Podcast Summary: "Why are Executives Paid So Much?"

Is Business Broken?
Host: Kurt Nickish
Guest: Charlie Tharp, Professor of the Practice at Questrom School of Business
Release Date: February 20, 2025

1. Introduction to Executive Compensation

In the inaugural episode of the Is Business Broken? series titled "Why are Executives Paid So Much?", host Kurt Nickish delves into the contentious realm of executive compensation. The discussion aims to unravel the complexities behind CEO paychecks, exploring why they have become so substantial and divisive in recent decades.

Notable Quote:
Kurt Nickish [00:00]: "Executive compensation, just hearing that term can spark strong reactions. For some, it's a glaring symbol of inequality and excess. For others, it's a justified measure of performance that drives success."

2. Historical Perspective and Pay Ratios

Charlie Tharp highlights the staggering increase in CEO pay over the years. He references historical perspectives, such as Peter Drucker's 1980s recommendation that CEOs should earn no more than 20 times the average worker's salary. In contrast, modern examples like the McDonald's CEO earning 1,220 times the average salaried worker illustrate the dramatic escalation.

Notable Quote:
Charlie Tharp [02:25]: "Most other jobs are skill-based in larger companies. There are hundreds of academic studies on executive compensation, and we all agree on one thing: very big companies pay more."

3. Factors Leading to High CEO Pay

Several factors contribute to the soaring executive compensation:

• Market Dynamics: There's a robust market for executive talent, which drives up pay due to supply and demand dynamics.
• Organizational Complexity: Leading large organizations requires specialized skills, justifying higher pay.
• Equity-Based Compensation: A significant portion of CEO pay is tied to company performance through stock options and equity, aligning executive interests with shareholders.
• Globalization and Company Size: As companies expand globally, the scope and complexity of managing such entities increase, necessitating higher compensation for top executives.

Notable Quote:
Charlie Tharp [03:24]: "Executive pay tends to vary by the size of the organization, which isn't true of most other jobs. And almost every study agrees: bigger companies pay more."

4. Structure of Executive Compensation Packages

Executive compensation packages are multifaceted, typically comprising:

• Base Salary: Accounts for about 10-15% of total pay. For instance, a CEO might earn a base salary of $1.5 million.
• Annual Incentives: Approximately 20-25% of total compensation, based on financial and non-financial metrics like diversity, equity, and inclusion (DEI) and environmental concerns.
• Long-Term Incentives: The majority (60-70%) consists of stock options, performance shares, and restricted stock, contingent on future performance and company growth over several years.

Notable Quote:
Charlie Tharp [15:39]: "About 60 to 70% of pay are awards that are contingent on future performance. They're either stock options or performance shares, which are meant to encourage sustained performance, not just short-term gains."

5. Role of Boards and Shareholders in Setting Pay

Executive pay is primarily determined by a company’s board of directors, specifically through a compensation committee comprised of experts such as former CEOs, governance specialists, and financial advisors. Shareholders have gained more influence through mechanisms like the say-on-pay vote introduced by the Dodd-Frank Act in 2010, allowing them to express approval or disapproval of CEO compensation packages.

Notable Quote:
Charlie Tharp [10:17]: "Shareholders have a chance to go thumbs up, thumbs down on whether they approve CEO pay. The average level of support is about 90%, indicating that investors generally believe executive compensation is justified."

6. Impact of Regulations (e.g., Dodd-Frank)

The Dodd-Frank Act has introduced greater transparency in executive compensation by requiring detailed disclosures and enabling shareholder votes on pay packages. This regulation has led to a decline in perquisites (supplemental benefits) as companies become more cautious about non-performance-based compensation elements.

Notable Quote:
Charlie Tharp [14:17]: "Dodd-Frank has created more transparency because of say-on-pay, and companies are more cautious, especially on non-performance elements like perquisites."

7. Stock Buybacks and CEO Compensation

The discussion touches on the controversial practice of stock buybacks, which some argue inflate CEO compensation by boosting stock prices. Regulatory attempts, such as President Biden's proposed 1% excise tax on stock buybacks, aim to redirect excess corporate cash towards employee wages or capital investments instead. However, Tharp suggests that the impact of buybacks on executive pay is limited due to the long-term nature of stock option vesting periods.

Notable Quote:
Charlie Tharp [26:18]: "Stock options aren't one-year awards; most vest over four years and have a life of 10 years. So a one-time buyback probably has a little impact on executive compensation."

8. The Debate on Income Inequality and Executive Pay

While executive compensation garners significant public attention as a symbol of income inequality, Tharp argues that the real issue lies in the disparity between executive pay and average worker wages. He posits that redistributing executive pay would have minimal impact on improving the lives of average employees and instead suggests focusing on enhancing the earnings and skills of the broader workforce.

Notable Quote:
Charlie Tharp [28:28]: "Executive compensation is a red herring. The real issue is the difference between executive pay and that of the average worker. Improving the earnings of the average worker is where the focus should be."

9. Conclusion and Future Directions

The episode concludes with the notion that while executive compensation is complex and often perceived negatively, it is a result of market dynamics, regulatory frameworks, and the inherent complexities of leading large organizations. Future discussions in the series will delve deeper into the roles of external stakeholders like shareholders in determining CEO pay.

Notable Quote:
Charlie Tharp [30:05]: "That's just fun. Thank you."
Kurt Nickish [30:12]: "That's Charlie Tharp, professor of the practice at Questrom School of Business. Next week, we dive further into executive compensation and focus on external stakeholders like shareholders."

Key Takeaways:

• Market-Driven Pay: CEO compensation is largely influenced by market dynamics, organizational complexity, and the need to attract top talent.
• Equity Alignment: A significant portion of executive pay is tied to company performance through stock-based incentives, aligning executives' interests with those of shareholders.
• Regulatory Influence: Regulations like the Dodd-Frank Act have increased transparency and shareholder influence over executive compensation.
• Income Inequality Debate: While executive pay is often criticized as a symbol of income inequality, addressing wage disparities among the broader workforce may have a more substantial impact.
• Future Episodes: The series will continue to explore the intricacies of executive compensation, focusing on the influence of shareholders and other external stakeholders.

This episode provides a comprehensive overview of the factors contributing to high executive compensation, the mechanisms in place to regulate it, and the broader implications for income inequality and corporate governance.