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BUSINESS AT OXFORD
The economics
of a CEO’s pay
The great CEO compensation debate, and how it will impact
an emerging economy such as India
B Y T HOMAS N OE
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EXCLUSIVE
A s any reader of the
business press
knows, CEO
compensation has become
the subject of intense
debate. The debate started
in the US, it has reached
the UK (as evidenced in
the imposition of “say on
pay” regulations) and, with
the rise in continental CEO
salaries, is spreading
across Europe.
How will this debate
affect India—by far the
largest emerging market
economy with Anglo-Saxon
legal and financial
institutions, exactly the sort
of institutions that birthed
the CEO compensation
debate? I will try to answer
this question by looking
beyond the outrage of
critics and the
rationalizations of boards,
focusing instead on the
underlying economics of
CEO compensation.
The attack on CEO
compensation comes from
two directions. Some argue
that CEO compensation is
too high, exceeding the
level CEOs would obtain in
arm’s length transactions;
others argue that CEO
compensation is too
low-powered, that is, too
insensitive to firm
performance.
The problem with the
“too high” argument is that
it is not easy to find an
absolute threshold beyond
which CEO compensation
becomes unreasonable.
At a company such as
Walt Disney Co., with
around $3 billion (around
Rs12,945 crore) in after-tax
profits, a CEO capable of
boosting profits by a
modest 5% could—even if
we capitalize earnings at a
modest price-earnings
multiple of 5—raise
corporate value by $750
million. In this context, the
“outrageous” salary earned
by Disney’s ex-CEO,
Michael Eisner, of around
$100 million does not seem
so outrageous.
• Because it is difficult for
critics of CEO
compensation to measure
either the scope for CEO
value creation or the
diffusion of star talent
across the population of
CEOs, critics for the most
part attack the level of CEO
compensation through
comparisons, either by
comparing the CEO of
today with the CEO of
yesteryear or by making
cross-country comparisons.
Lucian Bebchuk and
Yaniv Grinstein (2005), for
example, show that US
CEOs’ compensation
relative to corporate profits
has grown substantially
between 1993 and 2003.
Martin J. Conyon and Kevin
J. Murphy show that in
1997, CEO compensation in
the US was more than
double CEO compensation
in the UK.
• At first glance, these
observations seem to
support the idea that, at
least in the US, lowering
CEO compensation would
be in shareholders’ interest.
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However, upon further
inspection, the case is less
clear. Much depends on
how compensation is
measured. Carola Frydman
and Raven Saks (2007)
show that relative to assets,
the increase in US CEOs’
compensation is very
modest. Moreover, the
increase over the 1990s
compensated for a decrease
in normalized
compensation in the
preceding 10 years.
Comparisons of CEO
compensation across
countries are also fraught
with problems because
CEO compensation is part
of a larger system of
corporate control that
includes law, accounting,
board design, and
institutional investors.
As my research with
Michael Rebello and
Ramana Sonti shows, the
marginal contribution of
each of these checks on
opportunism varies with
the strength of the other
checks. Thus, perhaps in
the UK, where the legal
system imposes fewer
constraints than the US on
direct intervention by
institutional shareholders,
the marginal value of high
CEO compensation
packages is lower. The
relevant question for a
firm’s compensation
committee is not how
much the firm’s CEO
should be paid in an ideal
world, but how much the
CEO should be paid in the
actual business world in
which the firm operates.
• The indictment of CEO
compensation that is
based on “low
performance sensitivity” is
also less than air-tight. The
argument is that
“high-powered” CEO
compensation, which deals
out very high rewards on
average but concentrates
these rewards at the top
end of firm performance, is
MONDAY, JUNE 2, 2008 ° WWW.LIVEMINT.COM
the ideal way to incentivize
managers. This rests on
the assumption that a
board’s problem of
designing incentives for
the CEO is qualitatively
similar to the standard
problem of inducing effort
from an employee.
However, the CEO’s
position relative to
shareholders is
fundamentally different
from a worker’s position
relative to his boss. The
CEO has a huge
information advantage
over the board and
enormous discretion. In
this environment, CEOs
need incentives to do the
right thing, even when
their firm is sailing
through rough seas and
very ambitious
performance targets are
out of sight.
• Moreover, a weak
relation between the CEO’s
current performance and
current compensation does
not imply a weak relation
between long-run
performance and the CEO’s
long-run compensation.
In a dynamic world,
MALAY KARMAKAR/MINT rewards for performance
need not be meted out at
the same time as
performance. My research
with Rebello shows that
optimal CEO compensation
can lead to a very weak
relation of current CEO pay
and current firm
performance and yet
produce a very strong link
between the long-term
value of the CEO’s position
and firm performance. The
empirical research of John
F. Boschen and Kimberly
Smith (1994) shows that a
weak current but strong
long-term link is typical of
US firms.
• How will the great
debate on CEO
compensation, thus far
conducted mostly in the
developed economies, play
out in emerging market
economies such as India?
Lacking a crystal ball, but
armed with humility, I will
venture the following
predictions: In India, the
growing mobility of human
capital, combined with
economic growth, will lead
to sharp increases in CEO
compensation and
management
compensation generally.
Because of higher CEO
turnover, the timing of CEO
rewards will become more
closely synchronized with
firm performance, leading
to a stronger measured
pay-to-performance
relation. The weakness of
institutional investor
monitoring will lead boards,
even if they are concerned
with outside shareholder
welfare, to grant CEOs fairly
generous bonus plans for
meeting modest
performance targets.
The increase in
compensation will be
decried by some in the
business press, while others
will praise the strengthened
pay-to-performance relation.
Send your comments to
businessatoxford
@livemint.com
Thomas Noe is Ernest
Butten professor of
management studies
at the Saïd Business
School, University
of Oxford.