Executive compensation: How market forces propelled salaries to the heights

Compensation practices at financial institutions receiving federal bailout money raised the ire of citizens and lawmakers this winter, but the huge salaries and bonuses paid to some corporate leaders are not new. How did executive compensation reach such lofty levels? Market forces have been at work, say management professors Robert Hoskisson and Luis Gomez-Mejia. Changing dynamics in American board rooms have shifted the bulk of management responsibility away from directors and back almost entirely onto top executives, they say. And because these executives now bear this huge burden alone, they are demanding contracts that reflect this level of responsibility and offer them some kind of protection. That's because when things go wrong and the CEO is fired, he knows that the chances are small that he will ever claim the top job again.

The public fumes when failed CEOs pocket huge bonuses or severance packages: witness the outcry when former Home Depot CEO Bob Nardelli claimed a $210 million severance package after ushering the company's stock into the ground.

But never was the public outrage more visceral and more vocal than earlier this year, when insurance giant AIG — a company that had just received $173 billion in U.S. government aid in the wake of its near collapse — announced that it would pay its top executives bonuses totaling more than $160 million. The same execs whose poor judgment had brought the world's largest insurer — and, by extension, the world's economy — to the brink of collapse were being handed millions in bonuses.

Meantime, millions of Americans were losing their homes, their jobs and their nest eggs. The media pounced, and so did politicians. An apparently outraged President Barack Obama publicly challenged AIG to "justify" the bonuses, but when the company tried to make its case, nobody was listening. That's too bad, according to Robert Hoskisson and Luis Gomez-Mejia, because much of AIG's explanation was true.

It was true that AIG was contractually obligated to pay those bonuses. But it was true also that if AIG wanted to attract the people it believed to be the best in their fields, then they had to pay the going rate. Hoskisson and Gomez-Mejia understand it's a not a popular position during hard economic times, but they say the public has to understand that executive compensation has not reached lofty levels by accident.

There are market forces at work, they say. The arguments made by AIG in the wake of the bonus scandal contain some legitimate points that apply to most top corporations. The researchers say they understand the public reaction to executive pay — especially the idea that executives should not be rewarded for poor performance. They note that the critics aren't necessarily all that well-informed, however, and some of the criticism leveled at compensation practices is not well-founded.

Hoskisson and Gomez-Mejia say there are reasons why top executives get paid so well. "I'm not justifying it," Hoskisson says. "I'm not saying it's right that the top person in an organization is paid 2,200 times more than the people at the lower level. I'm just trying to explain why it happens and why there's no apparent connection between performance and pay."

The rewards of risk

The reason why execs like Nardelli can be "rewarded" with massive pay packages even when they fail can be summed up in a few words, says Hoskisson: Upfront contracts and risk. That's the conclusion from Hoskisson's latest paper, "Complementarity in Monitoring and Bonding: More Intense Monitoring Leads to Higher Executive Compensation."

Hoskisson and his co-authors, W. P. Carey doctoral candidates Mark W. Castleton and Michael C. Withers, argue that changing dynamics in American boardrooms have shifted the bulk of management responsibility away from directors and back almost entirely onto top executives. Because these executives now bear this huge burden alone, they are demanding huge contracts that reflect the level of responsibility and offer some protection.

To executives, these huge pay packages represent financial security in lieu of job security, since average CEO tenure has been trending downward for years. To the board members, these multi-million dollar deals are simply the cost of doing business in a changed corporate world. In other words, as AIG explained, attracting top talent takes top money.

The issue, Hoskisson explains, is rooted in the decline of "insider" culture in corporate America. In the old days, a board of directors usually included people who knew the business from top to bottom, often because they had worked at the company in management. They were closely involved with the company, beyond their mandatory director obligations.

In recent years, however, institutional investors and private equity barons have been claiming an increasing number of board seats that used to be occupied by these insiders. Today, 70 percent of all public stock is owned by institutional investors, and those investors dominate the boardroom, too. That's not necessarily a good thing, Hoskisson says, especially for chief executives. "Let's say you were a manager in the early period, and you had a lot of insiders that understood, really, the strategy of the firm," Hoskisson says.

"You would go forward understanding that you're taking a risky strategy, but also that everyone understands that strategy and that it can fail, so if it fails you're not necessarily entirely to blame. But if you have a bunch of outsiders on the board who don't have the time to [understand the company] because they're only coming to four or five meetings a year, you as a manager are making whatever decisions you make and you're solely being judged on the outcomes, good or bad. … The CEO today just has more responsibility for the outcomes."

In other words, CEOs may see any kind of risk as a bad thing — if not for their company, then at least for themselves. But business history tells us that risk-taking is essential to corporate success. Great strategy is often built on risk. "Risk-taking is necessary," says Gomez-Mejia. "You need risk to generate higher returns. Executives should be able to take risks without being afraid. They can't be worried about getting punished."

Looking Out for No. 1

Often the CEO is punished. When an executive's strategy fails — regardless of the reasons why it fails — these new-look, non-insider boards don't think twice about cutting loose their top executive. Once a CEO has been labeled a failure, finding more work can be downright impossible. In February 2009, the Wall Street Journal reported that 61 companies in the Standard & Poor's 500-stock index changed CEOs during 2008, up from 56 a year earlier.

The story added that although there is no concrete data, management consultants, recruiters and the CEOs themselves say few are able to secure the top job again. "I'm sure there are situations where managers are paid too much," Hoskisson says. "But why is that? And why is pay not connected to performance? Well, it comes partly as a result of the risk-shift phenomenon. People are coming in and demanding big contracts, and the boards are going along with it because it's the only way they can actually get these people.

Tenures are down, dismissals are up, and the media is stigmatizing these CEOs such that they can't get a job again. There are hardly any repeat CEOs these days. That's our argument." Is it an argument the public — and, by extension, the government — will buy? Probably not, because public perception assigns a large share of the blame for the current economic troubles to top corporate leaders.

Both Hoskisson and Gomez-Mejia say the wounds of this economic crisis are too fresh for their message to be embraced. Still, Gomez-Mejia says, it's interesting to contrast attitudes toward executive pay today to what attitudes were a few years back when the economy was booming. Back then, he says, executive pay may have appeared outrageous, but, to borrow a word from President Obama, it also seemed a bit more "justified."

"Three or four years ago, everyone was making money, companies were doing well, the economy had been doing well for 10 years, and people probably figured, 'You know, that's a hard job. A difficult job. And I don't want to do it. I don't want to work 90 hours a week. Yeah, they're making money, but they're also making a significant contribution,'" Gomez-Mejia explains.

"I think a lot of people thought that way. But when things go poorly, and we have this whole financial mess, then it's a different matter. All of a sudden it looks insensitive. It looks like they're getting rewarded for failure."

Bottom Line

• Outrage over executive pay is nothing new, but the issue was raised once again earlier this year when it was revealed that top managers at struggling insurance giant AIG were going to be awarded millions in bonuses — even though the company needed more than $170 billion in government aid to avoid collapse.
• In the wake of this news, AIG said it was contractually obligated to pay the bonuses. To attract top talent, the company asserted, it needs to pay top dollar. Two researchers from the W. P. Carey School say AIG's position — though unpopular — is actually correct.
• New W. P. Carey research shows that changing board dynamics have shifted management responsibility almost entirely to executives. This means that when companies perform poorly, the CEO is often blamed — and fired.
• As a result, CEOs are now demanding 'security' up front, negotiating contracts that promise to pay them huge sums of money even if they don't perform well. And boards agree to these demands because that's the only way they can bring in the most talented executives available.