EXECUTIVE PAY: REGULATION VS. MARKET COMPETITION
January 13, 2009
The current executive pay system -- the "pay-for-performance" model -- is working effectively. In other words, say Ira Kay and Steven Van Putten of executive compensation consultants Watson Wyatt Worldwide, pay levels track corporate performance.
Their study, which analyzed the relationship between the total return to shareholders generated by companies and the related stock option compensation for executives in the largest 1,088 companies in the United States in 2006, found that executives in companies that performed well were rewarded for that better performance
- While executive compensation packages of 10 seem exorbitant, CEO pay is a very small part of the overall cost structure of companies.
- Total CEO pay in 2004 was just 0.09 percent of sales, 0.06 percent of market capitalization and 1.3 percent of net income of companies.
- In 2006, CEOs in high-earning companies earned far more realizable pay -- the actual cash bonus paid the in-the-money value of stock options and the real value of restricted stock, plus the payout from performance plans -- than CEOs at companies with low earnings; the former also earned 3 times as much in realizable long-term incentives (LTI).
These higher returns for high-performing executives are not "baked in the cake" when executive pay packages are originally offered. The proof is that the correlation between company performance and LTI opportunity is very weak, says Kay and Van Putten.
Thus, executive skill at producing high returns for shareholders is what generally determines the actual compensation that CEOs receive, conclude Kay and Van Putten.
Source: Ira T. Kay and Steven Van Putten, "Executive Pay: Regulation vs. Market Competition," Cato Institute, Policy Analysis, No. 619, September 10, 2008.
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