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Studies Fault Current Systems for Executive Compensation

A paper on the growth of U.S. executive pay, written by Harvard Law professor Lucian Bebchuk and Cornell University professor Yaniv Grinstein, highlights the importance of the ongoing debate over executive compensation. The paper found that executive compensation between 1993 and 2003 grew at a level beyond that which could be explained by changes in firm size, performance and industry classification. Bebchuk also released a paper co-written with University of California law professor Jesse Fried on the flawed compensation arrangements at Fannie Mae between 2000-2004. The Fannie Mae paper calls for a reform of the executive pay and corporate governance systems.

Executive pay has been economically meaningful, according to the Bebchuk and Grinstein study. They defined annual compensation as the grant-date value of the compensation package in the year it was given which included salary, bonuses, long-term incentive plans, restricted stock awards and the Black-Scholes value of options granted. To adjust for inflation, the study is based on 2002 dollars. The aggregate compensation paid by public firms to their top five executives during the 1993-2003 period was about $290 billion, which accounted for 6% of the aggregate profits of the firms during that period. Executive pay accounted for 10.3% of the aggregate profits for the period between 2001-2003.

Among S&P firms, the study reported that average CEO compensation rose from $3.7 million in 1993 to $9.1 million in 2003, an increase of 146%. The average compensation for the top five executives rose 125%. The study found that the increases in equity-based compensation were not accompanied by a reduction in cash compensation, suggesting that directors did not use equity-based compensation as a substitute for "performance insensitive" cash compensation.

The equity-based compensation was not designed in the most cost effective way to provide the best incentives, according to the study. The study suggests that the use of options made large compensation amounts more defensible than a large outlay of cash. The growth in equity-based compensation has not been accompanied by a significant reduction in cash compensation, the study noted, and compensation growth has been correlated with weak shareholder rights. The potential costs of flawed compensation arrangements could be very meaningful for investors.

The study of executive compensation at Fannie Mae identified four problems with the arrangements. They richly awarded executives for reporting higher earnings without requiring the return of the compensation if the earnings turned out to be misstated. The arrangements provided "soft landings" for the executives who were pushed out by the board. The study concluded that even if the executives had retired after years of unblemished service, the value of their retirement packages would have been largely unrelated to their performance in office. Finally, the study found that Fannie Mae was not transparent about the total values of the retirement packages in its disclosures.

Bebchuk and Fried noted that Fannie Mae's pay arrangements are typical of those of other public company executives rather than an exceptional aberration. This generous treatment of managers who have not performed well weakens their incentives and imposes costs on shareholders. Executives frequently receive substantial payouts when they leave that are unrelated to fund performance.

The authors said the case of Fannie Mae highlights the importance of reforming compensation practices and called on the SEC to adopt more stringent disclosure requirements. For example, the SEC should require companies to state the dollar amount of retirement benefits, in the authors' view. They also called on institutional investors to pressure companies to improve the link between pay and long-term shareholder value. The authors called for the adoption of reforms that make boards more accountable to shareholders and more attentive to the costs imposed by flawed pay arrangements.