Total Compensation: An interview about trends in CEO pay
Compensation packages for executives have skyrocketed even as wages for the rank and file have flattened, leading critics to ask: Do CEOs really deserve such exorbitant pay? Well, actually, they might! This is a surprising argument recently posed by Anup Srivastava, an assistant professor of accounting information and management at the Kellogg School. But while some CEOs are signing lucrative contracts, others are accepting very modest pay, at least in terms of base salaries. Clare Wang, also an assistant professor of accounting information and management, recently investigated the rationale behind the one-dollar CEO salary. Both agreed to sit down with Kellogg Insight to discuss some of the latest trends in executive compensation. Here is an excerpt from our conversation, edited for length and clarity. Listen to the accompanying podcast to hear more.
Kellogg Insight: Anup, I’d like to start with you. Can you give us a bit of a perspective on just how much executive pay has risen with respect to the average worker’s pay?
Srivastava: In an American context, the average ratio of a CEO’s total compensation to an average worker’s salary has increased from approximately 20 to 30 times to approximately 300 to 400 times over the last few decades. It seems exorbitant when we compare it to similar economies, for example, in European countries.
KI: The common perception, I think, is that executives are asking for and receiving excessively large paychecks just because they can. But you argue that the rise in CEO pay may not be as outlandish as it looks from the outside.
Srivastava: The composition of CEO compensation has changed from salary and bonus-based towards more stock options-based and restricted stock-based. Stock options are turbo-charged. By that I mean that if there is a 10% fluctuation in stock prices, it can lead to 40 or 50 or 80 percent changes in the value of stock options.
This is especially important because CEOs cannot hedge the risks of their exposure to their own firms’ stock prices. A CEO cannot go out and sell his stock options on the market. Therefore, it is in a CEO’s interest to forecast future firm risks and adjust his or her portfolio. So, to the extent that the CEO puts effort into forecasting future risks, this is also beneficial for the firm.
I find a surprising link between CEOs’ modifications of their personal portfolios, and ex-post risk, which indicates that CEOs can indeed forecast future risks that are not known to the market. I call this an extraordinary ability. And I find that the turbo-charged portion of CEOs’ compensation is highly linked to that ability, which indicates that either the compensation contracts incentivize CEOs to put effort into forecasting risks, or the compensation contracts lead companies to select people who are better at forecasting risks.
KI: Clare, you looked at another CEO compensation scheme that’s become increasingly popular over the decades: the one-dollar CEO salary. Why would a CEO accept a one-dollar salary?
Wang: The practice goes back to Lee Iacocca, the former CEO of Chrysler Corporation. He accepted the one-dollar salary as a part of the federal loan package for Chrysler in the late 1970s. It seemed to embody the spirit of sacrifice that allowed Chrysler to survive and return to profitability in the 80s. Subsequently, he recounted the story in his best-selling autobiography in 1984, and it helped to validate and kind of popularize this one-dollar salary phenomenon. And it has been becoming relatively common. The CEOs of anywhere from 15 to about 30 publicly traded firms in the S & P 500 in any given year are taking a dollar salary. Once it is known that a few higher-profile CEOs have a dollar salary, other CEOs and boards of directors consider it, especially if they are in a similar situation.
KI: So what kind of a situation?
Wang: There are two broad categories. The first is that the salary aligns the CEO’s interests with those of the corporation. The CEO stands to benefit handsomely if the value of the corporation’s stock rises. Steve Jobs took a dollar salary for many, many years; in lieu of the salary he took stock options and restricted stock, which then helped him to become a multi-billionaire.
The second broad category involves a really poor recent performance by a firm, or a general downturn in the economy. The CEOs and companies in this category are more likely to lay off workers, and are really under pressure to show some empathy, or to share some of the sacrifice, with employees. The CEOs of the Big Three US auto manufacturers accepted an annual salary of a dollar as part of the bailout in 2008.
The irony that came out of our research is that alignment CEOs are sometimes described as engaging in a gimmick, while the downturn CEOs who took a dollar salary, are sometimes lauded. But the CEO of a successful firm who takes a dollar salary, along with stock and options, maintains the success of the firm, benefiting both the CEO and shareholders in the long run. And when you take a dollar salary as a symbol of sacrifice, it’s a good public relations move, but it does not change the economic fundamentals of the struggling firm.
KI: Do either of you think we’re seeing more creativity in how compensation is packaged than we have historically?
Srivastava: I think we are seeing less creativity than we saw during the late 90s. There is greater usage of restricted stock, compared to stock options. (Now accounting rules require stock options to be properly expensed in income statements.) Previously, firms had greater freedom.
Artwork by Yevgenia Nayberg
The Economic Case for Soaring CEO Pay: A new study suggests a method in the madness
Skyrocketing compensation for CEOs of U.S. companies, which has risen disproportionately to compensation for other workers over the past several decades, has provoked no end of public outrage. It has been called unfair, unseemly, unwise, unjustified. But is that the whole story? Anup Srivastava, an assistant professor of accounting information and management at the Kellogg School of Management, wondered whether today’s CEOs might actually possess some subtle quality to justify the extra pay. “Is there some ability that has made them more important over the years?” Srivastava asked.
His own research had shown the negative effects of hefty CEO pay packages. First, Srivastava found that when CEOs have a large stake in their company—a median level of $100 million—they start “doing funny things,” like using creative accounting to try to portray the firm in the most positive light, which in turn can keep stock prices high. Later, he showed that highly paid CEOs will sometimes do the opposite, deliberately missing earnings targets to sink stock prices in advance of being granted new stock options. “My past research has shown that abnormally high compensation provides incentives to managers to play with accounting tricks,” Srivastava says. (For Clare Wang’s insights into compensation at the other end of the spectrum—$1 CEO salaries—read here.)
But despite this evidence of bad behavior, he wondered whether there could nonetheless be a sound explanation for rising CEO pay. In a recent paper, Srivastava found that the extra pay can be at least partly explained by the increasing importance of executives’ ability to predict future risks to the firm. By tying part of their compensation to this risk-forecasting ability, firms can attract CEOs who are better at it. As companies have become on average smaller and “more susceptible to failure due to sudden changes in the business environment,” writes Srivastava, this ability has become increasingly important to ensure a company’s survival and growth.
CEOs for Uncertain Times
Today, companies operate in a less certain economic environment. Over the past two to three decades, says Srivastava, “firm failure rates have increased; the period at which a firm is a market leader has declined; the composition of Fortune 500 companies changes more frequently; and profits have become more uncertain.” Could it be possible that boards are responding to all those factors by selecting the right leader—and by writing the compensation contract such that it is in their leader’s best interest to put effort into forecasting future scenarios? This could enable the firm to plan better for future contingencies and to take advantage of emerging opportunities.
To answer his questions, Srivastava looked at how CEOs manage their personal portfolios, measuring their forecasting ability by the extent to which their own trades “contain information about future firm risks unknown to the market,” as he writes in the paper.
“The theory suggests that CEOs are averse to the risks of their own firm,” he says. “They do not want it to fail because they do not have diversified eggs in their nest.” Because stock options have become a far bigger source of compensation for CEOs than salaries or cash bonuses—CEOs on average hold stock options worth ten times their base salaries—they have disproportionate economic exposure to their own firms.
“Let’s say I’m the CEO, I hold stock in the firm, and I also have stock options in the firm,” says Srivastava. “If I expect my firm to fail in the future, say one to two years from now, then I’ll sell my stock or exercise my options and I’ll take that money out and put it in diversified funds. I might lose the time-value of stock options, but I can at least protect their in-the-money values. So my personal actions to exercise the stock options early may be related to my ability to forecast the future risks of my own firm.”
In fact, Srivastava did find a strong linkage between future risks to the firm (but unknown to the market) and CEOs exercising their stock options early. “It appears CEOs can forecast risk that the market cannot. That’s their extraordinary ability.”
Stock Options as Incentives
He then evaluated whether boards “provide high-powered incentives” that help lure the best risk forecasters. Stock options, he found, are indeed just such incentives. “We are all self-interested individuals,” says Srivastava. “If I care about my wealth, I want to protect my wealth portfolio from future risk.” Because options’ value fluctuates much more than the stock market, just a 10 percent change in the market can cause a 50 percent change in options. Boards want CEOs to forecast future risk so that they can use that knowledge to benefit the company. So they incentivize CEOs to spend more time and energy on forecasting risk by linking it to their own compensation.
Srivastava found that these “high-powered” components of CEO pay packages are linked to the risk-forecasting ability—whereas salaries and bonuses are not. In fact, when he compared 40 years of stock-option compensation to 40 years of “idiosyncratic volatility,” a measure of firm risk, he found that the graphs matched up (see below). “Firm risk peaked when stock-option compensation peaked,” he says. “It’s more than a coincidence.”
Top Figure: Idiosyncratic Volatility (A Measure of Firm Risk); Bottom Figure: CEO-to-worker Compensation Rate
Ultimately, the findings offer an economic explanation for the huge rise in CEO compensation over the past several decades. As he writes, “CEOs possess an ability that has become increasingly crucial for organizational success.”
Still, Srivastava cautions that his thesis “in no way overturns the widespread labels of ‘outrageous’ and ‘unfair’ attached to CEO compensation in the popular press and academic literature.” Opportunism may well still play a role in the decades-long spike. Instead, Srivastava’s work suggests that more reflection is needed. “I’m saying, ‘Wait a minute. Before we totally dismiss the increase as opportunistic and outrageous, it’s possible that there is some kind of economic explanation.’”
Artwork by Yevgenia Nayberg.
Will Work for Stock Options: A $1 CEO salary can signal confidence—or danger
When Lee Iacocca, former CEO of Chrysler Corporation, accepted a $1 salary as part of a federal loan package for his company in the late 1970s, he seemed to embody the spirit of sacrifice that allowed Chrysler to survive and return to profitability in the 1980s. Iacocca’s subsequent recounting of his story in a best-selling 1984 autobiography helped validate and popularize the $1 salary.
The arrangement has become relatively common since then. The CEOs of anywhere from 15 to 30 publicly traded firms earn a $1 salary each year—including, recently, the CEOs of Citibank, Google, Oracle, and Whole Foods. “Once it is known that a few high-profile CEOs have a $1 salary, other CEOs and boards of directors consider it, especially if they are in a similar situation,” says Clare Wang, an assistant professor of accounting information and management at the Kellogg School.
Wang’s research shows that $1 CEO salaries vary widely in their origin, structure, and outcome. The token salary can signal that CEOs—and their firms—are confident and optimistic about the future. Yet it can also indicate that the CEO is vulnerable and that the firm is going through hard times. Everything depends on the context. And despite Iacocca’s influential turnaround of Chrysler after taking a $1 salary, his story, as it turns out, is an anomaly rather than the norm.
Feast or Famine?
In an investigation of 92 firms with $1 CEO salaries, Wang and her colleagues—Sophia J.W. Hamm of The Ohio State University, and Michael J. Jung of New York University—found that rationales for the token salary could be somewhat evenly split into two broad categories. The first is that it aligns the CEO’s interests with those of the corporation: the CEO stands to benefit handsomely if the value of the corporation’s stock rises. The classic example of a CEO in the alignment category is Steve Jobs, Apple’s head during its emergence as one of the most valuable corporations in the world. In lieu of a salary, Jobs was paid in Apple stock options that helped make him, by the time of his death in 2011, a multibillionaire.
The second broad explanation for the $1 salary is poor recent performance by a firm, or a general downturn in the economy. The CEOs of companies in this “downturn” category are more likely than those in the first category to lay off workers (60 percent vs. 10 percent), meaning that they are under pressure to show solidarity with employees and demonstrate personal sacrifice. The CEOs of the “Big Three” U.S. auto manufacturers who accepted a $1 annual salary as part of the federal government’s bailout of the industry in 2008 are classic examples of this category.
Worlds Apart
So what do alignment and downturn CEOs look like? The groups share a few things in common beyond their $1 salary. For example, a majority in both groups was also the firm’s chairman of the board, while a significant minority was a founder of the firm. But the differences were far more striking than the similarities. On average, downturn CEOs received a $1 salary for just 2.4 years—about half the average duration for alignment CEOs. That is because downturn CEOs were frequently replaced by new executives.
More importantly, alignment CEOs were far more likely than their downturn counterparts to receive stock options in lieu of a salary: 86 percent versus 54 percent. (For Anup Srivastava’s thoughts on stock-based compensation, read here.) And the ultimate worth of those options varied widely between the two categories. For alignment CEOs, the value of the stock increased during their tenure, exceeding the purchase price, 69 percent of the time. The same was true for just 44 percent of downturn CEOs.
In other words, executives in the alignment category operate from a position of power. They believe that the loss of their salary will be matched, or far exceeded, by the value of their stock options. “The CEOs in the alignment category like the prospect of a large reward after they lead the firm successfully,” Wang says. “They naturally think that they will succeed because they are confident in their abilities.” In most cases, that belief is borne out. CEOs in the downturn category, by contrast, tend to operate from a position of weakness. Their vulnerability is confirmed by the poor performance of their stock options (among the roughly half who are fortunate enough to receive them) and their brief tenures.
The Iacocca Irony
There is notable irony in the emergence of the $1 salary. The alignment CEOs who receive large amounts of stock options in lieu of a salary are sometimes derided as engaging in a gimmick or a ruse, while the downturn CEOs who take a $1 salary with no other form of compensation are sometimes lauded. And yet “a CEO of a successful firm who takes a $1 salary along with stock and options seems to maintain the success of the firm, benefiting both the CEO and shareholders,” Wang says.
So appearances can be deceiving. Sacrifice for the sake of the cause might seem noble, demonstrating the dedication that made Lee Iacocca’s story so compelling. But the token salary does not necessarily translate into long-term success for the firm, much less the CEO. “It may be a good public relations move for a CEO to make a personal financial sacrifice when a firm is struggling,” Wang says, “but it does not change the economic fundamentals of the struggling firm.”
Artwork by Yevgenia Nayberg.
See more Kellogg Insight articles by Accounting professors