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July 16: Curbing Executive Pay Incentives Would Devastate Shareholder Equity, Indicates Carnegie Mellon Research


Mark Burd           

Curbing Executive Pay Incentives Would Devastate
Shareholder Equity, Indicates Carnegie Mellon Research

Analysis Finds Increase in Executive Pay Over 60-Year Period
On Par With Rise in Per Capita National Income

PITTSBURGH—Eliminating incentive-based components of executive pay packages — such as bonuses, stocks and options — could cut the value of U.S. firms by half over a period of just eight years because executives would have less reason to be mindful of shareholder interests, particularly in larger firms that are more difficult to manage, according to research from the Tepper School of Business at Carnegie Mellon University.
For example, the research predicts that financial returns in the aerospace industry would fall by almost 9 percent per year if the chief executive officers in each firm were paid a fixed wage. At the heart of these findings is the concept of moral hazard, in which an executive insulated from risk through a fixed wage may behave differently than one who was fully exposed to the risk associated with the management of the firm. The study is forthcoming in the American Economic Review.
"Properly designed incentive-based pay helps to discourage excessive risk-taking, and eliminating such compensation would undercut the critical role that it plays in ensuring the alignment of interests between shareholders and executives," said Robert Miller, professor of economics and strategy. "Such a change would do serious harm to the fiscal health of corporations and the wealth of shareholders, which in some cases is the U.S. taxpayer."

A more accurate measure of executive compensation
Co-authored with fellow Tepper School Professor George-Levi Gayle, the study uses a more accurate measure of executive compensation that goes beyond year-to-year earnings to take into account an executive's existing wealth in company stock and options, and the effects of his or her management on the performance of those holdings. "The total value of previously held stocks and options are often overlooked by analysts but represent the most volatile component of executive pay packages," Miller said. "An executive's total compensation can lead to windfalls during successful years but also yield situations where an executive loses a significant amount of wealth by working at a particular company."
Applying this new methodology and adjusting for the risk associated with a highly uncertain income, Gayle and Miller determined that CEO pay at an average-sized firm that maintained their size from 1944 to 2003 increased by a factor of 2.3, which is approximately equal to the growth rate of per capita national income over this same period. Per capita nonwage income - such as dividends and interest income - grew more quickly during this time period than average wages, which rose by only 55 percent.
In the case of the aerospace industry, average risk-adjusted CEO compensation between 1944 and 1978 for sampled firms employing an average of about 50,000 workers was $450,000 (measured in Year 2000 dollars), while average risk-adjusted compensation between 1993 and 2003 — when firms averaged more than 58,000 employees and had more than 10 times the asset value — was $1,314,000. Taken together, these findings fly in the face of widely held beliefs that high-ranking executives have seen their earnings skyrocket compared to the general population without good reason, such as increased volatility of earnings.
Not surprisingly, the authors found that CEO pay does increase with firm size, and firms achieved an average of triple the sales and six times the asset value over the 60-year time period. According to the study, the dramatic increase in the size of the firms that executives are being asked to manage is the single most significant factor explaining the rise in executive compensation, with its attendant moral hazard problems of incentivizing managers to maximize shareholder value. This has led compensation boards to leverage executive pay to more closely track firm value, and consequently increase the cost of the risk premium required to attract qualified people to positions of leadership in industry.
"Fundamental misunderstandings about executive pay have led many to demonize compensation practices that are not only on par with the rise in national income, but benefit shareholders as much or more than CEOs," Miller said. "Policymakers and citizens making the case to eliminate such compensation should carefully consider the consequences to ensure that government actions don't inadvertently diminish the worth of U.S. corporations, a recipe for disaster in the current economic climate." 
The study analyzed a wide range of compensation and firm data — primarily from the S&P ExecuComp, S&P COMPUSTAT North America and the Center for Securities Research (CSP) databases — for the aerospace, electronics and chemicals industries from 1944 to 1978 and 1993 to 2003.
The paper, "Has Moral Hazard Become a More Important Factor in Managerial Compensation?," is available for download at