Because most philosophies that frown on reproduction don't survive.

Thursday, April 23, 2009

Unreasonable Compensation

With people focused on the economic downturn, many have found it a good time to give a little extra thought to whether other people are making more than they ought to. The president has spoken out several times against "excessive compensation" of executives, and a number of people have floated the idea of adjusting the top marginal income tax rate to effectively cap total compensation at ten million dollars a year. MZ tackled the question somewhat humorously here.

Beyond question, $10 million is a lot of money. Most of us will never see anything like that much money, and so it seems entirely reasonable to demand: Why should anyone be paid so much? What's so special about CEOs and actors and baseball players that they deserve tens of millions of dollars? Aren't they running off with the money that we should be getting instead?

I certainly wouldn't claim that executives are not often paid more than they are worth. A board of directors is still a group of people with emotional commitments (including wanting to assure themselves that they made the right pick in choosing the current CEO) and they will certainly not always do what is in their own best interest. Though we may be comforted that in a free economy the incentives are in place to automatically punish them for not doing so.

To look at an example of the impact of high executive compensation, I consulted the handy Executive PayWatch Database which my friends at the AFL/CIO put together for me. I picked Hewlett-Packard Company to look at. CEO Mark Hurd made $34,031,021 in total compensation in 2008. This, the AFL/CIO helpfully calculates for me is the same as 836 years worth of salary for the average worker. Should we be outraged?

Well, if we look at Hewlett-Packard's financial results from 2008, we find that HP had 118.4 billion in gross revenue with 8.3 billion in profits. The CEO's total compensation is equal to 0.03% of gross revenue, and if his pay were reduced to $100k that would increase profits by 0.41%

If they took the CEO's pay down to 100k and spread the savings out as raises to all of HP's 321,000 workers, each worker would make $105.70 more per year: $8 per month.

So is all the money being siphoned off by executives? No.

But why pay them so much? The answer is basically that people get these absurdly high sums of money when they are in a position to affect a lot of money. Brad Pitt makes absurd amounts of money because whether or not he is in a movie can make a difference in $100 million in box office gross. (Or at least, that's what the studio is betting based on historicals.) Baseball and football players make vast sums because professional sports franchises produce huge amounts of wealth, and the players think that if their playing is what produces all that money, they deserve a decent percentage of it. And CEOs and other highly placed executives make a lot of money because the difference between having a good CEO and a bad CEO can be billions of dollars in revenues and profits. It doesn't make sense to ask, "What exactly is it that anyone can do that's worth $130,888 per day?" when it's not the actions of sitting in meetings, looking at spreadsheets, and talking on conference calls that result in CEO pay being so high. Sure, anyone could sit in those meetings and look at those presentations. However, the difference between a CEO who picks good goals and hires good executives, and one who ignores important opportunities and hires idiots, can be billions of dollars in growth and tens of thousands of jobs.

I don't deal with C-level executives in my company, but just thinking of the VPs and directors that I have visibility to, there are some who are very, very good -- and others that I would happily make a $100/mo paycheck contribution to have fired. The difference between a good or bad executive could be company growth or losses that allow me to get a raise, or cost me my job. And if I care at my level, it's no surprise that boards of directors care as well.

Now, I think there's a deeper question here. At a pragmatic level, if a company has to pay $40 million instead of $10 million to get the CEO who will allow them to grow and prosper, that makes sense for them to do in order to make profits for their investors and jobs for their employees. However, there's a cultural element here as well which we might well question. Who much is it reasonable for a single person to ask for in compensation, even if it is in the interest of the company to offer much more?

I'm of two minds on this. On the one hand, even if it's of marginal impact to each individual employee, I find myself wanting to say there's simply a limit to how much personal wealth anyone needs. On the other hand, if that wealth ends up in the hands of one person, it allows him or her to direct the use of that money for good -- whether that means founding a school, sending medicines to Africa, or starting yet another company which gives better livelihoods to thousands of people.

However, either way, I don't see the crusade to limit executive pay by law as a reasonable one. The current system allows companies to pay executives according to the benefit they expect to get from them, and use that money as a motivation to get the executives they think they need. If all CEOs were capped at the same level, that would simply mean that companies would have to find other ways to compete for top talent, and I don't see how that would be an improvement.


Jenny said...

Well said, thank you for sharing your thoughts on this issue.

Anonymous said...

Something like this has been tried before. During World War II, the available workforce was extremely limited and the government forbade companies from raising wages to attract workers. So, the companies developed other means to attract employees. They began to offer perks: pensions instead of gold watches, paid time off and, the biggie, paid healthcare. If this idiot law passes, the smart people running business will just figure out different forms of compensation. And, secondary to the law of unintended consequences, none of that compensation will be taxable. The large percentage of tax revenue previously provided by the top 5% of wage eaners will disappear and then what will our tax and spend government do then? Terentia

Anonymous said...

Darwin, it is ironic that you use HP's Mark Hurd as an example in favor of unlimited executive compensation. It was Hurd's predecessor, Carly Fiorina, who nearly wrecked the company but was still given a $21m severance package when she left. (HP's stock jumped when her departure was announced.)

The question isn't whether good CEO's are overpaid, since a good CEO is arguably worth more than their pay. No, the real question is why are bad CEO's paid eight figures? Why do stockholders and BoD's let this happen, when it is clearly against their own interests? We have a market failure here, which is why a legislative solution may be necessary to deal with it.


Darwin said...


I would assume that the reason why BoD's pay bad CEOs eight figures is that they imagine them to be good CEOs. (Recall that Carly had her fans for the longest time, and still does in some quarters, though I could never see it.) I'm not sure that's necessarily a market failure any more than that people often buy other junk for way too much money.

But in re bad CEOs: Wasn't it in a sense a good bargain for HP to get rid of her for 20Mil? Given their share price increase, didn't they make the money back pretty much immediately?

Sure, it might be more satisfying in a sense to flog her from the offices, but paying her off when terminating the contract kept there from being any litigation or kiss and tell. It was probably worth their money. (Kind of like I could never see why letting petty dictators escape to live off their swiss bank accounts is supposed to be so bad. It gets them out of the country more easily than fighting them!)

BaltoCath said...

We're not supposed to like these income inequalities. I know I don't. But I wouldn't want to live in a society where such things were regulated. And as your math shows, calls to do have only one solid justification: Envy.

Anonymous said...

A person deserves all the wealth that a person legally and legitimately produces. No one gets to redistribute from a person who produces to those who do not produce. Socialism - wealth redistributionism - is always wrong.

Now that being said, our corporate excutives in Amerika are NOT entrepeneurs in a free market but corporatists aided and abetted by the government in a mixed economy. They don't EARN wealth; they STEAL wealth and therein lies the difference. No one gets to steal.

Let's put it this way: a man invests in a gold mine, works 12 hour days years on end and eventually becomes filthy rich. HE is entitled to ALL his money; he worked for it.

Now another man who's a financial mercenary goes from compnay to company slashing and burning, and then bailing out with golden parachutes, all the while producing NO new wealth. Is he entitled to millions? Of course not!

Socialism - whether corporate socialism or welfare socialism - is inherently immoral. Read this:

Anonymous said...

That's really pushing it, anon 8:47.