The Outrageous Income Differentials Allowed In The US - Time For A Change

by: Elliott R. Morss

Summary

In the U.S. corporate world, "managers" get paid too much.

People running hedge funds/private equity firms get paid much more.

Something should be done.

Several weeks back, the New York Times (NYT) published its annual article on the highest-paid CEOs with data provided by Equilar. I read these numbers every year with the same disdain and disgust:

  • The CEOs appoint their boards and pay them very well to determine pay levels.
  • There appears to be no correlation between company performance and what the CEOs get.
  • The huge amounts the CEOs get -- ridiculous.

I develop these and other thoughts below.

The NYT/Equilar Numbers

In 1991, the CEOs of the largest U.S. firms received an average of $1.9 million. In 2015, the average had increased to $19.3 million --yes $19.3 million! Table 1 provides compensation of the top 20 executives. So the CEO of Expedia, a middling web travel agency, gets paid almost twice as much as the next best paid CEO? And Oracle pays two senior executive $53 million each? It makes you wonder.

Table 1. - Highest Paid CEOs

Source: New York Times

The Free Market

A "free market believer" would argue these men (and a few women) are getting paid what they are worth. Nonsense. The market is rigged. As I reported a few years back, Professor Edward E. Lawler of the University of Southern California's Graduate School of Business said: "It seems to get more absurd each year. What is outrageous is that one year becomes the standard for the next. And no one is in a position to say no." Graef Crystal, a longtime business consultant, also called the U.S. executive pay system "rotten to the core."

Here is how it works. Directors determine what senior corporate executives make. And CEOs have a lot to do with who gets appointed as directors. According to Bloomberg, directors' pay at Standard & Poor's 500 Index companies rose to a record average of $251,000 last year. Boards have boosted pay for themselves 15 percent since 2007, and some of them even have retirement packages!

According to the Bureau of Labor Statistics (BLS), employees in the private sector work an average 1,789 hours annually. Korn/Ferry International estimates that directors work 250 hours a year. That means directors get paid $1,004 an hour while salaried workers get only $24 per hour.

And what is the primary function of these directors? To hire an "executive pay" consulting firm to set the pay of CEOs. So how do the consulting firms determine what to pay CEOs? It appears to have very little to do with talent. They look at what other firms are paying their CEOs.

So how do you get into the CEO candidate "club?" It is not easy -- lots of prior senior executive experience. Might not some business school professors or their students have the knowledge to be good CEO candidates? Not considered, not part of the CEO "club."

No Correlation

If the market is not rigged, CEO compensation should vary with company performance: higher profits would result in higher total compensation/bonuses in the following year and the opposite if profits fell. To test this, I put company profit information together with Equilar data on compensation and bonuses. No such correlation exists. In fact, there is a negative (but insignificant) correlation between profits and bonuses (when profits go up, bonuses fell in the following year).

Table 2 provides examples of troubling results. It includes companies whose profits either fell or did not change along with what happened to the CEOs' total compensation and bonuses in the following year. For these companies, profits plummet while the CEOs' bonuses and total compensation grow. Why would this happen? It probably has something to do with the links between the CEOs and their directors.

Table 2. - Corporate Profit Changes, CEO Compensation and Bonus Shares

Click to enlarge

Source: Equilar and Yahoo Finance

Social Issues

From the outside, the huge payments made to CEOs are troubling. But within the firms, they have to cause frictions as well.

  • Senior engineers are critical to the success of auto companies because they are responsible for the mechanical design of the company's vehicles. Let's assume they get paid $300,000. How do they feel about having to report to a group in the executive suite making ten times more?
    • Is it reasonable to expect that the senior executives, technicians, and production workers in a firm with such differentials will be disposed to work together well?

Another important social question warrants attention:

Should anyone get paid these amounts? Do we want anyone in our society to receive so much more than they will ever be able to use? But before getting to this, consider the Institutional Investors Rich List. The average compensation of CEOs in the Equilar tables was $19.3 million. Peanuts. The top 25 managers on the Rich List earned a combined $13 billion last year, up more than 10 percent from the previous year. Table 3 lists the top ten on the Rich List along with their incomes.

Table 3. - Top Income Earners, 2015

Source: Institutional Investors Alpha

$1.7 billion for one year! And what makes this even more troubling: most of this income will be taxed at capital gains rates.

It is argued that these private equity/hedge funds keep markets working well. My sense is that markets are working well enough without these individuals earning such huge sums.

This leads to the question: does anyone want to live in a society where individuals earn such huge amounts? What can they spend it on? It would be a full time job just figuring out what to do with such sums. Buying or building real estate is what many do. Bill Gates is recognized for his philanthropic work but also lives in a 66,000 square foot house.

There is an interesting analogy to be made between rich individuals and colleges/universities with large endowments. Once they provide scholarships to all the students they want, they end up buying and building land/properties. For example, as I have reported, Harvard continually develops plans to annex neighboring towns.

What Should Be Done?

Let us turn now to the problem of people getting paid excessive amounts from the standpoint of our social values. While we have to be concerned about destroying work incentives, is there not an annual level of compensation that provides adequate incentives above which society deems the payment excessive? Consider an annual compensation limit of $10 million adjusted annually for increases in living costs. Can anyone claim that this does not provide adequate incentives for executives to work and performers to perform? And even if, as with athletes and other performers, the professional life is extremely short, you can live reasonably well on the annual interest and dividends provided by one year's work at a $10 million rate (invested conservatively, $10 million should provide $400,000 after tax without drawing down capital).

If society could agree on an upper limit, it would be reasonably easy to implement. The personal income tax was instituted because it was seen as the best measure of taxpayer's ability to pay. Implementing my suggestion would involve imposing a 100% marginal rate on any annual earnings that exceeded society's upper limit. Introducing this rate would mean the government would collect all of a person's annual payments in excess of $10 million.

It is worth considering.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Many companies mentioned in this article with tickers. No tickers picked up as secondary