Compensation packages for executives have skyrocketed even as wages for the rank and file have flattened, leading critics to ask: Do CEOs really deserve such exorbitant pay? Well, actually, they might!
This is a surprising argument recently posed by Anup Srivastava, an assistant professor of accounting information and management at the Kellogg School. But while some CEOs are signing lucrative contracts, others are accepting very modest pay, at least in terms of base salaries. Clare Wang, also an assistant professor of accounting information and management, recently investigated the rationale behind the one-dollar CEO salary. Both agreed to sit down with Kellogg Insight to discuss some of the latest trends in executive compensation. Here is an excerpt from our conversation, edited for length and clarity. Listen to the accompanying podcast to hear more.
Kellogg Insight: Anup, I’d like to start with you. Can you give us a bit of a perspective on just how much executive pay has risen with respect to the average worker’s pay?
Srivastava: In an American context, the average ratio of a CEO’s total compensation to an average worker’s salary has increased from approximately 20 to 30 times to approximately 300 to 400 times over the last few decades. It seems exorbitant when we compare it to similar economies, for example, in European countries.
The composition of CEO compensation has changed from salary and bonus-based towards more stock options-based and restricted stock-based.
KI: The common perception, I think, is that executives are asking for and receiving excessively large paychecks just because they can. But you argue that the rise in CEO pay may not be as outlandish as it looks from the outside.
Srivastava: The composition of CEO compensation has changed from salary and bonus-based towards more stock options-based and restricted stock-based. Stock options are turbo-charged. By that I mean that if there is a 10% fluctuation in stock prices, it can lead to 40 or 50 or 80 percent changes in the value of stock options.
This is especially important because CEOs cannot hedge the risks of their exposure to their own firms’ stock prices. A CEO cannot go out and sell his stock options on the market. Therefore, it is in a CEO’s interest to forecast future firm risks and adjust his or her portfolio. So, to the extent that the CEO puts effort into forecasting future risks, this is also beneficial for the firm.
I find a surprising link between CEOs’ modifications of their personal portfolios, and ex-post risk, which indicates that CEOs can indeed forecast future risks that are not known to the market. I call this an extraordinary ability. And I find that the turbo-charged portion of CEOs’ compensation is highly linked to that ability, which indicates that either the compensation contracts incentivize CEOs to put effort into forecasting risks, or the compensation contracts lead companies to select people who are better at forecasting risks.
KI: Clare, you looked at another CEO compensation scheme that’s become increasingly popular over the decades: the one-dollar CEO salary. Why would a CEO accept a one-dollar salary?
Wang: The practice goes back to Lee Iacocca, the former CEO of Chrysler Corporation. He accepted the one-dollar salary as a part of the federal loan package for Chrysler in the late 1970s. It seemed to embody the spirit of sacrifice that allowed Chrysler to survive and return to profitability in the 80s. Subsequently, he recounted the story in his best-selling autobiography in 1984, and it helped to validate and kind of popularize this one-dollar salary phenomenon. And it has been becoming relatively common. The CEOs of anywhere from 15 to about 30 publicly traded firms in the S & P 500 in any given year are taking a dollar salary. Once it is known that a few higher-profile CEOs have a dollar salary, other CEOs and boards of directors consider it, especially if they are in a similar situation.
KI: So what kind of a situation?
Wang: There are two broad categories. The first is that the salary aligns the CEO’s interests with those of the corporation. The CEO stands to benefit handsomely if the value of the corporation’s stock rises. Steve Jobs took a dollar salary for many, many years; in lieu of the salary he took stock options and restricted stock, which then helped him to become a multi-billionaire.
The second broad category involves a really poor recent performance by a firm, or a general downturn in the economy. The CEOs and companies in this category are more likely to lay off workers, and are really under pressure to show some empathy, or to share some of the sacrifice, with employees. The CEOs of the Big Three US auto manufacturers accepted an annual salary of a dollar as part of the bailout in 2008.
The irony that came out of our research is that alignment CEOs are sometimes described as engaging in a gimmick, while the downturn CEOs who took a dollar salary, are sometimes lauded. But the CEO of a successful firm who takes a dollar salary, along with stock and options, maintains the success of the firm, benefiting both the CEO and shareholders in the long run. And when you take a dollar salary as a symbol of sacrifice, it’s a good public relations move, but it does not change the economic fundamentals of the struggling firm.
KI: Do either of you think we’re seeing more creativity in how compensation is packaged than we have historically?
Srivastava: I think we are seeing less creativity than we saw during the late 90s. There is greater usage of restricted stock, compared to stock options. (Now accounting rules require stock options to be properly expensed in income statements.) Previously, firms had greater freedom.
Artwork by Yevgenia Nayberg
About the Writer
Jessica Love is the staff science writer and editor for Kellogg Insight.
About the Research
Hamm, Sophia J. W., Michael J. Jung, and Clare Wang. 2013. “Making Sense of One Dollar CEO Salaries.” Available at SSRN.
Srivastava, Anup. 2013. Do CEOs possess any extraordinary ability? Can those abilities justify large CEO pay? Asia-Pacific Journal of Accounting & Economics, 20(4), 349-384.
Suggested For You
Researchers were surprised by the variable that best predicted fatalities.
Here’s how companies can continue to adapt.
As a species, we’re cautious … except when the stakes are life-altering.
Most Popular Podcasts
Coworkers can make us crazy. Here’s how to handle tough situations.
Plus: Four questions to consider before becoming a social-impact entrepreneur.
Finding and nurturing high performers isn’t easy, but it pays off.