Sunday, April 22, 2012 6 comments ++[ CLICK TO COMMENT ]++

Sunday Spectacle CLXXI

The Ever-Rising Executive Compensation

I've been thinking about writing about the controversy over the rising executive compensation in North America. Here are some graphics that frame the current situation (chart data up to mid-decade).

I actually don't think rising executive compensation is as big of an issue as it seems. The rising discrepancy in wealth is caused by society starting to reward talent—not just in business but also in sports, media, and so forth. As you'll note in one of the charts below, a lot of the increase in compensation is from bonuses and equity-linked compensation. Base salaries of executives haven't gone up much; the issue, thus, is whether the "bonus" is deserved. So far, shareholders and owners seem to be satisfied with management performance and are willing to award large discretionary bonuses.

Structure of Executive Compensation
(source: "Executive Compensation: A New Solution to an Old Problem," FTI Journal, Issue 2 - April 2010.)

Executive Compensation
Average Worker Compensation
(source: "In the money," The Economist. January 18, 2007)

The Cynics Might Say...

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6 Response to Sunday Spectacle CLXXI

April 24, 2012 at 8:42 AM

Just because that's the way it has been in the past bunch of decades doesn't mean it's OK. Just because the system has worked decently so far, doesn't mean it's perfect and that we should stop looking for ways to improve it.

Having people make millions just because they happen to be good at putting a ball in a hole, through a hoop, or past a line while others who maintain the infrastructure that keeps the world going (utilities, roads, sewage) and educate children barely make ends meet, is not OK by any common sense measure. It's totally messed up if you ask me.

Executive compensation is even worse because, unlike in sports, for the majority of those guys you can't tell the ones that are lucky from the ones that actually are good at what they do. A large part of their compensation is effectively an option with no downside and unlimited upside often linked to factors completely outside the control of the executives. How does this reward performance and align interests with owners' interests?

And while executive compensation may be absolutely ineffective at doing what it's supposed to do, it has gone a great way in tearing the social fiber. A large income gap always means a lot of tension in the society which eventually makes it dysfunctional and testy.

If anything, there is too little noise about executive compensation.

Warren Buffett has said that good companies can be run by a hamburger and bad ones often supersede the excellence of the management anyway. So, why exactly do we need highly paid executives?

Howard Buffett also comments on the current state of affairs in his interview for XLSemanal

April 24, 2012 at 9:50 PM

Hi Dimitar,

Thanks for the responding.

"Having people make millions just because they happen to be good at putting a ball in a hole, through a hoop, or past a line while others who maintain the infrastructure that keeps the world going (utilities, roads, sewage) and educate children barely make ends meet, is not OK by any common sense measure. It's totally messed up if you ask me."

What's wrong with that? I mean that seriously. If you are a free-market-oriented person, and if companies and consumers are willing to reward individuals--say by buying sports tickets to games--what's wrong with that?

I think the suffering and the under-priviledged should be the taken care of and that's why I, as a bleeding heart liberal, is in favour of some charity and government redistribution of wealth to the needy.

But overall, though, if someone is talented, they will--and should!!--make more money than someone else. Now, I know you are saying it's the exorbitant amounts that matter but what's to say that someone doesn't deserve a $10 million pay cheque? If you create $100 million in wealth, doesn't it make sense that employers would pay you say $10 million?

I think executive compensation does have some problems and you are correct in pointing out that, just because things are the way they are, it doesn't mean that it shouldn't be fixed. However, I think the problem with exec compensation is on the downside--what happens when outcome is negative--and not necessarily on the upside. Most of the public discussion, by politicians, public, special interest groups, economists, and others, is on the upside; but the real problem is on the downside.

I personally don't care what someone makes but I definitely don't want them paid well if they destroy companies, jobs, etc. For instance, I think executives should not receive bonuses and other incentive payments if their companies are falling apart. Right now, executives are being paid bonuses as if they were base salaries. I think there is a big problem there--so I agree with you that element needs to be fixed.

April 24, 2012 at 9:57 PM

For anyone reading this, couple of articles on this topic that I was going to reference in any future article are the following:

Book excerpt: "How Superstars’ Pay Stifles Everyone Else" (New York Times)

Malcolm Gladwell also had a, as usual, fascinating, essay on how the compensation structure has changed--partly due to unionization and other effects. Well worth reading: "Talent Grab" (New Yorker)

April 25, 2012 at 6:01 AM

Thanks for the interesting articles, Sivaram.

I agree that making the upside and downside symmetric may solve most of, or even the whole, problem.

However, you are interested in stock picking, right? Hence, you can't really believe that the free market is always right. So, for a moment, allow for the possibility that it is occasionally failing at distributing rewards. How to go about fixing this is a thorny problem and should be handled with extreme care. But pretending it's not a problem won't make it go away.

It is well-established that the free market does not adequately reward public goods like education and defense because the benefits from these spread to everyone (a highly educated and well-protected society doesn't benefit just the individual who paid for the service, but the whole society) and no one in particular is willing to pay the full price, i.e., what these services are really worth. So, if we left it to the free market, we will end up with too little public goods and too much for private fun. And for a time it will be great.

Most of the time people don't see the big picture and the long term. That's why we have leaders - of countries, companies, and communities. It is not bad to reward them for their services. But how much money does a person, who loves his job, need to do it? None. Then how much does one need to have a comfortable life? Hundreds of millions? Billions? Seriously, this is crazy.

Of course, it is very probable that I sound crazy to some. But I do believe we have taken the materialistic side of life to an extreme and people are starting to realize it.

April 25, 2012 at 6:07 AM

From the NYT article:
Inequality spurs economic growth by providing incentives for people to accumulate human capital and become more productive. It pulls the best and brightest into the most lucrative lines of work, where the most profitable companies hire them.

Yet the increasingly outsize rewards accruing to the nation’s elite clutch of superstars threaten to gum up this incentive mechanism. If only a very lucky few can aspire to a big reward, most workers are likely to conclude that it is not worth the effort to try. The odds aren’t on their side.

Inequality has been found to turn people off.

They talk about finance attracting the best of the best and it reminds me of Charlie Munger's incessant complaining that there are not enough engineers in the USA while it is full of "helpers," as he refers to finance guys. Well, the incentive system must have to do something with it.

April 29, 2012 at 3:16 PM

Hi Dimitar,

I read your posts and thought I would save deeper response for the future.

Overall, I agree with you that large discrepancy in wealth can cause social problems. But it depends on the what the root cause is.

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