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every objective measure, American CEOs appear wildly overpaid. In 2005 the average chief executive earned $10.9 million, or 262 times an average worker's annual earnings of $41,861, according to a report by the Economic Policy Institute published earlier this year. Another recent study co-authored by Augustin Landier, a professor at NYU's Stern School of Business, found that between 1980 and 2003, the typical CEO's compensation increased sixfold.
Yet CEOs might be worth every penny, despite the image put forth by critics of fat cats lining their pockets with millions in salary, bonuses and stock options at the expense of employees' benefits and shareholders' returns. Landier, along with Princeton Prof. Xavier Gabaix, argue in their joint paper, "Why Has CEO Pay Increased So Much?", that skyrocketing compensation has more to do with exploding market capitalizations and small talent pools than unfettered greed.
"What we show is that if you believe what matters is the money at stake, the pay is pretty reasonable," says Lanier.
Thanks to huge run-ups in the stock market and strong economic growth, U.S. corporations have exploded in size in the past few years. As such, every business decision made by a CEO has more of a financial impact riding on it. What's more, there aren't very many men and women qualified to sit in the corner office of a major corporation, making competition for the few who are fierce. As the laws of supply and demand kick in, compensation packages climb exponentially.
"To become the CEO of an S&P 500 company, you need experience managing divisions," says Lanier. "Ultimately these people are drawn from a small pool. Yes, we have more and more people with MBA degrees, but the people who can be a CEO of those big companies are from a small pool."
And as long as U.S. companies continue to grow, there's little likelihood this trend will reverse. Landier calls it part of the price of success of the American economy. No matter how obscene the multimillion-dollar bonuses, private jets and country club memberships appear, shareholders and employees will probably have to get used to it.
SmartMoney.com: The subject of executive compensation has caused a stir in the past few years. How did you look at CEO pay that's different from how shareholders and securities regulators have looked at the issue?
Augustin Landier: There's a lot of outrage around this topic, and the feeling that CEOs are paid too much. The question for us economists is what's too much? How should we benchmark this thing? If you think seriously about it, what's the right benchmark to measure compensation? But the facts are true: There has been a spectacular growth in CEO pay. The average compensation package has increased by 500% in real terms since the beginning of the '80s. That's a huge number.
The question is why. Many journalists and commentators believe it's a sign of deterioration in corporate governance. That somehow a lack of governance in American companies lets these guys exploit the naivete of boards to get paid a lot. What we show is that if you believe what matters is the money at stake, the pay is pretty reasonable. By money at stake, we mean the value of the company the equity of a company plus its debt that has increased by about 500% in this time. It's increasing market caps.
The impact of a CEO when he makes a mistake, has a new idea this has a direct impact on the value of the company. Companies are competing for the best talent. So CEO pay should increase one for one with the aggregate value of companies. This is something people got confused about; everyone knew compensation was increasing with the value of companies. But if your company is bigger than the next company by 100% at a given point in time, the CEO's pay shouldn't increase by 100%.... [The important thing is] what are your competitors paying their CEOs? If there are very few big companies, your compensation should be small because not many companies are as big, and are competing for that talent.... The idea that if you're the CEO of a company double in size than my company, your pay should double is not true. If all companies increase in size, then the compensation should increase. It's determined by competition between companies, competing for top talent.
What we argue is that the order of magnitude of the pay increases is not so big.... It's because of supply and demand effects here for managerial talent. Indeed, governance matters. I think it's a little contra-factual to say that governance is deteriorating in the U.S. [The huge rise in executive pay] is not for lack of governance. There is a lot of governance in this country.... But we believe it's an effect on a smaller order of magnitude than the 500% [growth in market cap]. Governance can't explain that large increase.
SM: So chief executives' salaries aren't really driven by talent or track record but by competition effects of the CEO market itself?
AL: When you think about these numbers, the levels of compensation of CEOs, what they reflect is not the belief that CEOs are supermen, that they're so unique.... It comes from the difference in function and talent. When we calibrate the model, we show that if you replace the most talented CEO in the economy by the number 250 in the scale of talent, then you decrease the value of your company by something like 0.02%. That's a very small amount. But the money at stake is so big; these companies are valued at hundreds of billions of dollars. If you multiply that 0.02% by dozens of billions, say, you get a very big number. That's how we should think about CEO compensation. It's going to be very hard to decrease CEO compensation. It doesn't make sense to try to get a cheap CEO because it's little money compared with how much the company is worth.
SM: How did you measure a CEO's talent?
AL: We infer it from the compensation of the CEO. We assume the most talented guys are at the biggest companies, and have the biggest compensation packages. We don't measure directly the talent of a CEO; that's the job of the board..... Compensation includes stock options the value of the options at the time they are granted, not at the time they are exercised. That's a source of some confusion.... Paying with stock options is like paying with a lottery ticket. Some guys will get very lucky, some won't. What matters in terms of fairness is the value of stock options at the time they are granted. We include bonus, cash compensation and stock options.
I think this idea applies to other markets as well, like movies and sports. There's a scarcity for that type of talent. When we say talent we mean a network and experience. That pool is restricted. To become the CEO of an S&P 500 company, you need experience managing divisions. Ultimately these people are drawn from a small pool. Yes, we have more and more people with MBA degrees, but the people who can be a CEO of those big companies are from a small pool.
SM: Does the same phenomenon hold true for other countries?
AL: There is a scarcity of data for other countries. The U.S. has transparent rules about CEO compensation. Most countries don't have that. We used data from Towers Perrin [a global human-resources consulting firm]. You can explain most of the differences in cross-country CEO compensation by variations of the average size of the company. If you're the CEO of France Telecom, the biggest telecom company in France, there are not a lot of competitors in France. The labor market for CEOs in a country like France is not so international; they still prefer to have a French CEO. The companies trying to poach top talent are mostly French companies, if we're looking at French CEOs. They don't have a lot of international competition.
We predict that French CEOs' compensation should be smaller than CEOs of a U.S. company of the same size because in the U.S. there's a much bigger market and more competition. If a company tends to be smaller in a foreign country, compensation should be smaller even if the size of the company is same as a comparable American company. So it's not the case that they should be paid like their U.S. counterparts because there are fewer big companies in France. It's not only your company size that matters, but also other companies in the market for the compensation package.
SM: What are the "contagion effects" you mention in your paper?
AL: One thing we show is that there are very big contagion effects in this market. For example, if we show that 10% of companies in the market tend to overvalue the talent of a CEO, then all companies in that market have to follow. If one company is willing to pay a CEO twice as much as they're worth, then all companies will have to raise compensation by 100% to be able to retain their CEOs. If a few companies tend to behave in a crazy way, then other companies usually follow because top CEOs will get offers from other companies. We have seen compensation increase a lot in the U.S. in certain sectors like fund management, hedge funds, private equity.
For instance, during the dot-com bubble, bricks and mortar companies had to increase pay to retain their CEOs [because newer tech companies could afford to pay their CEOs more].... Anytime there's a bubble in one sector of the economy, all sectors will tend to experience a rise in CEO compensation.
In term of trends, one message of our paper is that in a sense we have to get used to the idea that CEO compensation will continue to increase because the size of companies is increasing. It's part of the success of the American economy. We are in a situation if the CEO of Apple makes a little mistake in the design of the iPod, the money at stake is much bigger than it was years ago.
SM: Under rules adopted by the SEC in July, companies will have to provide more details on executive pay and benefits. Do you think the stepped-up oversight will have an effect on the pay amount CEOs take home?
AL: [New laws demand] a more thorough look at pension benefits. In the U.S. the only thing that was a little opaque were these pension benefits.... [Former CEO of General Electric] Jack Welch, at the time he divorced his wife, a lot of private information was disclosed, which was a surprise to shareholders. What we're seeing now is more transparency, which is better. These things definitely matter, but it's not explaining the 500% increase in executive pay, which is a source of outrage among people. They should realize that the U.S. is definitely not a corrupt country compared to other countries.