Why CEO compensation tripled in the 90s then went flat

Between 1992 and 2001, median compensation for Standard and Poor's 500 more than tripled, but growth in CEO pay was relatively flat before 1992 and after 2001. This longstanding puzzle was explored in research presented at the 2015 ASU Sonoran Winter Finance Conference, hosted by the W. P. Carey School.

Between 1992 and 2001, median compensation for Standard & Poor's 500 CEOs more than tripled — from $2.9 million to $9.3 million (in 2011 dollars). But that fast rise was not part of a longer-term trend: before 1992, growth in CEO pay was relatively flat, as it was after 2001.

That 1990s off-trend spike in CEO pay piqued the curiosity of Kelly Shue, a finance professor at the University of Chicago, and Richard Townsend, a business professor at Dartmouth College. The two are co-authors of Growth Through Rigidity: An Explanation for the Rise in CEO Pay. Townsend presented the paper at the 2015 ASU Sonoran Winter Finance Conference, which is hosted by the W. P. Carey School.

Shue and Townsend sought to solve the “longstanding puzzle”: what caused CEO compensation to rise so fast in the 1990s?

Options: More is … more

Not every aspect of CEO pay rose fast between 1992 and 2001: salaries, bonuses and other forms of compensation didn’t grow much at all. But options did. An option gives its holder the right to buy a share of company stock at a predetermined price on some future date. If the market value of the company stock has risen above the predetermined price when the CEO exercises the option, he or she pockets the difference. Options can be a mutually beneficial means of compensation when the firm’s share prices are rising.

One way to think about options is in dollar, or value, terms; a CEO might expect to get, say, $50,000 worth of options a year. Another way to think about options is in number terms; a CEO might expect to get, say, 500 options a year. If options are conditional on the company’s performance, and the CEO thinks about options in number terms, then he or she might expect the number of options awarded to rise over time if the company performs well.

The anecdotal evidence suggests that is exactly how CEOs thought about options in the 1990s. In a Towers Perrin CompScan Survey cited by Shue and Townsend, executives were asked:

“Last year, you personally received options to purchase 1,000 shares at the stock’s then current price of $50. This year, the share price is up to $70. How many options should you get (assuming, for the sake of this simple example, that the competitive value of your job hasn’t changed from last year to this one)?”

If the CEO thought of options in dollar, or value, terms, he or she would expect to get a smaller number of options, because the value of each share had grown. But the majority of survey respondents actually expected to get more options — substantially more (1,500). In other words, those CEOs thought of options in number terms, not dollar (value) terms.

Shue and Townsend’s analysis corroborates the anecdotal evidence. In the 1990s, CEOs were getting the same number or more options year after year even as share values were rising. Why? Number rigidity. That is, “Firms were resistant to changing the number of options CEOs were granted from year to year,” Townsend explained.

The result of that number rigidity: outsized increases in total CEO compensation. “Number rigidity, combined with the high equity returns of the Tech Boom years, helps explain the longstanding puzzle,” Townsend said.

But what causes number rigidity? And why did the trend shift after 2001?

Nowhere to go but up

In the early 1990s, options were a relatively new form of compensation, so it’s not hard to believe that boards and CEOs didn’t understand well how to value them. “If either the board or the CEO, or both, doesn’t understand option valuation, then they might use the number of options as a rough proxy for value,” Townsend explained. But when stock prices are rising, the number of options is a poor proxy for value.

At the same time as the value of options pay rose, boards didn’t reduce other forms of CEO compensation. “At the same time that options are downward rigid — not inclined to decrease — so are other forms of compensation like salaries and bonuses. It's not common for a CEO to get a salary cut,” Townsend said. So while firms could have adjusted other forms of compensation downward to offset the rising value of options, they didn’t.

Post-2001 flatline

After 2001, CEO pay leveled off. Even during the mid-2000s stock market boom, CEO pay did not rise as fast as stock market returns did. That, explained Townsend, is because of regulations introduced in the early 2000s that forced firms to think about options in terms of value rather than numbers. “Regulatory changes in the 2000s required firms to begin disclosing and expensing the grant date value of option compensation.”

Townsend said that insofar as they have forced firms to think about options in terms of value, the regulations have been beneficial. “Paying the same number of options year after year even as the value of those options rises is unlikely to be optimal,” he explained. “Optimality in compensation means getting the right level of pay and the right mix of types of compensation to incentivize performance.” To accomplish that, boards, especially, have to understand how particular forms of compensation really work.

The bottom line

• CEO compensation was relatively flat prior to the 1990s and relatively flat again in the 2000s. Between 1992 and 2001, however, median CEO compensation tripled — from $2.9 million to $9.3 million (in 2011 dollars).
• One form of compensation — options — accounted for the majority of that growth. In the early 1990s, options were a relatively new form of compensation, and not particularly well understood.
• Options compensation is number rigid, meaning that CEOs expect to receive at least the same number of options as the prior year, even if the value of the options has risen substantially.
• "Number rigidity, combined with the high equity returns of the tech boom years, helps explain the longstanding puzzle”
• Regulations introduced in the early 2000s forced firms to think about options in terms of value rather than numbers. Coincident with those regulations, the outsize growth in CEO pay slowed.