PROBLEM ADDRESSED: Income & Wealth Inequality

SOLUTION: Limit Executive Compensation

Related Solutions: Expand Adoption of ESOPsExpand the EITCIncrease Taxes on the Wealthy, Raise the Minimum Wage

Last updated: Oct. 21, 2016

As we strive to create the framework for the safest, most stable financial system in the world, we must be mindful of the importance of protecting the fiscal interests of taxpayers as well as the dynamism and entrepreneurial spirit of our economy. In this regard, a measure of self-restraint on corporate compensation would seem to be a small price to pay.

–Robert Wilmers, chairman and chief executive of M&T Bank in Buffalo, N.Y., in his 2014 letter to the Bank’s shareholders.

Introduction

CEO compensation has risen dramatically since the 1980s while the average worker’s compensation remained relatively flat. Peter Drucker, the business management guru, advocated that CEO-to-worker pay ratio should not exceed 20 to 1 because he believed that excessive compensation made poor economic sense. Today, that ratio is close to 300 to 1.

The biggest driver of this rise has been the reliance of companies on equity-based pay for performance for the CEO and other top executives, such as the Chief Financial Officer. Both soaring executive compensation and the use of stock-based incentive pay have economic costs:

  • Large pay increases that are typically not shared equally down the line can and often do deflate morale and reduce productivity. Large increases can also lead to unwanted turnover among existing and rising stars.
  • News of CEOs who received large bonuses after massive layoffs tend to be a public embarrassment as well as a substantial drain on corporate morale.
  • Because compensation packages are often tied to stock-based incentives, a CEO may be motivated to take actions that shore up the stock price in the near term but have more risk of undermining the long-term sustainability of the company.
  • Linking executive compensation to the performance of company stock, as is frequently the case, sets up a false relationship that may not always be an accurate indicator of executive performance. This kind of arrangement is a greater incentive for short-term rather than long-term planning, and may mean the company is rewarding the CEO for outcomes unrelated to his actions (e.g., stock prices tend to rise when the economy does well, regardless of company performance).

With this recognition that executive incentives may be misguided, the business community has begun to focus on alternative mechanisms for structuring how executives are compensated. Based on corporate board decision-making since the “say on pay” requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act went into effect in 2011, additional federal regulation may be required in order to give those boards the strength to change.

Progress Updates

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Incomes Surge, Poverty Down Slightly

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Right Finds Common Ground with EITC Proposal

While Bernie Sanders is justly credited with turning the media and political spotlight on the problem of income inequality, conservatives have, indirectly, taken their seats at the table to open discussions on finding ...
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Learning Gap Is Closing Despite Income, Wealth Inequalities

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Alternative Views

Mandated Compensation Limits Don’t Work

As with campaign spending limits, critics can point to failed efforts to limit executive compensation and claim they don’t work. According to an article co-published by ProPublica and The Washington Post, federal attempts to regulate pay can even backfire and lead to even higher compensation packages. The article examined the effectiveness of Section 162(m) of the tax code, a provision passed by Congress in 1993 in fulfillment of a campaign promise by Bill Clinton to curb excessive executive pay.

The stated goal of 162(m) was to limit the deductions a corporation could claim for executive pay above $1 million, but it explicitly exempted equity-based pay from this rule. So, it is not surprising that in the years since passage of 162(m), executive compensation from stock options and other mechanisms not subject to the provision’s rules on deductibility rose 350%. What is surprising, however, is that compensation in categories where deductions are limited rose even more – up to 650%. Corporations, apparently, were not deterred by the taxes paid on compensation above the million dollar threshold.

The ProPublica-Washington Post article includes interviews with several people who understood the origins of the legislation that became Section 162(m). Like many well-intentioned laws, the original proposal went a lot farther than what ultimately was written into law to limit executive compensation. The bottom line is that the political process produced a result that represented exactly what the Democrats and Republicans could agree upon: It gave the appearance of delivering on a campaign promise while doing little to achieve any real impact.

Mechanisms for Getting Something Done

A number of mechanisms have been suggested for increasing taxes on the wealthy. Each is briefly summarized below. We invite you to review each one. Please feel free to suggest another mechanism that we have not yet covered. In time, we will offer an option for you to tell us which options make the most sense to you.

Dodd-Frank CEO Pay Reforms

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was a response to perceived causes of the Great Recession of 2008. It included several provisions related to executive compensation but only one, the “say on pay” provision, has so far been implemented and generated any historical data for review.

The intent of “say on pay” requirement was to limit executive pay by enabling investors to vote on compensation packages. Evidence to date suggests, however, that the “say on pay” rule has had only limited impact, in part because shareholder votes on pay are advisory only, meaning that the Board of Directors does not have to follow the advice. In fact, company boards have consistently shown that they are willing to ignore such advisory votes. More importantly, however, shareholders continue to vote in overwhelming numbers in favor of proposed compensation packages. According to the Center for American Progress, since the passage of Dodd-Frank, just 2% of pay packages are rejected by shareholders while more than 70% are approved by 90% of the shareholders who vote.

Note the italics used to emphasize the end of this last statement. According to the firm Broadridge Financial Solutions, which manages shareholder voting for its clients, just 27% of individual investors vote.

Below is a summary of the Dodd-Frank provisions targeting executive compensation reforms and the status of each.

Section Primary purpose Status
951 Gives shareholders a “say on pay”, that is, on annual compensation and golden parachutes. The “say” is advisory only and not binding on the Board of Directors. The section also includes disclosure requirements relating to golden parachutes and how institutional investment managers vote on advisory shareholder votes. Finalized in 2011 and implemented with limited effect on annual compensation. See below.
952 Encourages independence of company compensation committees through disclosure requirements relating to the role of, and potential conflicts involving, compensation consultants, and through listing standards that include certain enhanced independence requirements for members of issuers’ compensation committees. Finalized in 2012. The SEC has approved listing standards submitted by the NY Stock Exchange and NASDAQ
953 Requires disclosures relating to “pay-for-performance” and the “pay ratio” between the CEO’s total compensation and the median total compensation for all other company employees. Proposed pay for performance rules in 2015. Action pending.

Adopted pay ratio rules in 2015; takes effect with compensation paid in 2017.

954 Requires listed companies to adopt a no-fault clawback policy [LINK to clawback definition: “Enables shareholders to recover for the company compensation already paid to executives, irrespective of fault, should there be a negative restatement of company performance.”] applicable to executive level, incentive-based compensation. Proposed rules in 2015. Action pending.

 

955 Requires disclosure of hedging transactions [LINK to definition: “A type of transaction that limits investment risk with the use of derivatives, such as options and futures contracts. (Investopedia)”] relating to whether directors and employees are permitted to hedge or offset any decrease in market value of the company’s stock. Proposed rules in 2015. Action pending.

 

Adapted from the US Security and Exchange Commission, “Corporate Governance Issues, Including Executive Compensation Disclosure and Related SRO Rules”, July 1, 2015 and Seyfarth Shaw LLP, “Dodd-Frank and Executive Compensation: Where Are We Now?”, August 28, 2015.
Modify Structure of Executive Compensation

Most executive compensation packages are equity-based, meaning that the executive receives stock in the company as an incentive to perform his job well. According to research reported in the Wall Street Journal, six years after “Equity incentive awards now make up 70% of CEO pay in the U.S.” For reasons outlined in the Introduction, businesses should strive to find alternative mechanisms to reward their executives for high performance.

Two of these alternative models are discussed below.

Pay in debt

In 2010, the investment firm AIG altered its compensation practices, tying bonuses to the price of its corporate bonds rather than its stock price. For years, AIG and other investment companies had regularly engaged in high-risk investments that ultimately led to the financial crisis that started in 2007 and turned into the Great Recession a year later. In making the change to its compensation practices, AIG eliminated the stock-price-related incentives that drove its executives to make a series of decisions that brought short-term benefits to the company and high personal rewards while driving the company to the brink of bankruptcy. By linking executive bonuses to bond prices, AIG believed the new approach offered disincentives for the kinds of decision-making that had nearly caused the company’s collapse and instead encouraged its executives to follow a more sustainable, long-term strategy.

Research published around the same time supported this move by AIG. As the more recent research reported by the Wall Street Journal indicates, however, few companies appear to have followed AIG’s lead.

Use informal agreement with more attractive options

Professors Peter Cebon of the Melbourne School of Business and Benjamin E. Hermalin of the Haas School of Business and Department of Economics proposed this idea in their paper, “Why Less Is More: The Benefits of Limits on Executive Pay”. They suggest that corporate boards should rely on the kind of informal, or relational, contracts that are commonly used for most white collar employees. As the “manager” of the CEO and other top executives, the board would have to identify specific criteria other than the performance of the stock price that they would use to evaluate executive performance.

This approach would really address two shortcoming in the current system: 1) easy reliance on the stock price often as the primary indicator of performance; and 2) a passive level of oversight that is common to many boards (and company shareholders) and that often leads to rubber stamping compensation and other proposals. In particular, boards would be forced to better understand the company and its market in order to establish applicable and reasonably achievable performance results.

Cebon and Hermalin take the idea a step further and suggest that the only way that corporate boards will make this transition is for the federal government either to put a cap on incentive-based pay or to creative disincentives, such as a very high tax, that discourage this kind of compensation. Without such government regulation, they argue, most boards will lack the will and sufficient independence to implement such a change.

The quote from Robert Wilmers used at the top of this article indicates that some in the business community are aware of the problem and are calling for voluntary limits on corporate compensation. Undoubtedly, many companies already do strive to keep executive pay more in line with their employees because they understand that it makes good business sense. Large corporations may be slow or reluctant to adopt a new, more equitable approach because their very size and influence on the economy enables them to challenge standard market factors regarding community.

Take Action.

The resources below can help you become a more informed and engaged citizen, shareholder, business person, voter – and maybe even an American leader. Our list is not comprehensive, so if you know of another resource that belongs here, please let us know.

Shareholder Communications Coalition. “The Shareholder Communications Coalition is an advocacy organization dedicated to improving the ability of individual investors to vote their shares and communicate with the publicly traded companies in which they invest.”

Boardroom Accountability Project. Launched in 2014 by NY City Comptroller Scott String on behalf of the City’s pension funds, the Project seeks to give shareholders the ability to nominate members of the Board of Directors in order to gain more independent representation on executive compensation and other issues.

A Guide to CEO Compensation. This Investopedia article is a good starting point for better understanding this very challenging issue.

Bond Basics: What Are Bonds? Investopedia.com offers a good explanation of bonds that allows you to get into as much detail as you can handle.

New thinking on executive compensation: Pay CEOs with debt. In this 2010 article, an economist discusses the findings of his research.

ProxyMonitor.org. Launched by the Manhattan Institute, the site tracks shareholder proposals “in real time” and provides the results of votes on each proposal.

Executive Paywatch. This AFL-CIO website tracks and compares executive and worker pay, aggregating and analyzing data from several publicly available databases.

Why I Am a Patriotic Millionaire by Leo Hindery Jr., blog post, Patriotic Millionaires, March 8, 2016. In this blog post, businessman and author Leo Hindery Jr. explains why he opposes the “amazing chasms in wealth”.

Why Excessive CEO Pay Is Bad for the Economy by Robert Wilmers, chairman and chief executive of M&T Bank in Buffalo, NY, excerpt from his 2014 letter to shareholders as published in Bank Think on AmericanBanker.com.

Sources

Cebon, Peter and Hermalin, Benjamin E., When Less is More: The Benefits of Limits on Executive Pay, Rev. Financ. Stud. (2015) 28 (6): 1667-1700 first published online December 17, 2014, http://rfs.oxfordjournals.org/content/early/2015/01/31/rfs.hhu140.abstrac%20t. Accessed August 16, 2016.

Seyfarth Shaw LLP, “Dodd-Frank and Executive Compensation: Where Are We Now?”, August 28, 2015, http://www.seyfarth.com/publications/MA082815-CORP. Accessed August 17, 2016.

Center on Budget and Policy Priorities, “Income Gains Widely Shared in Early Postwar Decades – But Not Since Then” (based on US CensusBureau data), http://www.cbpp.org/income-gains-widely-shared-in-early-postwar-decades-but-not-since-then-0. Accessed April 1, 2016.

Mishel, Lawrence and Davis, Alyssa, “CEO Pay Has Grown 90 Times Faster than Typical Worker Pay Since 1978”, Economic Policy Institute, July 1, 2015, http://www.epi.org/publication/ceo-pay-has-grown-90-times-faster-than-typical-worker-pay-since-1978/. Accessed August 15, 2016.

Wilmers, Robert, “Why Excessive CEO Pay Is Bad for the Economy”, American Banker, March 14, 2014 (excerpted from Wilmers’ 2014 letter to shareholders), http://www.americanbanker.com/bankthink/why-excessive-ceo-pay-is-bad-for-the-economy-1066239-1.html. Accessed August 15, 2016.

Woocher, Jacob, “It’s Still Tough To Curb CEO Pay After Five Years Of Dodd-Frank”, Campaign for America’s Future, July 15, 2015, https://ourfuture.org/20150721/its-still-tough-to-curb-ceo-pay-after-five-years-of-dodd-frank. Accessed August 16, 2016.

Francis, Theo, “Best-Paid CEOs Run Some of Worst-Performing Companies”, The Wall Street Journal, July 25, 2016, http://www.wsj.com/articles/best-paid-ceos-run-some-of-worst-performing-companies-1469419262. Accessed August 16, 2016.

Wharton School of the University of Pennsylvania, “Why It Pays to Link Executive Compensation With Corporate Debt”, July 7, 2010, http://knowledge.wharton.upenn.edu/article/why-it-pays-to-link-executive-compensation-with-corporate-debt/. Accessed August 19, 2016.