Pay Without Performance: The Unfulfilled Promise of Executive Compensation

Uncover the realities of executive compensation and its decoupling from performance

Paper reviewed:

Bebchuk, Lucian A. and Fried, Jesse M., Pay Without Performance: The Unfulfilled Promise of Executive Compensation. Harvard University Press, 2004, Available at SSRN: https://ssrn.com/abstract=537783

Summary

This research reveals the alarming rise in executive pay, far outpacing that of average workers, and exposes the flaws in the 'official view' of executive compensation, highlighting the significant role of managerial power in shaping pay arrangements

Key Findings

• The average real pay of CEOs of S&P 500 firms more than quadrupled between 1992 and 2000, rising from $3.5 million to $14.7 million, with option-based compensation accounting for the majority of the increase.
• The growth in executive compensation far outpaced that of other employees, with the average large-company CEO receiving approximately 140 times the pay of an average worker in 1991 and around 500 times in 2003.
• The "official view" of executive compensation, which assumes that boards operate at arm's length from executives and design cost-effective compensation arrangements, has significant shortcomings and fails to account for the realities of executive compensation.
• Managerial power has played a crucial role in shaping executive pay arrangements, with executives using their influence to obtain "rents" - benefits greater than those obtainable under true arm's-length bargaining.
• The decoupling of pay from performance has been a significant issue, with much of the additional value provided to executives not being tied to their own performance, resulting in shareholders not receiving the expected benefits.

Implications

Business and Policy Implications

• Companies and policymakers must recognize the flaws in current executive compensation arrangements and take steps to address them.
• Boards must be made more accountable to shareholders to reduce the influence of managerial power on pay arrangements.
• Reforms should focus on increasing transparency and linking pay to performance to ensure that executives are incentivized to create shareholder value.
• Regulators and investors should be aware of the potential for camouflage and manipulation of compensation arrangements and take steps to prevent them.
• The development of more effective corporate governance practices is crucial to addressing the problems in executive compensation.

Introduction

The issue of executive compensation has been a topic of heated debate for many years, with the surge in CEO pay during the 1990s and early 2000s drawing intense scrutiny from investors, financial economists, regulators, and the public. The corporate governance scandals that began in late 2001 further intensified criticism of executive compensation practices, with many questioning whether boards have employed arrangements that serve shareholders' interests. This book, "Pay Without Performance: The Unfulfilled Promise of Executive Compensation" by Lucian Bebchuk and Jesse Fried, aims to provide a comprehensive analysis of the executive compensation landscape and the flaws in current arrangements.

Background and Context

The rise in executive compensation during the 1990s was characterized by a significant increase in option-based compensation, with the value of stock options granted to CEOs jumping ninefold between 1992 and 2000. This growth in executive pay far outstripped that of other employees, with the ratio of CEO pay to average worker pay increasing from approximately 140:1 in 1991 to around 500:1 in 2003. The "official view" of executive compensation, which underlies existing corporate governance arrangements, assumes that boards operate at arm's length from executives and design cost-effective compensation arrangements that provide incentives to increase shareholder value. However, this view has been criticized for failing to account for the realities of executive compensation, with many arguing that managerial power and influence have played a significant role in shaping pay arrangements.

The authors argue that the "official view" is based on a flawed assumption that boards negotiate pay arrangements at arm's length from executives. In reality, directors have various economic incentives to support, or at least go along with, arrangements favorable to executives, and social and psychological factors such as collegiality and loyalty also influence their decisions. The authors contend that market forces are not sufficient to compel arm's-length outcomes and that the pay-setting process deviates substantially from the arm's-length model.

The book is divided into four parts, with Part I discussing the shortcomings of the "official view" and Part II examining the managerial power perspective on executive compensation. The authors present evidence that executives have used their influence to obtain "rents" and that pay arrangements have often been designed to camouflage the level and performance-insensitivity of executive compensation. Part III analyzes the decoupling of pay from performance, with a focus on the role of equity-based compensation and the failure of firms to filter out windfalls unrelated to managers' own performance.

The stakes are high, with flaws in compensation arrangements imposing substantial costs on shareholders. The authors estimate that the excess pay received by top executives due to their power amounts to significant sums, with the total compensation paid to the top five executives at each company in the ExecuComp database totaling around $100 billion between 1998 and 2002. The authors' analysis has significant implications for companies, policymakers, and regulators, highlighting the need for reforms that increase transparency, link pay to performance, and improve corporate governance practices.

The widespread flaws in executive compensation arrangements and their significant economic impact make it essential for business leaders and policymakers to understand the issues and take action to address them. As the authors note, the subject of executive compensation is not just a matter of symbolism but has real-world consequences for shareholders and the broader economy. By examining the processes by which pay is set and the structure of pay arrangements, the authors provide a comprehensive analysis of the problems in executive compensation and lay the groundwork for discussing potential reforms in the subsequent parts of the book.

Main Results

The study "Pay Without Performance: The Unfulfilled Promise of Executive Compensation" by Lucian Bebchuk and Jesse Fried presents a comprehensive analysis of executive compensation practices in publicly traded companies. The authors' main findings can be summarized as follows:

The Failure of Arm's-Length Bargaining

The authors argue that the arm's-length bargaining model, which assumes that boards of directors negotiate pay arrangements with executives at arm's length, has failed to accurately describe the pay-setting process. Instead, they find that managerial power has played a significant role in shaping executives' pay arrangements.

Managerial Power and Influence

The study reveals that executives have substantial influence over their own pay, which has led to compensation arrangements that deviate from arm's-length contracting. The authors identify various factors that contribute to this influence, including directors' economic incentives to support or go along with arrangements favorable to executives, as well as social and psychological factors such as collegiality and loyalty.

Decoupling Pay from Performance

The authors find that much of the additional value provided to executives has not been tied to their own performance. They document that cash compensation, including bonuses, has been at best weakly correlated with firms' industry-adjusted performance. Furthermore, they show that equity-based compensation, such as stock options, has often been designed in ways that favor executives, allowing them to reap substantial rewards even when their performance is mediocre or poor.

Camouflage and Outrage Costs

The study highlights the importance of "camouflage" and "outrage costs" in shaping executive compensation arrangements. The authors argue that executives and directors have incentives to obscure and legitimize the level and performance-insensitivity of executive compensation to minimize outrage costs. This has led to the adoption of inefficient compensation structures that harm managers' incentives and company performance.

Methodology Insights

The authors' research approach is based on a critical examination of the existing literature on executive compensation, as well as an analysis of empirical evidence on pay practices in publicly traded companies. They draw on a range of data sources, including the ExecuComp database, to document the trends and patterns in executive compensation.

The authors' methodology is innovative in several ways. Firstly, they challenge the dominant paradigm in financial economics, which assumes that pay arrangements are the product of arm's-length bargaining. Secondly, they provide a comprehensive analysis of the various factors that influence executive compensation, including managerial power, camouflage, and outrage costs.

Analysis and Interpretation

The study's findings have significant implications for our understanding of executive compensation practices and their impact on corporate governance. The authors' analysis suggests that the widespread flaws in executive compensation arrangements are not simply the result of temporary mistakes or lapses of judgment, but rather are systemic and deeply ingrained.

The decoupling of pay from performance has significant consequences for shareholders and the broader economy. The authors estimate that the excess pay received by top executives due to their power and influence amounts to tens of billions of dollars.

The study's findings also highlight the need for reforms that increase transparency, link pay to performance, and improve corporate governance practices. The authors argue that recent reforms, such as the new stock exchange listing requirements, are insufficient to address the identified problems and that more fundamental changes are needed.

Some key statistics that illustrate the main findings include:

• Between 1992 and 2000, the average real pay of CEOs of S&P 500 firms more than quadrupled, climbing from $3.5 million to $14.7 million.
• The growth of executive compensation far outstripped that of compensation for other employees, with the average large-company CEO receiving approximately 500 times the pay of an average worker in 2003.
• During the five-year period 1998-2002, the compensation paid to the top five executives at each company in the ExecuComp database totaled about $100 billion (in 2002 dollars).

Overall, the study provides a comprehensive analysis of the flaws in executive compensation arrangements and highlights the need for reforms to improve corporate governance practices and link pay to performance. The findings have significant implications for business leaders, policymakers, and regulators, and provide a foundation for discussing potential reforms in the subsequent parts of the book.

Practical Implications

The findings of "Pay Without Performance: The Unfulfilled Promise of Executive Compensation" by Lucian Bebchuk and Jesse Fried have significant practical implications for businesses, managers, and policymakers. The study's conclusions about the flaws in executive compensation arrangements and the need for reforms to improve corporate governance practices have far-reaching consequences.

Real-World Applications

The study's findings can be applied to various real-world scenarios, including:

• Executive compensation design: Companies can use the study's insights to design more effective and transparent executive compensation arrangements that link pay to performance.
• Corporate governance reforms: Policymakers and regulators can use the study's findings to inform reforms aimed at improving corporate governance practices and reducing the influence of managerial power on executive compensation.
• Investor activism: Shareholders and investor activists can use the study's conclusions to advocate for changes in executive compensation practices and corporate governance structures.

Strategic Implications for Businesses and Managers

The study's findings have significant strategic implications for businesses and managers, including:

• Re-evaluating executive compensation practices: Companies should reassess their executive compensation arrangements to ensure they are aligned with shareholder interests and not influenced by managerial power.
• Improving corporate governance: Businesses should prioritize improving their corporate governance structures to reduce the influence of managerial power and ensure that boards are more accountable to shareholders.
• Enhancing transparency and disclosure: Companies should prioritize transparency and disclosure in their executive compensation practices to reduce the potential for camouflage and outrage costs.

Who Should Care About These Findings and Why

The study's findings are relevant to various stakeholders, including:

• Shareholders: Shareholders have a vested interest in ensuring that executive compensation arrangements are aligned with their interests and that corporate governance practices are effective.
• Business leaders: Executives and board members should be aware of the study's findings and take steps to improve their company's executive compensation practices and corporate governance structures.
• Policymakers and regulators: Policymakers and regulators can use the study's findings to inform reforms aimed at improving corporate governance practices and reducing the influence of managerial power on executive compensation.

Actionable Recommendations

Based on the study's findings, the following actionable recommendations can be made:

1. Implement more transparent and performance-based executive compensation arrangements: Companies should prioritize transparency and performance-based compensation to reduce the potential for camouflage and outrage costs.
2. Improve corporate governance structures: Businesses should prioritize improving their corporate governance structures to reduce the influence of managerial power and ensure that boards are more accountable to shareholders.
3. Enhance shareholder engagement: Companies should prioritize shareholder engagement and activism to ensure that executive compensation arrangements are aligned with shareholder interests.
4. Reduce the influence of managerial power: Businesses should take steps to reduce the influence of managerial power on executive compensation arrangements, such as by increasing board independence and shareholder oversight.

Implementation Considerations

When implementing these recommendations, businesses and policymakers should consider the following:

• Gradual implementation: Reforms should be implemented gradually to avoid disrupting existing executive compensation arrangements and corporate governance structures.
• Monitoring and evaluation: Companies and policymakers should continuously monitor and evaluate the effectiveness of reforms to ensure they are achieving their intended goals.
• Stakeholder engagement: Businesses and policymakers should engage with stakeholders, including shareholders, executives, and regulators, to ensure that reforms are well-informed and effective.

Conclusion

The study "Pay Without Performance: The Unfulfilled Promise of Executive Compensation" provides a comprehensive analysis of the flaws in executive compensation arrangements and highlights the need for reforms to improve corporate governance practices. The findings have significant practical implications for businesses, managers, and policymakers, and provide a foundation for discussing potential reforms.

Summarize the Main Takeaways

The main takeaways from the study are:

• Executive compensation arrangements are often influenced by managerial power and deviate from arm's-length contracting.
• The lack of transparency and performance-based compensation has led to excessive pay and poor corporate governance practices.
• Reforms are needed to improve corporate governance practices, enhance transparency and disclosure, and reduce the influence of managerial power on executive compensation.

Final Thoughts on Significance and Impact

The study's findings have significant implications for businesses, managers, and policymakers. By implementing more transparent and performance-based executive compensation arrangements, improving corporate governance structures, and enhancing shareholder engagement, companies can reduce the potential for camouflage and outrage costs and improve their overall performance. The study's conclusions provide a foundation for discussing potential reforms and highlight the need for continued research and analysis in this area.