The CEO Pay Slice
There is now intense debate about how the
pay levels of top executives compare with the compensation given to
rank-and-file employees. But, while such comparisons are important, the
distribution of pay among top executives also deserves close
In our recent research, we studied the
distribution of pay among top executives in publicly traded companies in
the United States. Such firms must disclose publicly the compensation
packages of their five highest-paid executives. Our analysis focused on
the CEO “pay slice” – that is, the CEO’s share of the aggregate
compensation such firms award to their top five executives.
We found that the pay slice of CEOs has
been increasing over time. Not only has compensation of the top five
executives been increasing, but CEOs have been capturing an increasing
proportion of it. The average CEO’s pay slice is about 35%, so that the
CEO typically earns more than twice the average pay received by the other
top four executives. Moreover, we found that the CEO’s pay slice is
related to many aspects of firms’ performance and behavior.
To begin, firms with a higher CEO pay slice
generate lower value for their investors. Relative to their industry
peers, such firms have lower market capitalization for a given book value.
The ratio of market value to book value, termed “Tobin’s Q” by financial
economists, is a standard measure for evaluating how effectively firms use
the capital they have.
Moreover, firms with a high CEO pay slice
are associated with lower profitability. The operating income that such
firms generate, relative to the value of their assets, tends to be lower.
What makes firms with a higher CEO pay
slice generate lower value for investors? We found that the CEO pay slice
is associated with several dimensions of company behavior and performance
that are commonly viewed as reflecting governance problems.
First, firms with a high CEO pay slice tend
to make worse acquisition decisions. When such firms make acquisition
announcements, the stock-market returns accompanying the announcement,
which reflect the market’s judgment of the acquisition, tend to be lower
and are more likely to be negative.
Second, such firms are more likely to
reward their CEOs for “luck.” They are more likely to increase CEO
compensation when the industry’s prospects improve for reasons unrelated
to the CEO’s own performance (for example, when oil companies benefit from
a steep rise in world oil prices). Financial economists view such
luck-based compensation as a sign of governance problems.
Third, a higher CEO pay slice is associated
with weaker accountability for poor performance. In firms with a high CEO
pay slice, the probability of a CEO turnover after bad performance
(controlling for the CEO’s length of service) is lower. Lower sensitivity
of turnover to performance reflects less willingness on the part of
directors to discipline the CEO.
Finally, firms with a higher CEO pay slice
are more likely to provide their CEO with option grants that turn out to
be opportunistically timed. A high CEO pay slice is associated with an
increased likelihood of the CEO receiving a “lucky” option grant with an
exercise price equal to the lowest price in the month in which it was
granted. Such “lucky” timing is likely to reflect the use of insider
information or the backdating of option grants.
What explains this emerging pattern? Some
CEOs take an especially large slice of the top five executives’
compensation because of their special abilities and opportunities relative
to the other four. But the ability of some CEOs to capture an especially
high slice might reflect undue power and influence over the company’s
decision-making. As long as the latter factor plays a significant role,
the CEO pay slice partly reflects governance problems.
We should stress that a positive
correlation between a CEO’s pay slice and governance problems does not
imply that every firm with a high CEO pay slice has governance
problems, much less that such firms would necessarily be made better off
by lowering it. In some such firms, the large pay slice captured by the
CEO may be optimal, given the CEO’s talents and the firm’s environment,
and reducing the CEO pay slice might thus make the firm and its
shareholders worse off.
Still, our evidence indicates that, on
average, a high CEO pay slice may signal governance problems that might
not otherwise be readily visible. Investors and corporate boards would
thus do well to pay close attention not only to the compensation captured
by the firms’ top executives, but also to how this compensation is divided
© 2010 The
President and Fellows of Harvard College