Executive Salaries With the Current Thesis

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It has been shown that the acquisition of talent not an area specific to each individual position at top companies. The highest-performing companies build pools of talent from which they can draw as needed (Michaels et al., 2001). Thus, there will inevitably be talented people who are at times underutilized. Their higher-order needs are not being met and thus they must be generously compensated. Otherwise, when the time comes to move someone from the organization to a fulfilling, higher-order executive position, the talent will not be there.

CEO pay proponents also point out that the bulk of the "excessive" executive compensation comes in the form of stock or options. These instruments were brought into executive compensation packages specifically to align the interests of management with those of the shareholders. It was the shareholders and the boards of directors who initiated this, as a means to protect shareholder wealth. There have been some instances where executives have abused this system, but those executives find themselves prosecuted. The argument here is that a properly-constructed executive compensation plan will yield the desired results. If a firm does not design their plan well, it will fail. Thus, it is not the size of the compensation package that determines its level of effectiveness but its structure. Many firms have sound structures and the high level of executive pay is matched by high performance. In most situations, there is little publicity or outcry about the issue. Largely, it is only when performance is poor that the issue of executive compensation is raised. If performance is poor and bonuses are given out, this has bad optics but evidence has shown that reducing executive compensation sends a red flag to investors, causing rapid erosion of shareholder wealth as the stock price drops (Hume & Tokic, 2005). It is unreasonable, then, that the entire system of executive compensation be regulated or scrapped simply because some firms are not good at designing executive compensation plans.

At the core of the pro and con arguments is the fundamental belief regarding regulation in industry. The free market philosophy underlies the beliefs of those who believe that executive compensation is not too high. Those who believe it is want the system to build in limits, or a sense of common justice. Some of those who believe in the free market perspective feel that the market is irrational. The use of equity-based compensation was encouraged by favorable tax treatment. By the time the tax treatment was changed, the concept had become standard practice. It is only recently that shareholders have begun to exercise their rights in a meaningful way. Even now, there are only a handful of major institutional investors, such as CalPERS, that have strict policies regarding executive compensation (Business Wire, 2004).

While CalPERS and Warren Buffett oppose high executive compensation on financial grounds, it is social justice that forms the basis for most objections to executive compensation levels. The social justice view stems from the notion of patterned principles -- that there is a social order that is more just than others and that the role of government is to pull levers of power to bring reality closer to that just social order (Epstein, 2008). Nozick argues that such involvement in the pursuit of patterned principles is itself unjust, because the rules of the game are not the same for everybody and there are needless barriers erected. If the market wants CEOs to make millions, so be it. The rules are the same for everyone.

Current Crisis

The AIG bonus scandal has become the flashpoint for discussion about excessive executive compensation and the global economic crisis. AIG, of course, represents a special case in that the company is essentially owned by the American taxpayers. Thus, the bonuses paid to executives came directly from the taxes paid by American workers. It is interesting to note that among shareholders there is seldom this same outrage.

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The fundamental principle is the same, however. High levels of executive compensation, if not translated into improved performance, are a drain on shareholder wealth.

The current crisis exemplifies this well. The crisis has a number of different antecedents, from the government reaction to the savings & loan scandal to the Fed's interest rate policies after the dot-com bubble burst to the creation and subsequent lack of oversight of Fannie Mae and Freddie Mac (Knowledge @ Wharton, 2008). The wide range of factors that have contributed to the crisis makes it difficult to accurately gauge the impact of executive compensation. However, there was a role in the development of the crisis that was caused by executive compensation schemes.

Flush with cash as a result of the Fed's aggressive interest rate cutting following the bursting of the dot-com bubble, banks began to invest aggressively in consumer credit markets. The main manifestation of this was the dramatic increase in subprime lending. Bank executives were willing to take this risk because they believed it would result in increased profits. They were essentially making a gamble on the housing market. For a few years, the housing market paid off and banks recorded stellar profits. Executives cashed in hundreds of millions of dollars in bonuses, options and stock. To ensure that the profits were maximized, bank executives package up their mortgages in mortgage-backed securities. By doing this, they were able to reduce their risk. This was not the case, but bank executives felt at the time that they were offloading some of these subprime loans.

Ultimately, executive compensation only played a minor role in the current economic crisis. Bank executives, armed with options, sought to increase profits. In doing so, they lowered their lending standards too much. They are not entirely culpable, though. It was the Fed who gave them so much money to lend. A bank executive who sits on cash is a bank manager who is losing money, so they were inevitable going to find ways to invest, and the demand was in the mortgage market. It is reasonable to expect that bank executives would have pursued such tactics regardless of the structure of their compensation packages, especially since they were being guided in that direction by the Federal Reserve.

Annotated Bibliography

Taub, Stephen. (2006). CEO Pay is Too High, Directors Say. CNN. A survey of board members found that 81% of them believe CEO pay is too high. The link between pay and performance should be strengthened, they argue.

FASB Statements 123 and 123R. (1995 & 2004). These FASB statements govern the tax treatment of equity-based compensation.

Khurana, Rakesh w / Lagace, Martha. (2002). The Irrational Quest for Charismatic CEOs. Harvard Business School. This interview of HBS professor about his book on the subject reveals evidence that boards do not act rationally when they set executive salaries to extremely high levels.

Novy, Danielle. (2009). Rebalance Compensation from Top to Bottom. Bnet. This article outlines the issue from an employee morale perspective -- a high disconnect between CEO pay and worker pay may be bad for morale and by extension bad for business.

Desai, Mihir & Margolis, Joshua. (2006). Fixing Executive Options: The Veil of Ignorance. Harvard Business School. Retrieved May 1, 2009 from http://hbswk.hbs.edu/item/5555.html

Epstein, Richard A. (2008. Robert Nozick Vs the U.S. Congress. Forbes. This article outlines the views of Robert Nozick vis-a-vis the concept of patterned principles that drive the behavior of Congress.

Michaels, Ed; Handfield-Jones, Helen & Axelrod, Beth. (2001). The War for Talent This book discusses the HR practices at successful companies. The main finding is that the most successful companies build deep talent pools, which must be retained with strong financial packages until they are ready to be moved into better positions.

Hume, Evelyn C & Tokic, Damir. (2005). Is Executive Stock Option Repricing a Red Flag? Journal of Corporate Accounting and Finance. This article outlines the risks.....

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