation of CEOs proved far more rapacious.

Five years into the Obama Administration’s hands-off treatment of financiers, it’s hard to imagine that the Elder Bush Administration put Milken in prison, but it did.

Steve Sailer April 14, 2014 at 6:01 am

Anybody have any other nominees for the individual most responsible for the change to a culture where a hired (i.e., non-founding) CEO like Richard Fuld of an old line firm like Lehman Brothers could make $457 million in the decade 2000-2009 (and just imagine how much Fuld could have made if Lehman had survived the entire decade on his watch!)?

Highest paid CEOs of decade:
http://online.wsj.com/news/articles/SB10001424052748703724104575379680484726298

Robert April 14, 2014 at 5:57 pm

Milken actually strikes me as more interesting AFTER he left federal prison in 1993: Milken used his business acumen to start various philanthropic entities, most of which were dedicated to eradicating serious diseases. Rudy Giuliani, the prosecutor who successfully prosecuted Milken, stated that he would have supported a presidential pardon for him had Bill Clinton considered it (you’ll recall that Clinton instead pardoned Marc Rich). Giuliani based his support for a pardon on Milken’s wide-ranging philanthropy.

ummm April 14, 2014 at 5:32 am

ummmm…no they aren’t. the board of directors controls compensation like bonuses and salaries

Steve Sailer April 14, 2014 at 5:48 am

And who nominates directors? When I was the right hand man to a CEO, directors would butter me up so I’d put in a good word with the big guy about how they should be renominated (because they could use the directors’ fees).

Rahul April 14, 2014 at 6:02 am

Well, true. It’s not really scratching their own back but more like a small circle with everyone scratching the back of the next guy.

dearieme April 14, 2014 at 6:59 am

Something smaller than a class but bigger than an individual: a cadre?

ummm April 14, 2014 at 8:18 am

It’s not as bad as it seems. The majority of CEO’s make around 2-10x the average worker, which is understandable considering they have more responsibility. The extreme pay is only for a very small number of companies

Rahul April 14, 2014 at 8:25 am

I doubt the multiplier is as low as you state. I thought it was more like 300x for the Fortune500 list.

Urso April 14, 2014 at 9:58 am

Right, but “for the Fortune 500 list” is quite the qualifier. What % of CEOs are CEOs of Fortune 500 companies?

Adrian Ratnapala April 14, 2014 at 10:33 am

And here lies the whole point. A very small number of CEOs are taking a large fraction of the money. There is no real contradiction between Rahul and ummm.

rpl April 14, 2014 at 10:44 am

Who cares? It’s the highly paid ones that people are up in arms about. Averaging the pay of Fortune 500 CEOs with web startup CEOs to arrive at a figure of 2-10x is a little bit like saying the “average” person is half male and half female.

rpl April 14, 2014 at 10:45 am

(The last comment was meant to be addressed to Urso, not Adrian)

Thomas April 14, 2014 at 8:36 pm

The “multiple of average worker” statistic is as useful as the average person on the internet talking about it.

A CEO who employs a bunch of low-skill workers should be the very embodiment of social justice if she simply outsourced, automated, or otherwise fired a bunch of low-skill workers.

Paul Andrews April 14, 2014 at 11:57 pm

Lack of shareholder involvement due to forced investment by lots of small investors via institutions such as pension funds.

prior_approval April 14, 2014 at 5:18 am

An alternative explanation is found here, at least concerning CEO pay, which tends to set the scale for all the other upper executive pay levels in a firm –

‘As a practical matter, the directors rarely serve as an effective check on pay because they often owe their position as a director to the CEOs. They tend to view their directorships as a sort of sinecure, giving them hundreds of thousands of dollars a year for attending a small number of board meetings. Many directors serve on multiple boards, sometimes racking up over $1 million a year in the process.

This was the motivation for CEPR’s Director Watch and its partner project with the Huffington Post, Pay Pals. Corporate directors are generally prominent public figures. (This is the reason they are selected.) These people fail the shareholders and really the whole country when they do not impose restraint on CEO pay.

How often at board meetings do they ask if they could get a comparably talented CEO from Europe or Japan, or even China, at a lower cost? Most likely this question is never raised, which means that corporate directors are not doing their job — they are ripping off the shareholders in taking excessive pay while allowing the CEOs to write their own blank checks.’ http://www.cepr.net/index.php/blogs/beat-the-press/corporate-directors-give-corporate-ceos-bloated-pay

Millian April 14, 2014 at 5:22 am

A CEO in China is, shall we say, unlikely to have achieved his position through raw business talent. The others aren’t dumb enough to take less pay than their new peers.

prior_approval April 14, 2014 at 5:29 am

You mean like this guy? – ‘Yang was born on 12 November 1964 to parents both educated as surgeons. He grew up poor as his parents were paid the same salaries as manual laborers. Yang spent his childhood in Hefei in Anhui province.[1] Yang’s parents were repeatedly persecuted during the Cultural Revolution. Yang’s father, Yang Furong, was a disciplined man with strict standards. Yang said of his father, “If he set a target, no matter what happened, he wanted to reach it.”

While his parents wanted him to pursue a career in medicine, and he had a budding interest in literature, Yang decided to study computer science on the advice of a family friend who was a university professor. Yang earned an undergraduate degree in computer science from Shanghai Jiaotong University in 1986 and graduated with a master’s degree from the University of Science and Technology of China in 1988.’

But then, why would any American company be interested in Lenovo’s CEO?

Millian April 14, 2014 at 7:36 am

Well done. I can find one good US CEO too.

prior_approval April 14, 2014 at 5:32 am

Or would a typical American CEO be frightened of something like becoming part of their company’s business culture? –

‘In 2012, Yang received a $3 million bonus as a reward for record profits, which he in-turn redistributed to about 10,000 of Lenovo’s employees. According to Lenovo spokesman, Jeffrey Shafer, Yang felt that it would be the right thing to, “redirect [the money] to the employees as a real tangible gesture for what they done.” [5] The bonuses were mostly distributed among staff working in positions such as production and reception who received an average of 2,000 yuan or about US$314. This was almost equivalent to a month’s pay for the typical Lenovo worker in China.[6] Yang contributed another $3.25 million bonus to 10,000 Lenovo employees in 2013. Employees in 20 countries benefited from Yang’s gift. 85% of recipients were in mainland China. As in 2013, these workers were generally hourly production staff.’ http://en.wikipedia.org/wiki/Yang_Yuanqing

dearieme April 14, 2014 at 9:29 am
jon April 14, 2014 at 8:23 am

Many board members are actually CEO’s or have previously been CEO’s (now retired). It’s an old boys network. You scratch my back I scratch yours. Why would a CEO that is on a board opt to give a fellow CEO lower pay? It could directly impact his own salary when companies mimic eachother strategies.

Rahul April 14, 2014 at 12:48 pm

MBA schools are a big part of this problem. And the big consulting firms. They grease & facilitate this back scratching.

rayward April 14, 2014 at 9:30 am

Of course, this leads to a discussion of inequality: inequality in income from wages (all that executive compensation) leads to sharply increasing inequality in income from capital which leads to sharply increasing inequality in wealth. Professor Shiller (Cowen’s pointer for this blog post) proposes a modest, very modest, measure to mitigate inequality (http://www.nytimes.com/2014/04/13/business/better-insurance-against-inequality.html?ref=business). Shiller is no wild-eyed Frenchman. Yet he doesn’t explain why it’s so important to mitigate inequality. Why is it? Is it because rich people are a bore? Is it because poor people might mount an insurrection? Piketty says its because excessive inequality is socially destructive. Maybe. The historical evidence suggests it’s because excessive inequality correlates very strongly with financial and economic instability. Piketty says governments and central banks will always adopt counter-measures in the event of a financial crisis, as they did in 2008-09, and avoid another great depression. Of course, the counter-measures have the effect of preserving inequality. That’s the paradox. And, I suggest, that’s the greatest risk: governments and central banks, responding to public pressure, will eventually not respond to a financial crisis with counter-measures. Hence, it’s far better to adopt measures now to mitigate inequality so we never reach the danger zone.

bob April 14, 2014 at 9:37 am

The theory does not seem to apply to university presidents.

Chris Purnell April 14, 2014 at 12:30 pm

‘Compensation?’ Surely they are wage- slaves like the rest of us & spinning it that they are being ‘compensated’ for the loss of their freedom is an absurdity. Alternatively, you could say ‘rentiers’ but that has an Ancien Regime feel to it doesn’t it? Powdered 18th century French aristocrats as economic models for US CEO’s?

JAW April 15, 2014 at 12:22 am

Disclosure has been a disaster for CEO in a way not exactly touched upon by this paper, but sort of closely resembles it. Essentially, CEOs, Boards, and corporations live in a Lake Wobegon world. Every corporation believes/wants to believe/needs to believe that its CEO is at least above average. So they look around at their comparables and establish compensation for officers. Corporate minutes from compensation committees basically always go like this:

“In the past year our company [experienced great revenue growth/had high earnings per share/weathered a difficult period in the company's history as it transitioned into a new product market/survived market upheaval and left itself positioned for growth in the next 5 years.] Reviewing compensation at comparable companies that [experienced revenue growth/had high earnings...], the average compensation was $2 million with 30,000 stock options. The committee, in light of the company’s ability to position itself, thinks pay for the CEO should be 2.5 million and 40,000 stock options.” Then the other companies iterate this every year, getting some compensation consultant to make things look good and up and up and up we go. Disclosure makes the status game easy and relevant.

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