Thesis on "Executives Salaries Are They to High"

Thesis 10 pages (3105 words) Sources: 11 Style: MLA

[EXCERPT] . . . .

Executive Salaries

With the current financial crisis and intense controversy over government bailouts of floundering companies, the question of executive compensation has again come to the fore of business discourse. The issue is complex. In part, the controversy comes from the poor optics that arise when executives make hundreds or thousands of times what their employees make. The question of how valuable an individual person can be is a fair one is this context.

Yet, the defense is also reasonable. The market for executive talent is driven by supply and demand. There is limited supply and substantial demand. Generous compensation packages must be granted in order to attract top talent. Without top talent, the argument goes, the company will not meet its objectives.

The issue is also tied into the study of corporate governance. No matter how much compensation an executive receives, the structure of the compensation should align the objectives of the executive team with the objectives of the shareholders. Setting aside the question of why an executive should have such little moral fiber as to require being strongarmed into acting ethically, there is considerable discussion as to the degree that executive compensation can impact governance.

Yes, Executive Salaries Are Too High

A survey in 2006 of members of boards of directors revealed that 81% of them felt that CEO pay was too high. The underlying premise, they argued, was that executive pay should be linked to performance. In many cases the constructs were designed to do just this. The rise in equity-based compensation schemes was primarily because it was believed that if management had an ownership stake in the firm, its actions would be aligned with the objectives of other owners (shareholders). The tax structure at the time, FASB Statement No.123, encouraged the use of equity-based compensation by providing it with favorable tax status (FASB, 1995). This led to a proliferation of options-based compensation.

The problem with options-based compensation is that it does not satisfy its objectives. The intent is to resolve the agency problem but ultimately it only adds complexity to the agency problem. In many firms, executives have enough control over their compensation to build in some distance between their performance and their pay (Bebchuk & Fried, 2003). The objective is to align the interests of management with the interests of shareholders, but options and executive contracts are both finite. It is in the best interests, therefore, of the executive team to maximize value in the short-run, to the point of option expiry. As long as the options are in the money at expiry date, the executive will receive the compensation. This creates a short-term orientation for the executives. While any given shareholder may hold the security for the short-run, the shareholders as a group exist in perpetuity. Their interests are for long-term growth and profitability. This is not congruent with the short-term orientation created by the use of options. Indeed, some of the major accounting scandals of the early part of this decade were driven by this time orientation conflict. The FASB recognized the problem and amended the treatment of equity-based compensation with Statement 123R (2004). Other firms did not need the FASB to make the call for them. Companies such as Berkshire Hathaway have long eschewed giant executive payouts and kept equity-based compensation focused on the long-term.

The reason why executive salaries went so high -- and a main argument of those who feel they are not too high -- can be found in a statement from WorldCom. "Our executive compensation policy…is designed to provide a compensation program that will enable us to attract, motivate, reward and retain executives who have the skills, experiences and talents…" (NYU Stern, 2002).

This is essentially the supply and demand argument. Underlying the free market argument is the assumption of rational markets. The market for CEOs and other high level executives, however, has been found to be irrational. This has been attributed to a number of factors. One is the rise of institutional investors, who demanded that underperforming management be removed. This made the executive talent pool shallower, but also fed the belief among boards that it is better to hire an executive with an extensive track record of success, as it reduces risk. A myth has developed with respect to the constricted nature of the CEO labor market. As a consequence boards behave irrationally, and thinking that there are few talented people available, they drive up the price (Khurana, 2002).

There is also the question of motivation. The notion that CEOs should be motivated by money only runs counter to our understanding of human motivation. One motivation theory used in compensation planning in Abraham Maslow's Hierarchy of Needs. Financial compensation meets low level needs of security and comfort (The Economist, 2008). Executives should ideally be motivated by higher-order needs, having long since met their basic needs. It is not unreasonable to expect that individuals as successful as executives should be motivated by actualization needs rather than financial ones. Some companies already adopt this approach. Executives at Berkshire Hathaway's constituent companies, for example, do not receive high levels of compensation, but rather compensation tied directly to performance (Associated Press, 2008).

The last argument is based less on economics and more on moral relativism. It is not the huge salaries that are the problem, per se, but the disconnect they represent from the populace at large and the workers of the company. Not only is this apparent lack of social justice a problem for the usual union and workers' groups, but there is credible evidence to support the view that it is bad for employee morale. Food giant Sysco, for example, took the step last year of cutting executive salary and simultaneously giving its workers a raise in order to keep the compensation differential within reason, especially given the firm's expected sluggish performance in the economic downturn (Novy, 2009). When employee morale is at stake, curtailing executive pay seems perfectly reasonable.

Using the philosophies of John Rawls, it might be suggested that there are models out there that would bring more social justice into the issue of executive compensation. If executives were to be in the dark about the timing and strike price of their options, would be more inclined towards the best interests of the company. There would not be a sense of urgency with respect to pumping up earnings before an expiry date. With an unknown strike price and expiry date, the executives would be compelled towards everyday excellence. They may ultimately received millions, but it would be based strictly on performance and the temptation to "fix" earnings would be removed (Desai & Margolis, 2006).

No, Executive Salaries are not Too High

The first argument that executive salaries are not too high is the free market argument. The market for executive talent is a free market, subject to the laws of supply and demand. It is the market participants that determine executive salary. The factors that go into this calculation of worth will vary depending on the firm. For some firms, the board may feel that it is essential to have an experience CEO. The money that is paid to the CEO -- even if in the tens of millions -- is a small fraction of what the CEO is worth to the company's bottom line.

This argument can be used to refute the claims made by opponents. The gulf between workers' salaries and executive salaries is related to the relative worth of each participant to the organization. A mid-level worker is paid little because they contribute little and are easily replaced. A good CEO can be worth millions to the company and cannot necessarily be easily replaced. The free market argument holds true with respect to the Berkshire Hathaway argument. It is market participants who determine what CEOs are paid. If one company does not feel compelled to pay millions of dollar to its executives, it has that prerogative. It is a fair competition. Even if we accept that the market is irrational, it is still a fair market and responsibility for executive salaries still falls to the market participants.

Another argument is that executive talent must be well-compensated in order to be attracted and retained. Such talent does take non-financial factors into consideration when choosing their employment situation, but that is their prerogative. They should, as rational actors, extract the highest package of compensation -- financial and non-that they can. In a competitive environment, this allows them to receive their salaries. Again, the company chooses to pay these salaries because the opportunity cost of not paying them is deemed to be too high. Boards must answer to shareholders. In many cases, if the shareholders -- these days they are often institutional -- do not receive a good return then they start replacing board members. The board therefore has a vested interest in attracting the type of talent that will keep the company competitive. Should their compensation package not be competitive, they risk their jobs in… READ MORE

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