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The economic slowdown and the active politi-cal season are generating calls for imposing new regulationsonexecutivepay.Thepresidentialcan-didatesofthetwomajorpartieshavelashedoutatwhat they perceive to be excessive pay for certainexecutivesorforcorporateexecutivesingeneral.Such populist sentiments are often based onmisunderstandings about the role of corporateexecutivesintheeconomyandthevigorouscom-petition that exists for these highly skilled lead-ers. In the past, federal regulatory efforts basedon such misunderstandings have generatedunintended consequences, which have damagedthe economy and hurt the ability of the marketfor executives to self-regulate over time.The labor market for executives and the asso-ciatedpaylevelsarealreadysubjecttohighlevelsof regulation. Indeed, U.S. corporations are sub- ject to more stringent executive pay disclosurerequirementsthancorporationsanywhereelseinthe world. Before additional regulatory and leg-islative efforts are unleashed, policymakersshould examine the rationale for current pay structuresandthestronglinksbetweenexecutivepay and corporate performance.Themisperceptionsthatdriveregulatoryeffortsaregroundedintheideathatthemarketforexecu-tives is not competitive and that pay levels do notreflectsupplyanddemandfortalent.Criticsclaimthatexecutivesessentiallysettheirownpaythroughtheir influence over the boards of directors of cor-porations. This “myth of managerial power” leadssome policymakers to conclude that greater gov-ernmentregulationisnecessarybecausethemarketis “rigged.” However, a large body of empiricalresearch documents that labor markets for execu-tives are indeed competitive, and that pay levelstrackcorporateperformance.Thisstudyexaminesthemarketforcesthatsetthe parameters of executive compensation, theprocess that boards use to determine pay pack-ages,andthedatathatindicatetheefficientwork-ings of the current “pay-for-performance” model.It also discusses the adverse consequences of imposing rules and regulations on an executivecompensationsystemthathashelpedtogenerategreatwealthforshareholdersandmillionsofjobsforAmericanworkers.

Executive Pay

Regulation vs. Market Competition

byIraT.KayandStevenVanPutten

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IraT.KayisglobalpracticedirectorofexecutivecompensationconsultingatWatsonWyattWorldwide.StevenVan Putten is a practice leader of Watson Wyatt’s executive compensation consulting practice.

Executive Summary

No. 619 September 10, 2008

OverviewoftheIssues

TheexecutivepaymodelwidelyusedintheUnitedStatesisessentialtothesuccessofU.S.corporations and continued growth in theeconomy. But this “pay-for-performance”model is now threatened by overregulation,which is driven by misperceptions about thelabormarketforexecutivetalent.Thatisunfor-tunate,becausethecompetitivesystemofexec-utive pay has helped fuel business growth,which has generated wealth for shareholdersand opportunities for corporate employees. Attemptstocontrolthelabormarketforexec-utives and reshape the pay levels it producesmayunderminethissuccessfulsystem.The success of the U.S. economy is closely connected to its unique approach to humancapital. This approach is based on relatively unregulated labor markets, high labor mobili-ty, and a century-long reliance on variousforms of incentive pay. In general, labor mar-kets in the United States are among the leastregulated in the world.

Job candidates enterthemarketandcompetewithothercandidatesforthehighestwages,whileemployerspaythewagesrequiredtorecruitandretaintalentandmotivate performance. Supply and demandgenerally set the parameters for pay, withoutthegovernmentrestrictinghowmuchemploy-eescanearnforthevaluetheycreate.TheU.S. labormarket for corporateexecu-tives is an important exception to the generalU.S. policy of minimizing labor market regu-lation.Criticshavearguedthatthelabormar-ket for executives does not reflect supply anddemand for executive talent, and that execu-tives essentially set their own pay throughpower over their boards of directors. Compli-ant human resources executives, compensa-tionconsultants,andboardmembersbendtothe will of the chief executive officer (CEO) inshaping executive pay packages. We refer tothisviewasthe“mythofmanagerialpower.”

Productive discussions about the bestmethods of setting executive pay have beenpartly preempted by faulty assumptionsaboutexecutivepaypromotedinthepopularpress and the business media. Media storiesoften portray a corporate America ruled by executive greed and excess.Nevertheless, meaningful debates aboutexecutive compensation are taking place. In a recent Watson Wyatt survey of board mem-bers of major corporations and institutionalinvestors, we found that board membersbelieve that the pay-for-performance modeldirectly contributes to improved corporateperformance.

Bycontrast,manyinstitutionalinvestors tend to view executive pay as exces-sive.Giventhesedifferencesinhowboardsandinvestors assess executive pay, the two groupsneedtoworktogethertocontinuerefiningpay structures.Theimportantpointisthatexecu-tive pay structures evolve over time and aresubject to ongoing reforms within a competi-tivemarketenvironment.

ADynamicandCompetitiveMarket

Theparametersforexecutivepayaredeter-mined by supply and demand, and incentivepayouts for executives are generally deter-mined by performance. In the market for topcorporate executives, companies search forand hire CEOs from an extremely small poolof people. Those people must be capable of managing large and complex organizationsand be willing to risk a large portion of theirpayontheirabilitytoincreasecompanyvalue.Many executives are paid handsomely, buttheirpayreflectsonlyasmallshareofthetril-lions of dollars of wealth they help to createforshareholders.The labor market for CEOs is very com-petitive. They are hired and fired, and theirpay goes up and down, commensurate withthe performance of their companies. Thatconclusion is based on our own research andthe results of many academic studies.

Butthis reality of the competitive pay environ-ment of America’s executives is at odds withthe myth of managerial power.Many examples show how executive pay-for-performance works, but let’s look first atstock options. Although stock options havebecome less popular recently, they remain thearchetypal executive pay program and are still

The parametersfor executive pay are determinedby supply anddemand, andincentive payoutsfor executivesare generally determined by performance.

grantedtothousandsofCEOs.Table1reportsour analysis of the relationship between thetotalreturntoshareholdersgeneratedbycom-paniesandtherelatedstockoptioncompensa-tion for executives.

A review of the largest1,088 companies in the United States in 2006shows that the higher-performing companiesprovided larger stock option profits to execu-tives and the largest increase in stock optionprofits over the prior year. Thus, executives incompaniesthatperformedwellwererewardedforthatbetterperformance. Aswithmostmarkets,outliersexistintheexecutive pay market. At some companies,the executive does not demonstrate excep-tionalperformanceandstillreceivessubstan-tialpay.Suchoutliersareoftenchallengedby shareholders and called out in the press. Butthe market usually corrects itself, and suchexecutives are commonly ousted for poorperformance. The outliers push the bound-aries of the system, but they spur self-regula-tion and reform.Most economists and executive pay expertsbelievethatthelabormarketforexec-utive talent functions well. Supply anddemand primarily determine the amount of compensation that executives receive, whileotherinstitutionalfactors,suchasmanageri-al power and the structure of corporateboards, play a minor and secondary role.Here is some of the evidence that the U.S.market for corporate executives is competi-tive and efficient:

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Executivesalwayshavetheoptiontoquit,andmanydo.Oneoftheprimaryrespon-sibilities of corporate boards is to ensurecontinuityofmanagement.Boardsknow thatifexecutivesareunderpaid,theycanleave and gain higher pay elsewhere. Thecostofahighlyskilledexecutivequittingcan be billions of dollars in market capi-talization.

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NewlyhiredCEOsfromoutsideareoftenpaid much more than internal promo-tions. The managerial power argumentcannotexplainthatdifferential.

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High-performing companies rewardexecutives with higher “realizable” pay than low-performing companies, as weexamine below.

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Market pressures work. In recent years,boards and executives have responded tomarketpressuresbyputtinginmoreper-formance-basedpayprogramsandreduc-ing or eliminating non-performance-based programs, specifically severance,perquisites, and executive supplementalpensions.

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Priorattemptstoreducepaythroughleg-islation and regulation have probably resultedinhigher,notlower,payforexec-utives. Examples include the limits ongoldenparachutes,the$1millioncaponthe tax deductibility of certain corporatepay, and enhanced proxy disclosure.These rules have generally not reducedpaybutforcedcorporateboardstoadopt

Prior attemptsto reduce pay throughlegislation andregulation haveprobably resultedin higher, notlower, pay forexecutives.

Table 1Company Returns and Profits on Stock Options

Companies Executive Profits on Stock Options Number of One-Year 2005 2006 Change (%),Companies Return (%), 2006 $millions $millions 2005–2006Companies Creating High Returns 544 28 6.6 10.8 63Companies Creating Low Returns 544 -3 8.8 5.5 -38All Companies 1,088 12 7.9 7.6 -4

Source: Watson Wyatt Worldwide data. Notes: All numbers and percentages are medians, except for the number of companies. Returns refer to total share-holder returns (stock price appreciation plus dividends).