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Hal Weitzman: Chief executives of S&P 500 companies are paid, on average, about $10 million a year. That’s 200 times US median household income. In surveys, people say that’s too much, and policy makers are responding. The European Union is capping banker bonuses, and in Switzerland, voters have overwhelmingly backed limits on pay for all top executives. But CEO pay has actually fallen since 2000, and inequality, though still vast, has narrowed since the financial crisis. So are CEOs overpaid, and what should be done about inequality?
Welcome to The Big Question, the monthly video series from Capital Ideas at Chicago Booth. I’m Hal Weitzman, and with me to discuss the issue are a pair of Chicago Booth faculty heavyweights.
Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance and the David G. Booth Faculty Fellow at Chicago Booth. He’s president-elect of the American Finance Association and the author of the books Saving Capitalism from the Capitalists and A Capitalism for the People.
And Steven Kaplan is the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at Chicago Booth. He’s an expert in private equity, venture capital, and corporate finance, and he serves on the boards of several companies.
Panel, welcome back to The Big Question.
Steve Kaplan, are chief executives overpaid?
Steven Kaplan: So that’s a very complicated question. As you mentioned earlier, CEOs are paid a lot, and they’re paid a lot relative to the typical person. And there’s this perception that they’re overpaid. I think part of the reason they have this perception is that if you read the press, pay keeps going up and up and up and up, and CEOs are never disciplined.
And as you said, in fact, pay for the S&P 500 CEOs has gone down by almost 40 percent, or roughly 40 percent, since 2000. So there are misconceptions that are pretty marked in this area. So now the question is, are they overpaid?
I think there are two ways to look at that. One is whether it’s fair, and that’s where it’s really, it’s a judgment call that depends on your political perspective or many things. And I think some of that is where this perception comes from.
But what I looked at, and the question I asked is, are CEOs paid more than their market value? And when you look at it that way, it’s actually hard to see that they’re overpaid, and let me give you a few examples.
First of all, if you look at what CEOs are paid relative to other people at the top, so let’s say the top .1 percent, the CEOs of the S&P 500 companies are about where they were 15, 20 years ago relative to the top 0.1 percent, meaning that their pay hasn’t gone up by any more than other people who’ve done well.
Lawyers, for example, you look at law partners who are businesspeople or who are doing things related to business, their pay has gone up by about the same amount as S&P 500 CEOs. If you look at CEOs and executives of private companies, these are companies where they’re probably being run by either a family or large shareholders, the pay of executives in private companies appears to have gone up by more than the pay of public company CEOs. So if you look at—
Hal Weitzman: What do we learn from that?
Steven Kaplan: What we learn from that is that if you worry that public company CEOs are somehow overpaid because they’re taking advantage of their boards, you have to ask, why has their pay gone up by less than private company CEOs, where their boards are either themselves or large shareholders?
So there’s no way for them to be taking advantage of an agency problem or of the fact that it’s other people’s money. They’re getting paid from either their money or shareholders’ money, and their pay has gone up by more than the public company CEOs.
The other thing that’s very interesting, if you look at CEO pay at the S&P 500 to net income of the companies, that ratio is the lowest it’s been in 20 years. It’s actually gone down since 1993. So the CEOs are taking a smaller percentage of the annual income of their companies. So you look at it on all those dimensions, and, again, from a market perspective, it’s hard to see today that they’re overpaid.
And one other thing I’ll mention, since Dodd-Frank, we’ve had to have a say-on-pay vote every year—
Hal Weitzman: The overhaul of US financial regulation.
Steven Kaplan: The overhaul of US financial regulation. In there, it required a shareholder vote that was advisory on the pay of top executives in US companies. And we’re now in our third year of that, and in every year, at least 97 percent of the companies have gotten a favorable vote.
And in fact, you see commentators, liberal commentators, who are very upset that the say-on-pay rule hasn’t worked. It hasn’t worked, not everybody is getting approved. And my response is, well, there was not a big problem in the first place, so of course they’re getting it.
Hal Weitzman: So it has worked.
Steven Kaplan: Well, there was no problem for it to address, or it wasn’t a big problem to address. It addresses the outliers, so the 3 percent who are not doing a good job, it puts attention on them. It focuses attention on them, but for the typical company, which is what, again, I’m arguing, the typical company, the typical CEO is reasonably paid. They’re getting very positive votes, and so it’s not a surprise to me. It is a surprise to the people who thought the system was broken.
Hal Weitzman: Luigi Zingales, let me bring you in, because your Financial Trust Index, that’s a survey that you run every quarter, that’s the one I cited earlier where two-thirds of regular Americans say CEOs are overpaid.
Are they wrong?
Luigi Zingales: It’s very hard to tell whether they are overpaid or underpaid. Are we faculty overpaid or underpaid? It’s very hard to tell. I think that—
Hal Weitzman: (laughing) That’s a loaded question. I would never answer.
Luigi Zingales: But I think the reality is they are poorly paid, not certainly paid poorly, but poorly paid in the sense that the way they are structured, the compensation, and also the decision process is not very linear, transparent, and the decision process that a priori will lead to a good outcome.
In situations where it’s very hard to tell whether the outcome is correct or not, we need to look at the process, and the process is not a good process. So let me tell you why. First of all, we know that they get paid a lot for luck. So if I am a CEO of an oil company, I get rewarded tremendously if the oil price goes up.
It’s not my merit if it goes up, and it’s not honestly my fault if it goes down. But the problem is that most CEOs, if the oil price goes up, they benefit tremendously through their stock options. If the oil price goes down, then they should use stock options to compensate for the fact that it went down.
So it’s a game in which if it’s head, I win, if it’s tail, you lose. And so, many of the measure that Steve used in his research is ex ante pay, and that ex ante pay
does not factor in this repricing, which can be important in some moments. So I think that clearly they’re poorly paid in that dimension.
Second, we know from the research of [Lucian] Bebchuk at Harvard that there’s a lot of camouflage going on. So if I’m not embarrassed of what I’m paid, I should disclose. I should not try to hide it in a lot of forms. And it seems that they do. So at the very minimum, they are overpaid according to public opinion. They are afraid of that, and they hide it.
And third, I think especially in publicly traded companies in the United States, boards are not really independent. They are sort of friends. It’s very costly for a board member to take an aggressive position against a CEO. Basically, either you fire him or her, or you wanna be nice with him or her to collaborate. And it’s not really conducive to collaboration that I am stingy in paying you upfront. And so the result is that I tend to overpay because in the grand scheme of things you say, it’s worth more to have a nice relation with the CEO rather than ruin this for a few million dollars.
So is this a disaster on average? Probably no. I think Steve is right on average. But we clearly have an upper tail of distribution, which is completely outrageous, and two, I think much of what he observes is the result of social pressure and regulation to try to reign this in. And it’s true, he’s absolutely right that say-on-pay overall was positive because CEOs and boards are very much afraid to be turned down. So they change their behavior ex ante in anticipation of that. So the fact that he finds, and we can discuss, how big is this decrease? The fact that he finds that this compensation goes down a bit is precisely because there is a societal pressure. Without it, we would’ve seen an explosion even more extreme.
Hal Weitzman: Steve Kaplan, what about this point about the transparency of the process?
Steven Kaplan: So let me just respond to that. Actually, since say-on-pay went into effect, pay has gone up. It went up the last two years somewhat because it had been particularly low in 2010. The UK experience is that CEO pay went up, in fact, by more than it did in the US since say-on-pay went in. Say-on-pay went in in the UK in 2002 or ’03, and since that time, CEO pay in the UK has gone up by more than it’s gone up in the US.
So it’s not clear that what you said is correct. It’s also the case, again, it’s hard for, what you said, for you to explain why CEO pay has gone down by almost 40 percent since 2000.
Luigi Zingales, But Steve, it went down from the peak of 2000.
Steven Kaplan: It did go down from the peak.
luigi Zingales: This was one year. You had the bubble, a lot of things, so if you take one part—
Steven Kaplan: Since 1998 it’s down.
Luigi Zingales: No, if you look at the median . . . I look at your data—
Steven Kaplan; The median is flat. The median is flat—
Luigi Zingales: The median is flat, so let’s look at the median.
Steven Kaplan: The median is flat.
Luigi Zingales: You always said that the median is a better measure, so let’s look at the median.
Steven Kaplan: No, ’cause you’re talking about outliers—
Luigi Zingales: No.
Steven Kaplan: The difference between the mean and the median says the outliers—
Luigi Zingales: But let’s focus on the 95 percentile. Has the 95 percentile gone down?
Steven Kaplan: Yes.
Luigi Zingales: I don’t know.
Steven Kaplan: Yes, absolutely, ’cause there are fewer outliers. So that’s one response. The relative versus absolute pay is a harder one that Luigi mentions, and in theory, you wanna be paying CEOs for the things they can control. You can’t control the price of oil, so you wanna see, say, some relative pay. And I think the real question there is, what are the costs and benefits of going to a relative pay versus an absolute?
And there it’s a little less clear to me, because private-equity investors who have an incentive to put in, call it “optimal pay packages,” they don’t use relative performance. It’s all absolute. So when they invest in a company, if it’s an oil business and the oil price goes up, their CEOs get paid for luck, as well. And if this were such a great thing to do, to put in relative performance, you would think they wouldn’t do it.
Two, they’re—
Hal Weitzman: What about that point? Should oil chief executives be paid for the high price of oil?
Steven Kaplan: I think the private-equity investors do that. I think that the two arguments for allowing absolute performance, or there are three arguments, actually, for allowing having absolute performance measures—and again, this is something that’s ambiguous. I can see the reason to have relative performance, but there are three reasons. Let’s hope I can remember them.
Number 1, let’s say you are operating in more than one business. You’re operating in two businesses. Well, and let’s say one business is tanking, but it’s tanking less than the competitors. The other one is doing well, but is doing as well as the competitors. If it’s relative performance, I’m gonna focus on the one that’s tanking and not move to the one that’s not tanking. And so absolute performance, I’m gonna do the right thing. I’m gonna get out of the one that’s tanking and go to the business that is doing better.
So that’s one reason. And many of these larger businesses are multidivisional and more than one business, so you care about that.
Number two, it’s confusing to do relative versus absolute. Absolute, if I’m the CEO or the top executive, I know exactly how to measure it. I know how I’m doing. When it’s relative and it depends on competitors in particular, then it’s confusing. Yeah, you may wonder, oh, it shouldn’t be confusing, but I can tell you from experience, people find it confusing.
And the third reason why you might have a problem is, let’s say you’re in a business and you hit a bad recession, the value of the business gets cut in half or the value of the industry gets cut in half, but your business only goes down 25 percent. Well, now you’ve got a 25 percent advantage.
You’re gonna get paid a lot in a period where you’re probably firing a lot of people, and the optics on that, paying someone a lot while there’s this huge pain creates a lot of internal politics and external politics that are problematic. So those are three reasons why relative pay has some costs, and the question is whether the benefits exceed those costs, and it’s not at all clear.
Hal Weitzman: What about this, the process, though, this question of transparency in how pay is determined?
Steven Kaplan: The process today, and this is where I probably agree with Luigi, is that I think it’s gotten better over time, that it was maybe not so transparent and boards might have been more tied to their CEOs. I think over time, the boards have become more independent, and partially maybe because of the public outcry and scrutiny and maybe say-on-pay. And so say-on-pay has some negatives, but it has some positives. And so now the process is more independent. Compensation committees hire an outside . . . they hire their own consultant rather than the company. And the process is more independent and more transparent than it was five or 10 years ago, and I think those are good developments.
And so the process has improved. And I guess where we might disagree . . . I don’t know if we disagree or not. I think it’s at a very good place now, and there are some who would say that it’s still very problematic.
Hal Weitzman: But if it’s the market determining pay, aren’t we always at a very good place, because the market is efficient so we should always be at the right point?
Steven Kaplan: Nothing is ever perfect. But the question is, can you make it better, and how much better can you make it? And that’s where I would say the system works reasonably well. In 1999, whether it was working or not, that’s also a . . . that’s a harder question.
Hal Weitzman: Luigi Zingales, what do you make of this EU proposal to cap bankers’ bonuses? Will it work? Is it the right instinct?
Luigi Zingales: It’s the wrong instinct to come in so dramatically with the cap. I think it’s the result of too long without doing anything, of doing very little. I think that there’s clearly a lot of resentment among people, even in America, even more so in Europe. This resentment is particularly strong against bankers, and partly I think for right reasons and partly maybe for wrong reasons, but in part for the right reason. And there doesn’t seem to be—this is the most shocking part in my view—is that among many companies and many banks, there doesn’t seem to be some awareness of this feeling.
So the natural thing, even Steve who is sort of extreme free market here, said, “We look at the optics of some things.” And the optics of these people being paid gigantic bonuses in the face of the collapse of the financial system is terrible. And what is terrible, what shows to me that there’s not really a deep understanding, is there is not even a sense of a bit of embarrassment.
When I testified in Congress on the Lehman bankruptcy, they were talking about the email that the Lehman board exchanged. Now, generally, we’re not privy of this information, but because this was a congressional hearing, they had access to their emails. And what was fascinating to me is that just shortly before, actually in the fall of 2007, one of the board members had this very good idea of saying, why don’t we forgo the bonuses and use this bonus to recapitalize Lehman?
So Lehman would not have gone bankrupt had they done that in the fall of ’07. Now, everybody else on the board started to make fun of him, saying, what did you drink this morning? So this shows, first of all, extremely bad corporate governance, but also, complete lack of sensitivity with what’s happening. And I think that the reaction of the EU is an extreme reaction that if it keeps going that direction is bad, but it’s justified by this lack of reactivity.
I think that the bankers’ pay is a problem. We’ve seen now that, for example, UBS has restructured in a major way the payment of bankers, and much of the bonus is forgone if results within a certain number of years are poor, and so on and so forth. I think that’s the direction we should take. And I think the smartest bankers have understood it. Hopefully, the other ones will before it’s too late, before we have bad regulation and tie our hands.
Hal Weitzman: Steve Kaplan, would it be good to hold back pay for bankers for a certain number of years and see how their companies perform?
Steven Kaplan: I largely agree with Luigi on that. I think that the ironic thing is that a number of the banks were doing that, and Goldman had a history of putting a lot of pay in stock and making you hold it for quite a while. I think Bear Stearns and Lehman did that too. They may not have done it as much as they should have. But in all three of those cases, the financial crisis happened and a lot of those executives lost a lot of money, and I think probably most of them wish they had behaved differently.
But I think the short answer is it’s a reasonable thing to do, is to push it into the future rather than to limit it, because if you limit it, you will get . . . the best people will go to places where they can make more money.
Hal Weitzman: Or the banks will just get around the rule, which is what they’re trying to do–
Steven Kaplan: By raising the base pay rather than the bonus, that’s correct.
Hal Weitzman:I wanted to ask you, Steven Kaplan, about this criticism we often hear about short-termism, that these vast salaries, performance-based bonuses, reward short-term behavior at the expense of long-term shareholder value. What should we make of that?
Steven Kaplan: Let’s take the financials out of this, or the financials and the investment banks. It’s more ambiguous. I don’t think that was the root cause, but people will argue on that, particularly lower down in the organization.
If you look at the nonfinancials in the US, the nonfinancial companies have done spectacularly well over the last 20 or 30 years. When I said CEO pay to net income is at its lowest level in the last 20 years, at a time when CEO pay, we know, has gone up quite a bit, it’s ’cause net income has gone up by more. And so for people that have been criticizing short-termism for the last 20, 30 years and yet the US companies have performed extremely well—
Hal Weitzman: So over the long term, short-termism has turned out to be a good thing?
Steven Kaplan: Over the long term, whether it’s short, and so this is my second answer, short term and long term, when you see a lot of cases when companies are complaining about the short-termism of the market, it’s because their short-term results are poor. And I would say in some cases it’s probably the case that, gee, we are investing for the long term and the market has gotten it wrong, but in the majority of those cases, it’s because not only is the short term a problem, but so is the long term, and they’re using the short-termism as a scapegoat for the fact that their results are not good.
And maybe the best example of this is the activist hedge funds. Those are the ones where everybody complains, oh, they’re short-term oriented and they’re looking for a short-term hit and in the long term, the company will have a problem.
And Lucian [Bebchuk] and two of our alums, Alon Brav and Jei Wiang, or Wei Jiang, excuse me, have a recent paper where they look at the activist hedge funds, the companies they’ve gone after, and then what happens in the next five years. And those companies outperform over the next five years.
So I think the short-term story, on average, is just not consistent with the evidence. In particular cases, sure, but again, you care about on average.
And the other thing that happens, you do see some companies respond to what they perceive as the short-termism of the market and they might make decisions to hit earnings that I think they shouldn’t, but it’s a management issue perhaps rather than a market issue.
Hal Weitzman: I want to ask about the bigger question of inequality. One of the reasons that people are concerned about CEO pay is just because of this divergence over many decades between worker and bosses’ pay. Luigi Zingales, how concerned should we be in economic terms about inequality, and what should we be doing about it?
Luigi Zingales: I think we should be very concerned about inequality, not only from a social perspective, but also, if you want, from an economic perspective, because in my view, in order to have a well-functioning marketplace, you have to have a consensus for the system. And the consensus is not easy to achieve when there is enormous inequality. I think what makes the United States so special in the grander scheme of the rest of the world is historically how much consensus there was for free market, and I think that the development in this country owes a lot to that. And that consensus owes a lot to the fact that there was a prosperous middle class. The generation that ended World War II was able to buy a house and their kids’ college and be much better than their parents.
And what is scary to me is not so much the inequality, but the fact that the lower part of the distribution, and increasingly so, the larger part of the distribution is not increasing. So the fact that the average American male who is 25 today makes in real term less than his father, that’s a big worry to me.
Hal Weitzman: Steven Kaplan, should we be concerned about inequality?
Steven Kaplan: Absolutely, and for all the reasons that Luigi said. I think the really hard question is, what’s the right policy to combat that? And that’s where, I suspect, there’s more disagreement, because on the one hand, one reaction is you just redistribute and that solves the problem.
And I think we’ve seen in Europe, Western Europe, that that does not work. And France is the poster child for that where they’re trying to do it, and it just doesn’t work because the capitalists or the people at the top just leave or they don’t invest. You have this situation today where I think what’s driving this inequality has been technological change, globalization, scale, and that’s a force that is a global force. It has really benefited a lot of people.
So this is the thing that even makes it harder. You go to China, you go to India, you go to Africa, the number of people living above the poverty line today is hundreds of millions, if not billions more than 20 or 30 years ago. It’s been wonderful for a lot of people in those places. It has not been good for the less skilled in the US and Western Europe, and that’s the conundrum.
You have this real strong force that isn’t going away, and the question is, how do you deal with it?
Hal Weitzman: Well, what’s your response?
Steven Kaplan: So my response would be that you wanna do two things at a minimum. Number one, you do wanna have a strong safety net at the bottom. That is, I think, important for the reasons Luigi mentioned. I think the second thing, which the US has gone in the opposite direction, is you wanna make labor markets more flexible, not less.
And I think some of the things that we see with a minimum-wage raise, labor markets providing this and providing that, makes companies . . . it exacerbates the forces that are already there for companies to use technology to replace workers.
It exacerbates the incentives to go overseas. I think what you wanna do is put in incentives to hire and to make it easier to hire rather than harder, ’cause when you hire people, then they get skills and they have an ability potentially to rise.
And of course, in Europe, where you have the worst labor-market rules, that’s why you have such huge unemployment in Spain, France in particular, for the young and the less skilled. And the one country that’s actually made their labor markets more flexible over the last 10 or 15 years? Germany.
Hal Weitzman: Luigi Zingales, would loosening the labor market rigidities actually decrease inequality?
Luigi Zingales: I’m not so sure about that. I agree with the first point of Steve, I think, the importance of the safety net. I will emphasize the second aspect, which is redistributing opportunities not outcomes. I think that the typical approach, the socialist approach is to redistribute outcome.
I think that the right approach is the golf approach. You don’t decide after the game who has won or not, redistributing outcome. You put a handicap at the beginning. And I think that we should learn from that in our society, especially in a world—I think Steve is absolutely right—that we have a combination of globalization and technology that basically increases the return to the winner. And as pioneer work done by late faculty member Sherwin Rosen shows in “The Economics of Superstars,” the incentives become very distorted, because if you start a little bit behind, your chances of becoming the first is very small, and so your reaction is to give up early on.
So while, if the outcome were more equal, there was more incentive for everybody to participate and starting a little bit ahead was not such a disaster. Today, it is. And so we need to provide better education for everybody, because I think that if you are wealthy and you can send kids to private school, you give them an enormous advantage in life that they don’t have otherwise.
We should try to make the market more competitive, and not just the labor market but every market. And I think that, for example, the private-equity market is a very nontransparent market in which incumbents have a huge advantage. People with a network have a huge advantage. Those things are not equalizing aspects. I think we need to work more on that dimension.
Hal Weitzman: Well, on that note, I’m gonna call time. My thanks to our panel, Luigi Zingales and Steven Kaplan.
For more research, analysis, and commentary, visit us online at chicagobooth.edu/capideas. And join us again next time for another The Big Question.
Goodbye.
(light piano music)
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