Adding to the dubious nature of any linkage between executive performance and financial reward, comes the extraordinary practice of companies lavishing enormous riches on CEOs even as they are firing them for failing on their jobs.63 Upon incurring the biggest financial loss in corporate history, Merrill Lynch terminated its CEO, Stanley O'Neal. Yet that did not keep him from walking away with a sizable severance package totaling US$160 million.64 Consider also the case of Home Depot's former leader Robert Nardelli. Even though he had been discharged as a result of his firm's lackluster share performance, Nardelli parachuted away with approximately US$210 million in severance.65
However, granted that some chief executives are overpaid, in light of simultaneously mismanaging their firms while getting handsome remuneration, not all of the complaints about CEO compensation stem just from these well-documented abuses. In addition, there is protracted debate centering around the sharp increase in average CEO pay that played out over several decades preceding the appearance of the financial crisis. Thus, the total real compensation for CEOs of large public companies rose 600 percent between 1980 and 2003,66 while median full-time earnings over the same time span only approximately doubled.67
On average, the CEOs of the largest companies pull down nearly five hundred times what rank-and-file employees make. Stated differently, that means the typical daily earnings of CEOs of big enterprises surpass many of their individual employees' annual salaries. And the way stock options are distributed reveal big swings, depending on one's level in the corporate hierarchy. In the typical firm three-quarters of them are allocated to CEOs.
Conventional Arguments Given by Economists: The Pay-for-Performance Paradigm
In the eyes of some boards, executives, and investors, such disparities may appear palatable insofar as their judgments are based on the pay-for-performance paradigm and the various arguments that flow from it. According to the pay-for-performance rationale, the focus should be on the economic value generated for the firm by an individual leader. Pay for performance can be viewed, on the one hand, as a reward for performance, or on the other hand, as an incentive to encourage performance. Some debate has arisen in the literature about whether and to what extent these seemingly alternative justifications—pay for performance versus performance for pay—are distinct, or not.68 At any rate, the underlying rationale for both is agency theory. The theory hold that agents, that is, managers and CEOs, should see it in their own interests to advance the interests of the principals, that is, the shareholders. Thus, if the agents are to be well compensated for superior performance the agents should be motivated to achieve that type of performance.
Competition
Competition for top management is a key pay-for-performance explanation. This position is advanced under several arguments. One argument asserts that, for publicly traded companies, a steady relationship exists in the market between total CEO compensation and the size of the firms they lead. The argument offers the so-called 30-percent rule as authority for this claim. For each 10 percent rise in the size of a company (calculated by sales, market value of assets, or other relevant indicia), CEO remuneration rises by approximately 3 percent. Since the correlation is alleged to have held constant since the 1930s, it is not thought to be the result of the steep escalation of stock options and other forms of compensation, which originated in the 1970s. And a seminal study found an average increase in CEO compensation of $3.25 for every $1,000 increase in shareholder wealth.69 However, deeper questions arise: What do these correlations mean in a normative sense? Are the various pay-for-performance arrangements, alleged to be driven by competition, generous, or are they meager, and by what criteria might one decide? The standard discussions of this type of metric in the economics literature are characteristically devoid of moral reflection on such issues.
Talent
A second argument asserts that the biggest firms tend to draw the greatest management talent. Accordingly, the argument runs, larger companies need to compensate their CEOs more highly so as to provide a disincentive for them to abandon their firms and go lead smaller enterprises. What is notoriously absent from this line of argument, however, is any satisfactory notion of what “talent” actually means, beyond the bare threat of departure for greener pastures.
A closely related argument states that the rise in CEO pay is a product of the increase in market value of companies. The head of a more valuable enterprise is more productive because even if he ratchets up firm value by only a few percentage points, the increase in absolute value is greater the more valuable the company is. Assuming two managers with equivalent skill, one who directs a small hardware store and the other Xerox Corporation, the manager of Xerox is responsible for creating bigger value.70
It is worth pointing out that the disclosure of companies' executive compensation structures and levels requirements sometimes triggers invidious comparisons; boards and compensation committees, goaded by executives and remuneration consultants, approve escalating pay packages. After all, firms do not wish to be seen deficient compared to peers. Part of the ratcheting tends to be attributed to the aforementioned apprehension of a “flight of talent” to better paying firms, or migration to private equity, despite a dearth of empirical evidence of this. Yet one might ask: What exactly is meant by the “talent” of a corporate executive? Is there really a distinctive talent that can be moved so readily from firm to firm, as Toscanini was able to transport his stature as a maestro conductor from the New York Philharmonic over to the NBC Symphony?71 And how deeply rooted, how sincere, are the commitments of a leader to the firm under his charge, given that he is so easily lured away, simply by the one-dimensional enticement of a bigger pay package?
Efficiency
Finally it is argued that considerations of social efficiency dictate that the best managers should lead the biggest firms. Their heightened skills, it is claimed, exert a greater influence, owing to the fact that they are managing a greater share of capital, labor, and other resources. In other words, an efficient coupling of superior management with bigger firms in a competitive market for top-flight executives implies a positive correlation between enterprise size and total compensation awards.
Counterarguments and More Questions
As others point out, such explanations about the allocation of CEO pay often have less to do with real talent, proven performance, and actual contribution than with brute power, cronyism, and outright manipulation. Moreover, the competition argument is attacked on the ground that if increases in CEO compensation really did attract greater talent, then the resultant heightened competition for CEO positions ought to have softened any steep rise in compensation. However, no significant overall dampening in CEO pay has transpired. Hence, it is claimed that a more plausible explanation is that the bigger a firm's market value, the more likely it is that the CEO's pay can be hidden away, along with the compensation of other high-ranking executives, such that the big disparities are not noticed. Thus, CEO compensation gets increased whether he or she has contributed to enhancing the value of the larger enterprise.
Further questions arise: What levels of executive remuneration are proper? How ought such levels to be established by a firm's board of directors? What standards should guide the establishment of compensation levels? Is this something that the government should keep out of? Is it best to leave everything to the market to decide?
One of the most heated topics broached at the Pittsburgh G-20 summit was executive compensation. Many believe that exorbitant remuneration is inappropriate in cases where financial institutions have enjoyed bailouts with public revenue.72 Others contend that perverse incentive arrangements prompted financiers to assume inordinately high risks. From this they conclude that incentive structures ought to be reconfigured to reflect longer-term firm performance and broader social contributions. By contrast, some people would maintain on deontological grounds that over-the-top