The media have recently been playing up populist comparisons denouncing the pay gap between the average worker and the most highly paid executives. We might be outraged by the salaries paid to CEOs of large companies, just as we might envy NBA basketball players their $6-million average salaries, or Hollywood actors who get $20 million a film.
But we should examine the situation more rationally and try to understand why shareholders – mostly through their elected agents, the members of the board of directors – agree to pay these amounts to their companies’ executives.
In most cases, the compensation of corporate executives depends on performance. A review of the 1,088 largest U.S. companies by the human-resources firm Watson Wyatt Worldwide revealed that, from 2005 to 2006, gains to executives from stock options rose 63 per cent in companies that performed strongly but fell 38 per cent in firms that performed poorly. In 2008, the median annual bonus paid to U.S. corporate executives fell by 19 per cent, with sharper drops in industries that suffered the worst profit slumps. As well, economists have calculated that the six-fold rise in CEO compensation between 1980 and 2003 can be explained entirely by the six-fold rise in the market capitalization of large U.S. companies.
The fact is that a company cannot attract good executives without paying the market price. Forty per cent of U.S. CEOs are hired from outside the company – a proportion that has tripled in recent decades – showing this market is highly competitive.
Of course, errors might be committed in evaluating an executive’s abilities or appropriate compensation. But this does not negate the fact that company shareholders and directors are in the best position to decide on appropriate compensation formulas and that it would be unwise for regulations to become more entangled in this issue, which is a matter of a company’s internal management.
A minority shareholder might not be able to decide directly on this issue but still has some influence: If he is not satisfied with the way a company is using his investment, he can sell his shares and invest his money elsewhere.
The economic crisis and the government rescue of bankrupt companies using public funds have served as a pretext for imposing caps on the compensation of some executives. When the government becomes a shareholder in a private company – far from an ideal situation given that electoral pressures and corporate management do not mix well – it can, of course, exercise its right to influence executive pay policies, just like any other company shareholder. However, apart from this unusual situation, the government has no reason to take a position on private-sector compensation policies.
Similarly, as regards the “say on pay” rule giving shareholders a direct say on a company’s compensation policies, it is entirely legitimate for the shareholders, who are the owners of the company, to adopt this type of rule. However, imposing it systematically by law would prevent us from knowing which compensation model provides the most effective incentives to corporate executives.
Unfortunately, government measures are not only useless but often have unintended consequences. For example, in 1993 the U.S. Congress eliminated tax deductions provided to companies for non-performance-based executive pay over $1 million, resulting in a shift toward variable compensation and, ultimately, higher overall executive pay. Strict disclosure requirements can also contribute to raising executive pay by allowing them to compare their conditions more easily with those of their counterparts.
When electoral pressures push governments toward attempting to replace supply and demand by setting compensation based on arbitrary rules, this upsets the most important mechanism that enables companies to influence the selection of their executives and their overall governance structure.
Corporate executive pay is a private matter that must be settled within each company. People who are concerned with wealth redistribution should devote their energies to debating tax policies.
Michel Kelly-Gagnon is president and CEO of the Montreal Economic Institute. Jasmin Guénette is the institute’s vice-president.