Tuesday, July 27, 2010

Executive Compensation: A Study

The New York Times’ DealBook edited by Andrew Ross Sorkin recently carried an amazing headline, “Study: Boards Use Peers to Inflate Executive Pay.” (See, http://dealbook.blogs.nytimes.com/2010/07/26/study-boards-use-peers-to-inflate-executive-pay/?ref=business.)

And in this remarkable study we find the following:

“Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance.”

Well, duh!

This was done in the 1970s and I experienced it first hand in the 1980s and 1990s. Yet the quote above states, with astonishment, that “over the last several years” this behavior took place.

The authors of the academic study being reported on, Michael Faulkender of the University of Maryland, and Jun Yang of Indiana University, ”found that companies usually benchmark their executive pay with peers in their industry group, but that they also choose peers that pay more than others.”

That is, not only did corporation use peer data to determine executive salaries, the peers chosen were generally those that had the highest pay among the similar companies.

“The motivation of corporate boards to consciously chose peers that are more generous than ones that are very similar but are just less generous helps to explain, at least in part, the huge increases in chief executive compensation over the years.”

Huge increases?

Oh, yes, “Executive pay has increased substantially over the last few years. For example, in 1965 chief executives at major American companies earned 24 times more than a typical worker, while in 2007 they made 275 times more,” according to the Economic Policy Institute, a nonprofit Washington D.C. think tank.

Note, we are talking about “major” American companies…the “big guys”. These are large bureaucratic organizations that have huge human resources divisions that are given responsibility for the remuneration and benefits of the employees of these companies.

Now, I am not disagreeing with results of the study and I am not disagreeing that these practices helped to contribute to the substantial relative growth in executive pay when compared to the “typical worker”, whoever that might be.

I am just astounded that the results of this study from the late 2000s seem to be such a surprise.

In the late 1960s and early 1970s, when the United States economy was growing at a relatively good pace and inflation began to become a part of the daily life of Americans, large companies had to seek a way to justify the compensation of their employees…all their employees.

Data from peer groups, companies of similar size and similar industry background, became useful in setting pay scales and in arguing with labor unions about worker compensation. Companies began collecting information from other similar companies that would share data and, as the use of peer data became more generally used, it started to be collected by consultants and agencies that could sell the information to interested organizations.

What could be a more reliable guide to executive, and worker, pay than information on what peer groups paid their executives…and workers.

To me, the use of peer data was ubiquitous in large companies by the end of the 1970s.

But, one must be careful with how incentives are administered. Executives found that pay scales based upon peer data could be very used to their advantage. As a consequence, executives became diligent students concerning the use of peer characteristics and of what items could contribute to higher and higher compensation packages.

Let’s see…of course…size, to pick one characteristic, makes a great difference in the compensation received by executives. Bigger companies paid their executives higher salaries.

So, let’s grow the company! Let’s engage in mergers and acquisitions! Let’s move horizontally as well as vertically! Anything to increase the size of the firm! Executives can almost always find reasons to grow their organizations.

Remember the companies we are referring to are the “big guys”!

What about the performance of these companies? That doesn’t seem to matter.

What about the fact that about 3 out of every 4 mergers consummated are unwound in seven years or less? We will just replace those assets with other mergers or acquisitions!

And, the argument can be extended to the “other” special characteristics that apply to the choice of “peers”.

That is, executives could design the strategic plans they used to guide their firms based upon the peer group they had chosen so as to achieve the largest compensation possible.

Could something like this happen? You may express some doubt if you have not read books like “Freakonomics” and “Super-Freakonomics.”

That is, you must be careful of the incentive scheme you choose to stimulate people because that incentive plan will help to determine the behavior of the people you are hoping to influence…and the results you get may not always be the ones you expect.

In this, top executives are no better or no worse than most of the rest of us. They too respond to the reward systems that are presented to them.

And, what about the workers?

Well, they could not choose either their peer group or the design of their company relative to the peer group they wanted to be compared with. Anyhow, ordinary workers competed in a whole different labor market, one that tended to have a lot of substitutes: all peer groups at this level were very similar. Thus, they could not expect much boost in pay from the use of this information.

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