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E-MailAlex Edmans is professor of finance at London Business School. This post is based on his recently published book Grow the Pie. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here); The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Toward Fair and Sustainable Capitalism by Leo E. Strine, Jr (discussed on the Forum here).
Executive pay is a topic that has captured nearly everyone’s attention—and anger. While most company decisions, such as appointing a new CEO, changing its strategy, and selling a division, typically only make the business pages of a newspaper, executive pay frequently makes headlines. And while politicians used to run for election promising to reform healthcare and education, now they also promise to reform pay. In the 2016 US Presidential election, Donald Trump and Hillary Clinton didn’t agree on much, but one of the few things they did agree on was that pay was too high. In the same year, Theresa May launched her ultimately successful campaign to become UK Prime Minister with a speech that promised to curb executive pay.
It’s easy to see why executive pay is so controversial. The sheer numbers suggest that it’s out of touch with reality. In the US, the average S&P 500 CEO earned $14.8 million in 2019, 264 times the average worker—compared to a ratio of only 42 in 1980. It seems that almost all the fruits of economic growth have gone to investors and executives, with workers gaining very little. How can it be fair for a CEO to earn in 1.5 days what an ordinary citizen earns in a whole year? This explains many citizens’ views that current capitalism benefits only the elites, and the strength of the calls for reform.
However, in a recent post, I highlighted the criticality of the pie-growing mentality that I introduce in a new book, Grow the Pie: How Great Companies Deliver Both Purpose and Profit. The value that a company creates for society can be represented by a pie. Executives, shareholders, and wider society share in the pie. Common criticism of pay is based on the pie-splitting mentality. It argues that if executives didn’t take so much of the pie, there would be more to pay workers or invest in new products. But the amount that can be redistributed by splitting the pie differently is very small. A $14.8 million salary is only 0.06% of the size of a median S&P 500 firm, which is $24 billion.
The pie-growing mentality highlights that the pie is not fixed—by investing in stakeholders, a CEO grows the pie, ultimately benefiting investors. Thus, reform efforts should focus on giving the CEO the correct incentives to grow the pie—by giving her a slice of the pie through cutting her fixed salary and replacing it with equity. Note that such a remedy would be ignored by the standard focus on the level of pay. A level of $14.8 million doesn’t tell you whether this is $14 million of cash and $0.8 million of stock, or $14 million of stock and $0.8 million of cash. Yet these two schemes have substantially different effects on how accountable the CEO is for performance. Under the former, the CEO is a salaried bureaucrat. Under the latter, she’s an owner, who’s invested—literally—in its future success. She can’t earn more unless she grows the pie; if the pie shrinks, her slice shrinks.
Indeed, a study shows that firms in which the CEO has a high level of stock ownership beat those in which she has a low level by 4-10% per year—far higher than the maximum 0.06% gain from splitting the pie differently. They also enjoyed higher return on assets, labor productivity, cost efficiency and investment, all consistent with growing the pie.
Of course, correlation doesn’t imply causation. One interpretation is that incentives work—high stock ownership today causes CEOs to improve the stock price tomorrow. But perhaps causality is the other way. When leaders expect tomorrow’s stock price to be high, they ask the board to pay them in stock rather than cash, or buy shares on the open market. Either way, they hold more stock today. The authors thus show that the link between stock ownership and long-run returns is stronger where incentives are more likely to matter, because the CEO would otherwise be unaccountable for poor performance—such as where institutional ownership and industry competition is low, takeover defenses are strong and the CEO was the founder.
Tying CEO wealth to the stock price seems narrow—the CEO is only held accountable for the value she delivers to investors, not to wider society. However, as discussed in my previous post, in the long run, the stock price captures not only the value delivered to investors, but also to many stakeholders.
The important words are “in the long run”. In reality, some pay packages are tied to the short-run. A study found that the top executive teams of Bear Stearns and Lehman Brothers earned $1.4 billion and $1 billion respectively from cash bonuses and equity sales during 2000-8. More generally, other research discovered that, when CEOs are about to sell their shares, they cut investment and focus on hitting short-term earnings targets.
The remedy is to extend the horizon of a CEO’s equity, so that it’s locked up for many years. Importantly, this requires the lock-up to extend beyond the CEO’s departure, so that she plans for succession and undertakes investments even if they won’t fully pay off until after she’s left. Indeed, a study shows that long-term incentives improve not only profitability, but also innovation and the value delivered to suppliers, customers, society, and particularly employees—they grow the pie for the benefit of all.
Importantly, this research documents causation, not just correlation. It investigates shareholder proposals to implement long-term incentives. However, such proposals don’t arise randomly. It could be that they’re proposed by a large engaged blockholder, and it could be the blockholder—not long-term incentives—that improve future performance. So, the authors use a “Regression Discontinuity Design”. They compare proposals that narrowly pass (with 51% of the vote) to those that narrowly fail (with 49% of the vote). Whether you narrowly pass or narrowly fail is essentially random, and uncorrelated with other factors such as the presence of blockholders—if there were large blockholders, they would likely increase the vote from 49% to (say) 80%, not 51%.
Overall, reform efforts should shift the focus from pie-splitting to pie-enlarging, from the level of pay to its structure. Rather than bringing the CEO’s pay down, we should incentivize the CEO to bring everyone else up.
