08.29.07
Executive Pay
CEO compensation makes for nice headlines, mixing in a bit of lifestyles of the rich and famous with the business news, but too often the discussion focuses on anecdotes of wild parties or salaries of a dollar a year, skipping over the basic facts and ignoring the issues about the incentives given to the men and women who run America’s largest corporations.
To interpret the facts it is useful to review some economic principles. Standard economic theory tells us that in a competitive market, an executive should be paid the value of his or her marginal product. In simple terms, the executive should be paid for what he or she produces. But an executive’s product is not a commodity like an apple, which is somewhat easy to measure. Rather, it should be manifest in how well a firm performs. Much of the controversy about executive pay thus concerns how one measures an executive’s output.
Three Possible Determinants of CEO Pay
Economists, perhaps not surprisingly, have over the years developed a variety of answers to the question of what determines executive pay. One holds that the value the value of an executive’s contribution is proportional to the size of the firm: the greater the size of the firm, the greater the scope an executive has to create value. Another argues that executives become more valuable with experience. This approach suggests that pay should be proportional to tenure. A third approach links the executive’s value to increases in the firm’s stock price.
To look at how well these suggestions explain differences in executive pay, we use data on CEO compensation obtained from Forbes, which publishes information on the 500 highest-paid chief executive officers (CEOs) in America and their corporations. Looking at the data for 2004, 2005, and 2006 highlights some trends and sheds a little light on these hypotheses.
The Forbes’ list of the top 500 highest-paid CEOs takes into account various components of CEO compensation. Along with the annual base salary of that fiscal year, Forbes includes annual incentives, long-term incentive payouts, discretionary bonuses, the value realized from the vesting of restricted stock and performance shares, stock gains, and the value realized by exercised stock options. Forbes counts “compensation when it turns into cash or marketable stock” and does not count options until they are exercised. Also included in the total compensation calculations are other personal benefits, such as premiums for supplemental life insurance, annual medical examinations, tax preparation and financial counseling fees, club memberships, security services, and the use of corporate aircraft.
CEOs Make a Lot of Money, but Income Gaps Are Widening Here, Too
After the obvious point that CEOs make a lot of money, what jumps out is the wide variation in executive pay, even at the top level. This should serve as a precautionary tale about generalizing from specific instances. Pay has been increasing over the past three years, but so has the variation across CEOs. Mean compensation is well above the median, showing that a small number of executives make a lot more than the typical boss.
| 2004 | 2005 | 2006 | |
|---|---|---|---|
| Mean | 10.24527 | 10.95133065 | 15.15517172 |
| Median | 4.689 | 5.555 | 6.71 |
| Standard deviation | 17.92834752 | 20.7638497 | 39.3963563 |
| Minimum | 0 | 0 | 0 |
| Maximum | 230.554 | 249.42 | 646.6 |
For 2006, the distribution exhibits quite a range with about half of the CEOs making less than $7 million. What is striking is that the differences in pay are most extreme at the high and low ends of the distribution.
No Single Cause of CEO Pay Difference Emerges
To what extent does firm size account for the differences in CEO pay? To answer that question, we rank each of the 500 CEOs on the the Forbes list and rank each firm in terms of its size. Then we plot pay rank against company size rank. The relationship is positive, so large firms do tend to pay more, but a lot of variation remains: CEO pay clearly depends on a lot more than company size.
Similarly, tenure matters—that is, CEOs who have been on the job longer tend to get paid more, though once again, the bigger message seems to be the high variability. Of course, it’s hard to sort out the causality here—maybe experience counts and the executive does better over time, or perhaps the most talented, with the highest pay, do the best job and survive longer.
Finally, the view that holds that the best measure of a CEO’s productivity is the firm’s stock price—how much he or she makes for the firm’s owners—also appears to explain only a small part of executive pay. The exact relationship between pay and a firm’s stock price is probably somewhat subtle, since a firm may want to look at multi-year returns, control for general market movements, or pay a turn-around specialist to arrest a slide. Certainly, however, it’s clear that CEO pay and stock performance differ substantially across firms.
In the end, none of these explanations by itself accounts for CEO pay. Each of these factors may interact in ways we don't yet understand, or there may be some as-yet-undiscovered factor which plays a role in determining what CEOs are paid.
Some Definitions:
Components of Compensation
Salary
Annual base salary earned during the fiscal year.
Bonus
Annual incentives earned during the fiscal year and discretionary bonuses.
Other
Includes long-term incentive payouts and the value realized from the vesting of restricted stock and performance shares. Also includes other executive personal benefits, such as premiums for supplemental life insurance, annual medical examinations, tax preparation and financial counseling fees, club memberships, security services, and the use of corporate aircraft.
Stock gains
Value realized during fiscal year 2006 by exercising vested options granted in previous years. The gain is the difference between the stock price on the date of exercise and the exercise price of the option.
08.20.07
It Ain’t Always Food or Energy
Wednesday morning Brent and I got to dig into the July Consumer Price Index (CPI) report—it’s really our favorite day of the month. We took a look at the distribution of component price changes, we examined all the seasonal factors, and we computed a whole lot of trimmed means (read about these here). And what we take away from the numbers is that this was a pretty good report, if by “pretty good” one means consistent with a more moderate inflation trend than what we’ve seen over the past year. Indeed, as we cut the numbers, it seems to us that inflation is tracking very close to 2 percent.
July Price Statistics
| Percent change, last | |||||||
|---|---|---|---|---|---|---|---|
| 1mo.a | 3mo.a | 6mo.a | 12mo. | 5yr.a | 2006 avg. | ||
| Consumer prices | |||||||
| All items | 1.4 |
5.2 |
4.9 |
2.4 |
3.0 |
2.6 |
|
| Less food and energy | 2.9 |
2.5 |
2.2 |
2.2 |
2.1 |
2.6 |
|
| Medianb | 2.0 |
1.8 |
2.4 |
2.9 |
2.6 |
3.6 |
|
| 16% trimmed meanb | 1.8 |
2.1 |
2.6 |
2.5 |
2.3 |
2.7 |
|
| Producer prices | |||||||
| Finished goods | 2.8 |
5.7 |
6.4 |
3.2 |
3.7 |
1.6 |
|
| Less food and energy | 3.8 |
2.0 |
2.3 |
1.8 |
1.5 |
2.1 |
|
a. Annualized.
Sources: U.S. Department of Labor, Bureau of Labor Statistics; and Federal Reserve Bank of Cleveland.
This is a rather bold statement when you consider that the traditional core CPI—the CPI that subtracts food and energy from the market basket—rose an annualized 2.9 percent last month after having averaged only 2.2 percent over the previous three-month period. Our preferred measures of the underlying inflation trends—the 16% trimmed-mean CPI and the median CPI—came in at 1.8 percent and 2.0 percent, respectively, in July. These are just a touch under their May and June readings and suggest that the more moderate pattern in retail price data we’ve seen lately is probably continuing. The ex-food and energy core measure, however, has been a little erratic of late, posting a 1.8 percent rise in May, followed by a 2.8 percent increase in June, and now a 2.9 percent rise in July.
What’s going on with the core CPI? Well, sometimes the transitory fluctuations in the price data come from components other than food and energy, and our read of the data is that this is exactly what has been affecting the core CPI recently. For example, the average cost of boy’s and men’s apparel and footwear jumped about 18 percent and 20 percent, respectively, last month (annualized), and medical care costs, which had been showing unusual restraint in recent months, jumped more than 7 percent in July (annualized). Last month the miscreants were tobacco and lodging away from home. Again, to be clear, we’re not suggesting that these costs aren’t important to people and certainly they can take a bite out of a household’s budget. But are they likely to persist and cause the inflation trend to turn upward? History suggests not. So when the 16% trimmed-mean CPI and the median CPI tell us the inflation trend is moderating some, we tend to listen.