Executive Pay Increase in Past 15 Years Cannot Be Explained by Firm Growth

Since 1993, CEO pay has increased 146% and the average pay for the top five executives increased 125% in S&P 500 companies. What can account for the swell in pay Lucian Bebchuk and Yaniv Grinstein use data on executive compensation to examine how compensation has been changing and the theories behind the growth. They find that compensation growth cannot be attributed to size, performance and industry mix. The compensation package has had a higher percentage of equity, though the cash portion has still grown in size. Evidence suggests that the arm’s lengths bargaining model and managerial power model are two theories that best explain these increases in executive pay.

Using data on executive compensation from ExecuComp, the authors are able to compile the changing compensation packages for 80% of the market cap (aka S&P 1500) between 1993 and 2003. The increase in the S&P 500 is mirrored in the S&P Mid Cap and Small cap. However, these immense increases cannot be explained by changes in firm size, firm performance and industry mix. When controlling only for firm size, the entire S&P 1500 CEO pay increased 96% and the top five executives pay enlarged by 76%. Bebchuk and Grinstein posit that only 66% of pay increase can be attributed size, performance or industry mix.

Delving further into how the compensation package has changed, Bebchuk and Grinstein analyze the equity and cash-based parts of the package. In 1993, 37% of the S&P 500’s CEO compensation packages were equity and in 2003, that percentage increased to 57%. Mid cap went from 41% equity to 51% and Small 34% to 41%. The new industry firms (tech, internet) had the highest percentage of equity. This might have caused the fraction of equity in a salary packaged to peak in 2000-2001. When controlling for size, performance and mix, a regression shows even more pronounced growth.

While a fast expansion of the equity percentage might lead one to think the cash portion decreased, the authors find otherwise. The proportion of cash to equity decreased because of the large increases in equity being offered, but the total amount of cash still increased. CEO pay growth experienced a 56% rise and 45% growth existed for the top five executives. Unlike equity, the cash amount did not dip in 2001.

To see how the growth in compensation packages changed on an aggregate level, Bebchuk and Grinstein added 2500 to 3500 smaller and mid companies not in the S&P 1500 found on COMPUSTAT. The authors created a benchmark regression for 1993 and then applied it to what the aggregate compensation would have been in 2003 if the same coefficients were used. The result was 20% lower than the actual aggregate compensation. At an aggregate level, the top five executive compensations accounted for 5% of company earnings during 1993-1995, but jumped to 9.8% for 2001-2003.

Attempting to explain the growth in compensation, Bebchuk and Grinstein consider two different theories: the arm’s lengths bargaining model and the managerial power model. Arm’s lengths bargaining’s main assertion is that directors seek the best deal for the shareholders when looking for executives, and executives are simply selling their managerial services. This model is similar to an ordinary supply and demand chart for any good. In a Bull market (like the 90s), there are three possible reasons.

1. the demand for executives shifts the demand curve and thus executives need more money.
2. As executives begin to make more money in the boom, supply decreases because executives no longer want to work. Compensation increases as an incentive to keep working
3. Booms require more work and thus executives need more compensation.

Other changes in the market could have indirectly influenced compensation. As firms begin to hire outside of the company more, executives gain additional mobility and bargaining power because of this. In addition, private firms can often afford to pay higher salaries, forcing public companies to lure back the executives by increasing their salaries as well. The acceptance of higher compensation might be rising. Also, equity could have increased as board members don’t understand the exact cost of options and see them as inexpensive.

Managerial power model states that directors are not acting in the interest of the shareholders and are willing to give the executives compensation packages that benefit the executives more than the shareholders. Reasoning from this theory usually leans toward fooling the shareholders. A market cap increase in a boom year is a convenient justification of pay growth. Giving the executives more equity appears to the shareholders as aligning CEO’s goals with the shareholders. While this equity escalation is acceptable by shareholders, it is just another way to legitimize an uncalled for pay increase. In addition, CEO’s want protection for being fired during a takeover. Because the directors are on the side of the CEO, they award the CEO a high severance package and compensation for the risk.