Depending on the method of calculation used, the average Chief Executive Officer makes some 300 times the remuneration of the average worker. That multiple is up from 26 to 1 in 1978. Yet CEO performance has deteriorated, if we measure the economy in terms of productivity and so forth. It is thus clear that most of the rise in CEO pay is undesirable; it is however not at all clear how to reverse it.
“Funny money” and the inexorable rise in the world’s stock markets account for much of this rise, along with an influential 1990 paper by Mike Jensen prescribing stock options as aligning management’s incentives with those of the company’s shareholders. Tax has also played a part, with a 1993 law limiting tax-deductibility of salaries over $1 million being especially influential.
Let us assume that we can do nothing about funny money for the moment, and that if the world’s stock markets dropped substantially, management’s first reaction would be to reprice all its stock options so they remain profitable at the lower price. We must find other means, even without sorting out the economy, to redirect incentives in the corporate sector so that management do not expropriate ever-larger percentages of shareholder wealth. This will be difficult; because of persistent ultra-low interest rates, corporate profits have risen to unprecedented levels, so a profits-based management compensation system inevitably over-compensates management.
During the 1990s, there was in general no expensing of stock options in company accounts provided they were not issued at a discount to the market price, so companies like Cisco could in effect pay out the whole of their profits (when calculated on an actuarial basis) to management, without worrying about shareholders at all. Then in 2005, the accountants finally started expensing options according to their “fair value” but with that value being very often heavily understated.
That made company accounts more reasonable, but it still left stock options with a huge tax advantage to their recipients, because no tax is payable by the recipient until the options are exercised, so executives receive compensation of a very significant value without paying tax on it. In addition, since holders of stock options do not receive dividends, their mass issue has caused companies to suppress cash dividends, instead indulging in huge stock buybacks. These are pro-cyclical, because management over-purchases stock in good years (very often dividends plus buybacks exceed 100% of earnings) then must undertake emergency share issues at a huge discount in the next recession.
The time has come to examine coldly Mike Jensen’s 1990 theory that rewarding management with stock options would benefit the economic system as a whole. Jensen claimed that doing so would align management’s interests with those of shareholders. It is patently obvious that it has not done so – the question of share buybacks is just one area where management’s incentives and the interests of shareholders are now in direct opposition.
In general, experience has shown that stock options incentivize management to make the stock price as volatile as possible. Indeed, a recent study has shown that a 10% increase in stock option grants increases the volatility of stock prices by 4.2%. This makes sense: if share prices zoom up and down, management can cash in its stock options during the highs and reprice them or issue new ones during the lows, thus assuring itself bonanza returns while diluting outside shareholders out of existence.
Beyond the problems of dividends and volatility, there is also a question of time horizons and business strategy. Of course, many shareholders hold only for a limited period in the hope of speculative gain, and that tendency has increased, exacerbated by 22 years of funny money. Nevertheless, the long-term, stable shareholders that are healthiest for other stakeholders in the company – its employees, customers and neighbors – are badly affected by management’s option-fueled behavior. Irene Rosenfeld’s 11-year career as Mondelez’ CEO, for example, may have done reasonably well for shareholders in an era of funny money and excessive leverage, but it has left a trail of devastation among such long-standing corporate icons as Kraft and Cadbury’s, with plants closed in defiance of pledges to government, tens of thousands of workers thrown onto the unemployment lines and much-loved products and business lines wrecked.
Corporate turbulence imposes a lot of negative externalities on the economy and especially on employees and customers, which are often not properly captured in corporate income statements and balance sheets. Option-remunerated management is short-termist and faddist, wasting corporate resources on supporting campaigns on immigration and the environment, for example, that are not in the best interests of shareholders, employees or customers. If top management is in a company simply for a quick boost to its net worth, the interests of everyone around it are likely to suffer.
It is thus clear that we need to move away from stock options as a form of remuneration, since they do not properly align management’s interests with those of stockholders. The corporate ideal should be Emerson Electric (NYSE:EMR), a worldwide company with 103,000 employees, which has increased its dividend in every year since 1957, thus providing admirable and reliable rewards to the longest-term of its shareholders. It has also had only three Chief Executive Officers since 1954, the current incumbent, David Farr, having been in place since 2000 and last year being remunerated at a relatively modest $3.51 million. Yet Emerson is involved in a fully global business in a number of high-tech areas, indicating that its long-termist approach is completely compatible with innovation, change, and globalization.
Given the immobility of current economic policies, the secret to transforming companies from Mondelezes to Emerson Electrics appears to lie in the tax system. For a start, repeal the absurd 1993 Clinton-era regulation that prevents companies from expensing base salaries of more than $1 million. $1 million is not very much these days, and we want CEOs to be motivated by the long-term health of their companies, aiming to remain in their positions for as long as possible. A higher base salary will tend towards this.
On the other side of the ledger, we want to discourage CEOs from playing games and short-termism; the way to achieve this is to attack stock options. Stock options are already inadequately expensed in corporate income statements, but correcting this would probably not have much effect except for the most egregious abusers like the 1990s Cisco. However, the grant of valuable stock options to executives is currently entirely tax free, unless the option price is at a discount to the current stock price. This needs to change; just as companies are able to deduct the “Fair value” of stock options they grant, so executives receiving those options would be taxed on that “fair value.” When stock options were exercised or sold, the tax paid at the start would be offset against any capital gains tax payable.
This would greatly discourage stock option issuance, and would encourage the issue of restricted shares, which are currently taxed on their full value when they are issued to executives. Unlike stock options, restricted shares pay dividends and do not give executives an incentive for excess leverage and over-risky strategies. Instead, executives with restricted stock have the incentive to manage the company in a long-term-oriented fashion, thus replicating the management approach of companies like Emerson Electric. If necessary, a modest discount of perhaps 20% could be applied to the initial taxation of restricted stock, recouped when the stock was sold, which would further encourage its issue to management and retention by them.
In the 1970s and 1980s, leveraged buyout artists and academics like Jensen accused U.S. corporate management of a “country club mentality” of preferring to enjoy their relatively modest remuneration without engaging in high-risk financial and other projects. In reality, a country club mentality in top management is much better for workers and customers than an overleveraged hyperactive financial engineering approach, where every six months brings a new acquisition or divestiture, with another billion dollars of debt added to the balance sheet. Genuine innovation happens in companies where the innovators are not constantly peering over their shoulders in fear of losing their jobs – AT&T’s Bell Laboratories was the most innovative operation of the last century and its employees enjoyed almost perfect organizational stability.
Flat modest salaries and equity participations based on outright share ownership. That’s what is needed to bring U.S. CEOs back to a proper sense of their long-term responsibilities – and by deft adjustment of the tax system, we can orient their remuneration in this direction.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)