Stern Professor Explains Soaring CEO Pay
In recent decades, CEO compensation in the United States has soared, outpacing the growth of shareholder earnings and employee pay and triggering a large amount of controversy.
Stern School of Business professor Augustin Landier, together with MIT professor Xavier Gabaix, recently examined the underlying causes of this trend, discovering that rising CEO pay has been a function of the substantial growth in the size and value of U.S. firms, a view contrary to past scholarly explanations.
Scholars have generally used three types of economic arguments to explain the phenomenon of rising CEO pay. The first explanation characterizes the increase as a function of the greater use of stock options since the late 1980s. The second, which gained momentum in the post-Enron era, argues that the rise is due to an increase in managerial entrenchment resulting from greedy bosses. The third argument favors the idea that the nature of the CEO job has changed, placing greater emphasis on general rather than firm-specific skills—a trend that increases CEOs’ outside career options.
Landier and Gabaix chose to examine executive compensation from a different perspective. They theorized that rising CEO pay in the last 25 years has largely been a function of the substantial growth in market value of U.S. firms: as firms become larger, they are willing to pay more to get top talent at their head, and the competition between them is the driving force behind the rise of executive compensation. Developing a competitive model of CEO pay that was simple enough to be calibrated, the professors used two different indices to chart the data measuring CEO compensation against the market capitalization of U.S. companies.
The first index was a sample from 1970 onward of all CEOs included in the S&P 500 and their pay as reported in Forbes and ExecuComp. The second set of data is based on cash compensation, bonuses and the BlackScholes value of options on the date they were granted for the three highest-paid officers in the largest 50 U.S. firms in 1940, 1960, and 1990. The comparison showed that CEO pay as produced by both datasets closely tracks the rise of market capitalization.
The study found that the six-fold increase in CEO pay between 1980 and 2003 can be fully attributed to the growth in market capitalization of U.S. companies. “In terms of trends, one message of our paper is that we have to get used to the idea that CEO compensation will continue to increase because the size of companies is increasing. It’s part of the success of the American economy. We are in a situation that if the CEO of Apple makes a little mistake in the design of the iPod, the money at stake is much bigger than it was years ago,” says Landier.
In addition, the professors’ research revealed that while the compensation packages of CEOs can seem very high, they do not imply outrageously high expectations on the level of CEO talent.
“When you think about the levels of compensation of CEOs, what they reflect is not the belief that CEOs are supermen,” says Landier. “They reflect really tiny differences in expected talent. When we calibrate the model, we show that if you replace the most talented CEO in the economy by the number 250 in the scale of talent, then you decrease the value of your company by approximately 0.02 percent. That’s a very small amount. But the money at stake is huge; these companies are valued at hundreds of billions of dollars. If you multiply that 0.02 percent by dozens of billions, you get a very big number.”
Ultimately, CEOs’ salaries are determined by two interconnected markets – the market for stocks and the market for talent and skills. The massive increase of money at stake for the shareholders is the reason CEO pay is soaring.