UNIVERSITY OF ESSEX Department of Economics EC 262 Economics of Organizational Management

1. UNIVERSITY OF ESSEX • Department of Economics • EC 262 Economics of Organizational Management • David Reinstein • “WEEK 7”: Managerial compensation • Topics • Empirical general patterns and institutions for CEO compensation. • Principles; Are CEOs too risk-averse? • Deferred compensation, performance pay, optimal intensity incentives for CEOs (the basic ideas) • Readings • Milgrom and Roberts, Chapter 13 • More Advanced: Kevin Murphy, “Executive Compensation” in Handbook of Labour Economics, Volume 3 and references.

2. Supplementary and more advanced readings Good survey article:  Kevin Murphy, “Executive Compensation” in Handbook of Labour Economics, Volume 3 and references. Empirical evidence on pay growth and theoretical explanations Bebchuk and Grinstein (2005). “The Growth of Executive Pay”Oxford Review of Economic Policy. Gabaix and Landier (2008). “Why has CEO Pay Increased so Much?”The Quarterly Journal of Economics. Frydman and Saks (2008), “Executive Compensation: a New View from a Long-Term Perspective.” NBER Bebchuk and Fried (2004). “Pay without Performance: The Unfulfilled Promise of Executive Compensation” Working paper. Murphy and Zabojnik (2004). “CEO Pay and Appointments: a Market-Based Explanation for Recent Trends.”AEA Papers and Proceedings.  The debate: • “Should Congress Put a Cap on Executive Pay?” by Robert H. Frank, New York Times, Jan 4, 2009 … • …versus “Supply, Demand, and Executive Pay” by Uwe E. Reinhardt, New York Times, Feb. 6, 2009 “Economix blog.”

3. Lecture Outline • Motivating managers – principles • Moral Hazard and incentives; motivating effort and discouraging “private goals” • Risk-averse CEO’s; motivating the “right” decisions • Typical components of CEO pay packages, examples • The recent increase in CEO pay • Evidence • Explanations, debate 4. Further issues and questions

4. 1. Principles. How “should” CEO’s and other managers be compensated?

5. Do managers have the “right” incentives? If not, why not? It is difficult or impossible to set up a contract to perfectly align the interests of the CEO and the firm’s shareholders! • Moral hazard • Hidden information • Free-riding of boards? Of investors? • Different portfolios  different attitudes towards risk

6. CEOs have many responsibilities, so how to determine what they are worth? • If the value maximization principle applies and stock markets are strong form efficient, CEOs should maximize the market value of the firm • This is true no matter in whose interests you believe the firm should be run • Even if these conditions do not hold, CEOs should maximize the market value of the firm if you believe the firm should be run in the interest of its owners

7. Moral Hazard and managers

8. Moral Hazard and managers Managers “should” make decisions in the best interest of shareholders, i.e., to maximize the value of the firm, as manifested in the share price. They have incentives to shirk or, more likely to use their position for power, personal gain (leverage for future jobs, perquisites, favours to friends), and prestige. • “Event studies” (analysis of stock-price changes following an announcement) attempt to show evidence of decisions that the market views as unprofitable. • Jensen (1986): managers choose to reinvest windfall profits rather than return them to shareholders. Other evidence of bias towards expansion. Depending on the compensation scheme, their goals may differ from the investors*

9. “Ideal incentive strength” (Assuming one dimension of decisions/effort) To induce a manager to only take decisions in the interest of the firm’s value, and never for alternative interests, she must have “high powered incentives.” More or less, her (lifetime) wealth must increase one-for-one in the value of the firm. (This is essentially impossible unless she “owns” the entire firm … but by this criterion this is optimal)

10. Optimal intensity incentives : • Incremental profits: • CEOs decisions important  more effort high impact on profits  high powered incentives • Precision performance evaluation: • CEOs goal is to maximize share value  performance relatively easy to measure  high powered incentives • Risk aversion: • CEOs relatively risk seeking?? • Responsiveness to incentives: • CEOs have a lot of flexibility to respond to incentives  high powered incentives

11. How strong are incentives? Jensen and Murphy estimated that an extra $1,000 of shareholder wealth is associated with 1.35 cents more salary pay to the CEO. Taking into account other wealth (such as stocks), the largest number they could generate was that CEO wealth rises $3.25 for every $1,000 increase in shareholder wealth

13. What does this mean? If we forget about risk aversion, a CEO would be willing to spend $1 million of shareholders’ money if he would receive $3,250 personal benefits in return Put another way: if the CEO would receive $500 in personal benefits, he would be willing to use more than $150,000 of the firms funds.

14. With small incentives like these, the question is if they work at all The evidence on this issue is mixed, although event studies tend to show that the market rewards incentive programmes.

15. Aside: Hidden information. Managers tend to know more than shareholders about which decisions are profitable, i.e., about which are “good” and “bad” risks. They may choose these investments strategically, given their contract. -- For example, a CEO whose own compensation is insulated from downside risk may always make an investment that is moderately successful 99% of the time but bankrupts the company 1% of the time. If executives have the potential to use this “private information” for personal gain, they must be paid an “information rent” to get them not to do so.

16. Risk-taking

17. Risk-taking Large organizations should be relatively risk-neutral • Shareholders can diversify their investments. • Idiosynchratic risk: like an independent coin flip, not correlated to other risks. • CAPM model: Investors do not care about idiosynchratic risks. They only care about risks that are “correlated to market risk” and thus cannot be “diversified away”

18. Coin flip example Suppose I have £1000, and I can bet on fair coin flips. My returns will have a “binomial distribution”. If I bet all £1000 in a single flip, there is a 50% chance I will lose my entire investment. If I bet £100 each in ten flips, there is a 38% chance that I will lose 20% of my investment. If instead, I bet it on 1000 coin flips, betting £1 on each, there is only 6.00% chance I will lose 5% of my investment or more, and only 1/10th of 1% chance that I will lose 10% of my investment or more.  If I can do this “diversification”, I am facing little risk.

19. Some companies do take enormous risks • Oil companies • Biotech firms Yet, “it is believed” that firms are not taking enough risks Are CEO’s too risk averse? • If so, why, and what can be done?

20. The dilemma: The only way to eliminate moral hazard is for the manager to “own” the firm (or have her lifetime wealth increase £1 for every £1 the firm’s value increases). This is not practical, unless the company is small and the manager is very wealthy. And even if the CEO (or owner) has 100% of her wealth tied to the firm she is undiversified, and less willing to take risks! … so there are difficult tradeoffs to be made.

21. Tradeoffs, issues High powered incentives discourage moral hazard, but they may discourage risk-taking! Incentive schemes are prone to manipulation • Increasing volatility may increase expected pay • Shifting costs into the future (argument for deferred compensation; but this is problematic) CEO’s reputation concerns may help, but are not a panacea.

22. 2. Typical components of CEO pay packages, examples

23. Base Salaries Determination, …, relevant as multiplicative factor for other compensation Use of surveys and “ratcheting” Seem based on crude statistics, little adjustment for age, experience, education, performance

24. Annual Bonus Plans • Mainly explicit • Measures, standards, and slope

25. Performance Measures Various forms and combinations. Especially earnings; “almost all companies rely on some measure of accounting profits" • These pass the "line of sight" criteria • … but they are inherently backward looking and short run, and can be manipulated

26. Performance standards Surprisingly little evidence of the use of relative performance pay • Targets and flat regions:

27. Budget standards Measured against business plan or set goals; most common • Incentive for CEO to "sandbag" the budget • Prior-year standards (year-to-year growth or improvement) • Problem of ratchet effect

28. …performance standards Peer group standards (relative to a select group of peer companies) • Seem underused relative to theoretical predictions Timeless standards (rarely used): • Avoid ratcheting problems • Hard to set the standard. • “Externally determined” standards lead to more variable bonuses

29. Pay-Performance Structures 80/120: Most common payout method! No bonus until 80% of the target, bonus capped at 120% of the target.* Obvious problem: flatness over a large region!** Often convex or concave over the "incentive zone" • Incentive to “inventory” profits (e.g., through “discretionary accruals”) for later period or “borrow” them.***

30. Stock options and other forms of compensation Executive stock options (with various expiries, vesting policies, rules) now the single largest component of CEO pay* Options value (Black-Scholes and Merton) calculation: blackscholesformula.pdf • Ceteris paribus, increasing the (systematic) volatility of the share price increases the options’ value!

32. ... options value from Murphy_ExecutiveCompensation-2.pdf • Looks not so bad, but the CEO can take risks to increase the stock-price volatility and shift this graph up! But if stock price goes “low” and there is little volatility the incentives are nearly “flat” An expensive form of compensation; CEO’s value them less then the market value* • …but they have favourable tax and accounting treatment!

33. USA: CEO compensation (Median total, average composition; log scale) (Frydman and Jenter, 2010, expanding Murphy, 1998)

34. USA: CEO compensation (Median total, average composition; log scale) (Frydman and Jenter, 2010)

35. 3. The recent increase in CEO pay: Evidence

36. Case study In 2000, Jack Welch of General Electric received total compensation of about $125 million, including • $4 million salary, • $12.7 million bonus, • $57 million in options • $48.7 million in restricted stock grants

37. Some rough numbers In the top US firms (those in the S&P 500) in 2003, annual CEO remuneration was (Guess median/avg...)  median was $6.7 million and the average $9 million. In 1980, CEO compensation was ??? times higher than that of average worker… (Guess...) .... 42 times higher in 1980. (Guess: what about in 2000?) …In 2000, CEO compensation was 531 times higher 2010 figure ? (AFL-CIO: 343 times worker’s median pay in 2010)

39. Does it reflect performance? Cotsakos (Etrade) received $77m in a year in which company lost $242m Nacchio (Qwest) received > $100m in a year in which the company lost $4bn and employees were laid off In 2001, Ford lost $5.45bn, workers were laid off and salaries for nearly everyone suffered … but the CEO Nasser who was fired still received $20m

40. Pay of CEOs in US differs from other countries • Average CEO earned in 1990: • 17 times that of average worker in Japan • 24 times that of average worker in France/Germany • 109 times that of average worker in US • Head of Exxon: $5.5m; head of Shell: $500,000 • Main difference between US and other countries is long-term incentive plans (not so much salary)

43. III. CaUSESOF INCREASE, Debate about CEO COMPENSATION

44. Debate about CEO compensation What has caused the growth? Is it “justified”? (Remember: only a change can cause a change!) This matters a lot to “policy”, loosely speaking. If firms are optimally setting CEO pay, then any restrictions or reform may reduce productivity (perhaps because it leads the best CEO’s to move abroad.) On the other hand, according to certain other arguments, e.g., “capture,” the high CEO pay may be both inequitable and inefficient (or neutral). Good discussion in Bebchuk and Grinstein, 2005, pp. 298-302 … they come out on one side.

45. Arms-length bargaining perspective  “Arms length transacting between executives selling managerial services and directors seeking to get the best deal for their shareholders… The [pay] can go up if • The value to companies of executives’ services goes up (demand side) • Executives’ reservation value … outside options … goes up (supply side) • The job’s nature … becomes more demanding or costly” --Bebchuk and Grinstein, 2005

46. “Yes, justified and helpful” CEO’s managing larger firms (larger than before). They contribute more to production (more than before). More pay buys a “better CEO”(and this quality matters more today, and/or the pay-quality tradeoff differs) Higher pay motivates CEO’s to perform “better”(and this motivation has become more crucial and/or more costly).*

47. Gabaix and Lander (2007) In the baseline specification of the model’s parameters, the six-fold increase of U.S. CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large companies during that period.

48. Murphy & Zabojnik (2004) Argue that CEO pay is increasing while boards are becoming increasingly independent, outside hires get paid more than executives promoted from within the firm, and outside hiring is increasing.* They claim that general (transferable) managerial skills have become more important and is well-remunerated, while firm-specific human capital is under-priced but declining in importance.** This is seen to be driving the increasing inequality since the mid-1980's at the “upper tail” in the US, UK, and Canada – see Piketty and Saez.

49. “Neutral” explanations*  Greater social or governmental acceptance of large salaries (relaxing the “outrage constraint” in bull markets). Managers have gained better bargaining power, perhaps because of “transparency” requirements, or because of greater mobility or larger markets**, allowing them to capture a larger share of surpluses.

50. “No, not justified” Managerial Power model Managerial “capture” of pay-setting process; (and this problem has become more serious). The increasing use (and possible misunderstanding of) stock options may have played a role in this. Managers have become more “entrenched,” able to block acquisitions through “poison pills” and thus can demand “golden parachutes” to step down.*