As a self-described “capitalist,” the idea of restricting executive salaries is as repugnant as 6 week old milk. However, a variety of changing factors in the last 30 years have necessitated the need for compensation restrictions for employees of publicly traded companies.
The primary factor compelling pay restriction is the proliferation of 401(k) retirement plans in American employee’s compensation plans. With the popularity of mutual funds, specifically index funds, a large percentage of Americans now own a small piece of hundreds of public companies. However, by design, these investments are without management in order to keep investing fees to a minimum. The lack of management allows board of directors and CEOs to compensate themselves without restriction.
While the “passive” index funds increase in popularity, by dilution, the “active” funds have more voice in company decisions. But because active funds usually hold stocks on a short-term basis, accordingly, those funds have only short-term earning perspective. In short, the voice of long-term investors is being squeezed out of publicly traded companies.
More and more Americans are becoming 401k investors and are increasingly dependent on their accounts for retirement. As a result, the executives of publicly traded companies have taken the role of a trustee of the American public’s money. Should these executive reward themselves with earnings of 300 times more than the average worker when their increasing compensation levels show no correlation with stock performance? Because CEOs are proving they cannot be trusted, the time has come for Restrictions on Executive pay.
The first major argument against limiting executive pay is that anybody who is being significantly undercompensated for her ability will simply go to another company or work for a European bank. So any proposal to limit executive pay will have to face the realities that big US companies need to attract top talent in order to thrive.
A second argument against limiting executive pay is that executive pay is a drop in the bucket compared to actual earnings. I concede that executive pay is a drop in the bucket compared to actual earnings, but when companies are earning LESS THAN ZERO (like losing BILLIONS of DOLLARS), then this argument is no longer sound.
The third major argument for against limiting executive compensation is that executives already do what is in the best interest of the company because their compensation is tied to stock options. This is true, but with the caveat that executives do what is in the best interest of the company for AS LONG AS THEIR STOCK OPTIONS INCENTIVIZE it. Therefore, if the compensation plan incentivizes that the stock options be excercised two years out, the executive will run the company to maximize the share price in the next two years. However earnings for the company in the next two years may not be the best thing for the long-term health of the company, which is what 401k investors care about.
My criticism of the third argument is that yes, executives are incentivized by stock options to do what is best for the company, but this strategy simply promotes risking company money for personal gain – the lure of lucrative stock options dwarfs the fear of failure. To put this in some perspective, let’s take a mid-level manager making $75,000 per year. His contract states that he will get a 25% commission on profitable contracts that he closes. An extremely risky contract that will be worth $10M is proposed by a Chinese company. Because the contract is for pseudo-military equipment, the shipments will be subject to restrictions imposed by the department of commerce. Lured by the attraction of receiving a $2.5M bonus, the manager ignores the risks, signs the contract and starts an engineering and production effort to build the required product.
After a huge cash outlay, the product shipments are seized by the commerce department and not allowed to be sold to the customer. The manager is fired for taking on so much risk. However, confronted with the opportunity to earn $2.5M compared with the fear of losing his job, the manager chose the high risk for the company because of the potential personal reward. After all, the manager will likely be able to find another job at his previous earnings. On a much larger scale, executives face this same dilemma.
Part II will look at what solutions have already been implanted and discussion of what an ideal solution would look like.