Dr. Mitra Labor Problems December 12, 2013

CEO Compensation Dynamics:The U.S. Differential

Sean K. Kelley

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Abstract

The objective of this paper is to analyze the compensation of CEO’s, or Chief Executive

Officers, of firms located in the United States relative to the international spectrum (in order to

identify the possibility of wage convergence or divergence). The primary sources of this paper

include excerpts from academic journals, economic and industry researchers. The pay

differential between United States executives and lower tiered employees is an ongoing issue

leading to constant debates on payment inequality. A relevant stream of analysis can be derived

from the comparison of CEO compensation on an international level and may be able to shed

some light on whether or not there is evidence of international compensation convergence,

divergence, or structurally different payment schemes. CEO pay is relatively high around the

world which is not an unexpected outcome. An interesting point however is that most countries

(of those that disclose CEO compensation) are significantly below the United States on average;

especially in regard to fringe benefit and non-monetary compensation payment methods. The

emergence of research on corporate governance and other causal factors of pay differentials may

be a determinant for understanding compensation dynamics generated by the United States

relative to the world. The United States has nearly double the average compensation structure for

CEOs relative to the world and the causal factors of this include: Corporate Governance, the

Agent-principal problem, Managerial Hubris, and the Managerial Power hypothesis.

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I. Introduction

“Labour was the first price, the original purchase - money that was paid for all things. It was not by

gold or by silver, but by labour, that all wealth of the world was originally purchased.” – Adam Smith

Recent attention in the U.S. has been drawn to CEO compensation and the perceived high

incomes that they have relative to their respective labor loads. This paper will investigate the

differential levels of pay for CEOs in the United States relative to exterior factors and attempt to

illustrate evidence of inflated payment schemes captured by corporate leaders. Influences from

corporate governance, the agent-principal dilemma and the managerial power hypothesis are

some of the most significant factors for determining the causation for the high levels of

compensation of chief executives in the United States. Does the United States place a higher

value on CEO operations or are global compensation schemes reacting optimally according to

firm performances and market demand for executive level business skillsets?

It has been an accepted idea until recently that the United States has a significantly higher

CEO wage relative to other countries. Recent Research argues that structural differences between

U.S. CEOs and non-U.S. CEOs are some of the main causes for the differing payment levels

(Fernandes). The United States places a high amount of emphasis on non-monetary payment

methods and also deferred payment methods. The most significant method is the use of bonuses

awarded in the form of stock options or fringe benefits. These benefits seem to be the main

source for the compensation differential for CEOs on the international scale relative to their U.S.

counterparts.

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II. Analysis: Corporate Governance & Structural Effects on Wages

The 21st century has made corporate governance and executive payment levels a big topic of

discussion for multiple reasons: Salary differential between executives and employees has been

publicly portrayed through scandals and movements (the 1% & 99% dilemma) through intense

media exposure and catalyzed by the ramifications of the Great Recession. The importance of

corporate governance in capitalist societies is large, and recent media exposure has served to

increase awareness and economic research on the subject.

A. Corporate Governance: The system of rules, practices and processes by which a

company is directed and controlled. Corporate governance essentially involves

balancing the interests of multiple stakeholders in a company; including shareholders,

management, customers, suppliers, financiers, government and the community

(Investopedia).

The welfare theories which justify competition in general terms assume that internal

organizations of firms reflect profit maximizing actions and efficient business decisions. This

emphasizes the fact that corporate governance is a crucially necessary ingredient to a capitalist

economy. In accordance with governance factors, the income differential for CEOs around the

globe should also be viewed from the employee side of the spectrum. In a recent study by the

Economic Policy Institute in 2008 the ratio of CEO compensation to the compensation of

manufacturing production workers in the year 2005 were compared on an international level. The

wage gap is quite evident in the case of the United States who boast nearly double the ratio of the

Non-US average (See chart 1).

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Structural differences seem to be an important driver for upper echelon wage determination

and examining these differences for hierarchy and corporate relationships may yield interesting

results. An article published in the Journal of Banking and Finance written regarding the

determinants and effects of CEO-Employee pay ratios showed that CEO–employee pay ratios

depend on the balance of power between the CEO and ordinary employees and also that

employees do not perceive higher pay ratios as an inequitable outcome in most cases. In addition

to these findings, their research also showed that a negative relationship between pay and

employee productivity does not exist, but rather that firm value and operating performance both

increase with relative pay increases (Faleye, Reis, and Venkateswaran 1). So if employees do not

perceive payment increases as a disincentive for productivity then it could be justified that

people believe CEO pay is inflated in terms of job responsibility and is deserved. Investigating

further into ancillary payment schemes like fringe benefits and stock options may offer key

insights for understanding the wage gap and why it has become the rule rather than the

exception.

Fringe benefits Correlation

Fringe benefits are basically multiple various benefits provided by an employer which are

exempt from taxation as long as certain conditions are met. Any employee who receives taxable

fringe benefits will have to include the fair market value of the benefit in their taxable income for

the year, which will be subject to tax withholdings, and social security benefits payments. Fringe

benefits enjoyed by CEOs can be considerably lavish in comparison to average employees. The

Washington Post published an article in 2010 that examined executive benefits and their

perceived exuberance. The article states that these fringe benefits can include country club dues,

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chauffeured drivers, personal financial planning services, security expenses (such as body guards

or home protection) and parking. Some increases in monetary value were in perks that Obama

administration officials consider among the most egregious, such as corporate aircrafts for

personal travel (Tse). For example J.P. Morgan Chase awarded its chairman and chief executive,

Jamie Dimon, $91,000 in personal travel on the company jet in 2009, up from about $54,000 the

previous year. His total perks increased 19 percent, to $266,000. It seems obvious that benefits

like security can be explained under the justification that these business men and women are

critical to the operation of the company and thus worth protecting. Other expenses like travel

however cannot be so easily measured as it is not always clear as to what extent the measures are

being used (i.e. personal expenses vs. corporate).

So why do CEOs manage to not only retain these benefit packages but optimally

increase them as much as possible without intervention? Research on United States CEOs shows

that the growth rate of stock options relative to salary is significantly larger (See Chart 3).

Corporate governance paradigms tell us that balancing the interests of multiple stakeholders in

order to function efficiently is the main objective for firms, but are these rules being followed in

the United States? It seems that there could be exploitability in the design of modern day

corporate structures for CEOs. They have the ability to influence their own payment as they

typically have significant influence and power over board members. This measure of corruption

is similar to congress to me in the sense that even congress isn’t allowed to raise their own wages

but can only raise the wage of future politicians (thus eliminating some exploitability).

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Principal – Agent influences on CEO Compensation

In the classical principal-agent problem, a principal must delegate a task to an agent,

whose incentives are not perfectly aligned with those of the principal. Could CEO pay represent

an accurate real-world example of the issue since shareholder (the principals) delegate nearly all

decision rights to managers (the agents)? Economic researchers Bebchuk and Fried argue that in

the case of executive compensation a large amount of issues exist that potentially distort boards’

preferences from coinciding with those of shareholders, thus creating boardroom dissonance. In

particular, the board of directors can potentially become “captured” by the CEO. As a result,

contracts that are negotiated between the CEO and the board are not likely to be those that

maximize shareholder’s profits. Rather, the contracts are likely to reflect optimal rent-grabbing

by the CEO, thus reaffirming the idea that corporate governance in today’s capitalist society

lacks specific checks and balances necessary for quality control. There are a number of reasons

why the board is likely to consider the CEO’s interests rather than the shareholders’. First of all,

board directors have incentives to keep their jobs.

The studies conducted by BebChuk and Fried show evidence that board directors receive

substantial benefits especially when choices made favor the CEO. On the other hand, opposing a

CEO’s wishes decreases the probability that a director will be re-nominated to the board and will

lose these benefits. Seems fairly obvious, but how can these influence abilities be reasonably

controlled? Nell Minow, co-founder of the Corporate Library recently conducted research on the

lavish fringe benefits corporate executives are receiving. He made a powerful statement

regarding boardroom efficiency and the ability to say no to CEOs in a recent Washington Post

article: "If it (boards) can't say no to the CEO on a club membership, then how can we expect

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them to say no to an acquisition or some other decision that is not in the interest of

shareholders? We have found over and over again that it is a leading indicator of a board that is

not providing effective oversight."

As a correlation, Bebchuk and Fried also cite studies indicating that in 2002, directors of

the largest 200 companies received an average of $152,000 annually and directors of the largest

1000 companies received an average of $116,000. As examples of valuable perks, directors of

UAL Corp. can fly free of charge on United Airlines while directors of Starwood Hotels receive

complementary stays (Bebchuk and Fried, p. 25). Since CEOs have the power to direct their

firms’ charitable contributions toward favored board members or directors they are intrinsically

awarded substantial amounts of power and influence. CEOs can then use this influence on the

companies that directors or board members may control lending benefits or monetary awards in

exchange for boardroom compliance. The influence observed could also serve to help directors

on the board to acquire additional lucrative directorships, thus demonstrating the severe

boardroom bias and dissonance. The Principal-Agent problem is significant in this case, and it

leads to the next problem that exists in the structural hierarchy of United States companies; the

managerial power hypothesis.

Managerial Power Hypothesis & Effects

The idea of the Managerial Power Hypothesis is that CEOs have significant control over

executive boards which can lead to the effect we discussed in class known as “Boardroom

Dissonance”. It seems evident that the CEO control includes the ability to (at least indirectly) to

affect his or her own pay level. Of course, there must be some factors that limit executive

compensation; in addition to external market forces, Bebchuk and Fried in their analysis

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introduce an additional type of cost that they refer to as “Outrage Costs” which are media driven.

Outrage costs occur when there are costs to the executives and directors from a public reaction to

executive compensation that is perceived as excessively high. The difference between the

managerial-power and principal-agent explanations is clear here: The level of pay in the

principal-agent approach is set so that the CEO receives at least his reservation utility, so that he

is paid just enough to keep him from leaving and going to another firm (Weisbach, 7). In

contrast, the level of pay in the managerial power approach is set as high as possible, with the

upper bound on pay determined by public perceptions.

Comparative Analysis: United Kingdom CEO compensation

Since there are only so many countries in the world that mandate the disclosure of CEO

pay and benefits, there are only so means with which to comparatively analyze. One of the best

examples is the United Kingdom, given that there are so many similarities between both the U.S.

and the U.K. in terms of structure and institutional hierarchies. A lot of research has been

conducted on this subject in recent years and one study published in the Economic Journal

written by Martin Conyon and Kevin Murphy analyzes the differential compensation between

the two countries. These authors conclude that the international pay gap is catalyzed by gains

realized from share options in the United States as well as higher base salary levels.

“Chief executives in the 500 largest UK companies in aggregate made 330 million pounds

(approximately 660,000 pounds each) in 1997, including 74 million pounds from exercising

options. In contrast, the top 500 US CEOs made in aggregate 3.2 billion dollars

(approximately 6.3 million dollars each), including 2 billion from option exercises”

(Conyon, Murphy, 640)

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The analysis of additional benefits received by CEOs seems relevant for determining how

much they affect compensation levels. In a recent study from The State of Working America,

CEO pay recorded by 14 countries who disclosed the CEO compensation levels including fringe

benefits, salary, stock options and other ancillary payments illustrate that U.S. compensation for

individual CEOs exceeded two million dollars; more than double the Non-US average of 1

million dollars (See Chart 4). Another study on Executive Compensation by Caro Frydman &

Raven E. Saks between the years 1936-2005 illustrates the extremely large growth rate of Stock

options, Long-term and incentive payments relative to the growth rate of base salary and

bonuses. It is evident empirically that CEO pay is dominated by these intertwined payment

schemes and not by base salary (See Chart 2).

III. Conclusion

While inequality remains a pressing issue in the 21st century, it is evident that CEO pay levels

are significantly skewed especially in the case of the United States. This is due to the longevity

of payment schemes used, the managerial power hypothesis, and the added value attached to

fringe benefits CEO’s receive. Another causal factor may be attributed to the structural nature of

the Principal-Agent problem. CEOs and lower level employees may believe they deserve

extremely high salaries as a result of their supreme management abilities leading to managerial

hubris. When thinking about CEO pay, I had the thought that perhaps their wages are hedonic in

nature. Just as someone is willing to pay an additional amount of money for the perceived added

benefit of a product it may be true that the perceived benefit for CEOs drives wage inequality.

Boardroom influence seems to be a key determinant overall regarding the structure of payment

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for CEOs particularly in the United States and will have to be the measure of quality control for

maintaining corporate governance paradigms in the future.

Obviously it is debatable whether or not CEO’s (both foreign and domestic) outright deserve

higher payment levels, but at what point does boardroom corruption (or maximization of rents

captured by CEOs through boardroom exploitation) reach the breaking point? These factors are

all drivers for the CEO pay differential which ultimately increase wage inequality. Media

exposure and optimal contracting may yield more appropriate pay schemes for the United States

in the future, although it is unclear at this point.

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Work Cited:

"Adam Smith and CEO's Compensations." Investorsconundrum.com ». N.p., 07 Feb. 2009. Web. 07 Dec. 2013.

Bebchuk, Lucian A. and Jesse M. Fried (2003) “Executive Compensation as an Agency Problem,” Journal of Economic Perspectives, 17, 71-92.

Bebchuk, Lucian A. and Jesse M. Fried (2004) Pay without Performance: The Unfulfilled Promise of Executive Compensation, Harvard University Press, Cambridge, MA.

CEO Pay in Advanced Countries in 2005. Digital image. The State of Working America. N.p., n.d. Web. 8 Dec. 2013. <http://www.stateofworkingamerica.org/tabfig/03/SWA06_Table3.47.jpg>.

Conyon, Martin J., and Kevin J. Murphy. "The Prince and the Pauper? CEO Pay in the United States and United Kingdom." The Economic Journal 110.467 (2000): 640-71. Blackwell Publishers Ltd. Web. 8 Dec. 2013. <http://dx.doi.org/10.1111/1468-0297.00577>.

"Corporate Governance." Investopedia. N.p., n.d. Web. 05 Dec. 2013.

Faleye, Olubunmi, Ebru Reis, and Anand Venkateswaran. "The Determinants And Effects Of CEO-Employee Pay Ratios." Journal Of Banking And Finance 37.8 (2013): 3258-3272. EconLit. Web. 7 Dec. 2013.

Fernandes, Nuno, et al. "Are U.S. Ceos Paid More? New International Evidence." Review Of

Financial Studies 26.2 (2013): 323-367. Business Source Premier. Web. 7 Dec. 2013.

Tse, Tomoeh M. "Perks Unchecked for Some Wall Street CEOs." Washington Post. The

Washington Post, 23 May 2010. Web. 09 Dec. 2013.

<http://www.washingtonpost.com/wp-dyn/content/article/2010/05/22/AR2010052200331

.html>.

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Weisbach, Michael S. "Optimal Executive Compensation vs. Managerial Power: A Review of

Lucian Bebchuk and Jesse Fried’s Pay without Performance: The Unfulfilled Promise of

Executive Compensation." National Bureau of Economic Research, 26 Nov. 2006. Web.

7 Dec. 2013. <http://fisher.osu.edu/supplements/10/10821/bebchukfried.pdf>

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Appendix

Chart 1

Chart 2

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Chart 3

Chart 4