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- [00:00]
Kurt Nickish
You're listening to Is Business Broken, A podcast from the Merotra Institute for Business, Markets and Society at Boston University Questrom School of Business. I'm Kurt Nickish. 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. It wasn't always this way. Why? And how did CEO paychecks become so massive and divisive? Who decides what leaders are worth? And what's the ripple effect on companies, workers, and the economy? Today, we're launching a series that pulls back the curtain on the world of executive compensation. We'll unpack how these massive pay packages are structured, why they've grown so much and gotten so complex, and what it all means for businesses, employees, and society at large. Our guest today is Charlie Tharp, professor of the practice at questrom School of Business. Charlie, thanks for talking.
- [01:14]
Charlie Tharp
It's a pleasure to be here.
- [01:17]
Kurt Nickish
Executive pay, it's obviously pretty important as a tool for businesses. They help have to attract executives, they have to reward those people for doing a good job. But it's also kind of become the face of what a lot of people see as big problems in capitalism today, wealth inequality. Why is executive compensation such a contentious issue?
- [01:40]
Charlie Tharp
Yeah, well, first of all, it's the level of pay that attracts attention. Obviously. S&P 500 executive at the CEO level, probably the median's around 15 million. By any measures, a lot of money.
- [01:54]
Kurt Nickish
That's real money, as they say.
- [01:56]
Charlie Tharp
That's real money. And the way compensation's reported, sometimes it's kind of hard to understand what executive pay really is.
- [02:05]
Kurt Nickish
Yeah, it's a little bit like when sports figures, you hear about these packages and options and, you know, over 10 years and, you know, but then also media rights and share of a franchise, and it gets. It's really hard to put a price tag on it. It definitely seems obscene, though, to a lot of people. Can you blame them?
- [02:25]
Charlie Tharp
No, actually. And I think we don't do a very good job of explaining it. And people often ask me, is executive pay too high? And I must tell you, I don't know if it's too high or not. But I do know there's a market for executive talent. And kind of as ironic, it's probably one of the most transparent markets. As you pick up the paper, you know exactly what your CEO's making. And this. It's like a lot of things, there's supply and demand, but is it too high? I don't know.
- [02:57]
Kurt Nickish
Well, as recently as the 1980s, management thinkers like Peter Drucker were arguing that CEOs should get no more than 20 times the salary of the average worker at their company. That seems almost adorable now, right? Because the McDonald's CEO earns 1,220 times as much as the average salaried worker at McDonald's. Why has it risen so much in just the past few decades?
- [03:25]
Charlie Tharp
Yeah, so the interesting fact about the McDonald's was called pay ratio. That's something all public companies have to report. The compensation of the CEO as a multiple of what's called median worker. McDonald's is an interesting one because it happens to be a crew member in a McDonald's restaurant in Poland who makes a little over $15,000 a year. First of all, I don't know if that's good pay or not in Poland, but I do know that's pretty much a competitive CEO pay for a company the size of McDonald's. So it's a very hard thing to compare the CEO pay to the pay of other employees because they're really different markets. And one thing that's very different about executive pay. Executive pay tends to vary by the size of the organization, which isn't true of most other jobs. Most other jobs are skill based in larger companies. There are hundreds of academic studies on exec comp. I did one for my dissertation. And we all agree on one thing and pretty much one thing only big companies pay more.
- [04:32]
Kurt Nickish
Yep. And what's the logic for that?
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Charlie Tharp
Complexity, scope?
- [04:37]
Kurt Nickish
It's just that much harder.
- [04:38]
Charlie Tharp
And therefore it's a tougher job and requires different skills. And as you notice, bad CEOs often their companies destroy a lot of value. Good CEOs often get very good returns for their shareholders and good customer products.
- [04:55]
Kurt Nickish
Yeah, I mean, I think with sports teams, for instance, a lot of people have a hard time thinking, oh, why is that receiver or why is that head coach making so much? And then you kind of get that, you know, there are only so many people that have those particular skills that can make a difference to win games, to make more money for the franchise or the team. And you can understand that with CEOs, I think a lot of people think that, well, there are a lot of great executives out there who don't get that chance. Why should they be able to demand so much? Shouldn't there be a higher supply of people to replace them?
- [05:33]
Charlie Tharp
Well, it's a good question. And in fact, companies spend a lot of time developing talent to try to make sure they have successors where Pay really ramps up and you're raising a great point. Where it really ramps up is when you have to go out and sort in the spot market, if you will, and try to entice a CEO from another company to join your company. They're obviously making good money and they wouldn't move laterally. And the nature of executive pay, so much of it is contingent pay for the future. So to get someone to move to buy out things that aren't yet vested, that they can't, you know, reach out and touch yet, those are the really, unfortunately, when you don't have good succession, you distort the market a bit because you're doing an external hire that is going to command a premium to change jobs.
- [06:23]
Kurt Nickish
So let's explain this the big jump, because you know, Peter Drucker was recommending 20 times when CEOs were maybe getting 40 times. Now it's like over 1,000 at McDonald's and other places. Like how did that perfect past that we had change to the present that we have today?
- [06:40]
Charlie Tharp
Yeah, so the 20 times was based probably on the disclosure of pay in that time. That's how they would do that calculation. The disclosure now has become much more robust. The long term incentives, which prior they didn't give much of a valuation to those in the disclosures. It was just more descriptive. It was only in 2006 or so, if I remember that in fact you had to present a number that was the total pay of the CEO before you just presented the components and people would have to figure out how that all added up. And, and so that's raised a bit of the awareness of total pay the way it's presented. The other is now so much of executive pay, especially a CEO, is based on equity. And you know, what's happened to the value of equity over just the last couple decades and for sure even over the last few years. And so what's been driving a lot of pay is the reliance on long term incentives which are primarily in the form of company stock. And the size of corporations has increased dramatically over that time. And as I mentioned, that's one of the drivers of really executive pay is the size of the organization they lead.
- [08:00]
Kurt Nickish
Part of executive compensation now is stock options compensation that's built on ownership of stock in the company that's being managed by the CEO. How did that come about?
- [08:14]
Charlie Tharp
Stock options have been around for a very long time. And back in, I guess World War II, the Korean War, in fact, there was some legislation that allowed companies in the Korean War to reprice options when the market went down, we would never do that now. So it's been a tool that's been around. They've declined in popularity. However, options used to be the primary part of executive pay. And after the dot com bubble burst and more investors were looking for what they called performance based pay. Well, you can argue options are performance based because if the stock doesn't go up, you don't make money. But an awful lot of the appreciation of an option is what goes on in equity markets, just not your company. So many investors like to see stock that's contingent upon earnings per share, total return to shareholders, those sort of measures. So it's become a little more sophisticated and at the same time the numbers have gone up.
- [09:18]
Kurt Nickish
So who decides what a CEO has paid?
- [09:21]
Charlie Tharp
Yeah, that's the board of directors. And the board. As with many things, boards do, they operate through committees. And there's a compensation committee of the board. In fact, if you're a company that's listed on the New York Stock Exchange or Nasdaq, that's one of the committees that's required for, just as we're talking today, to approve and review executive pay. And it's usually comprised of three to six sort of experts. They're former CEOs or they're governance people, they're lawyers, financial people. They're, you know, pretty high level sophisticated. Either former executives or current sitting executives that do have a good perspective on not only business itself, but how pay and incentives work.
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Kurt Nickish
And what say do shareholders have? What say does the government have in what CEOs are paid?
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Charlie Tharp
Yeah, so let's start with shareholders. Shareholders basically of a corporation have three rights. They can sell, they can vote and they can sue. So they get to vote on compensation. And this is new, by the way. This came under the Dodd Frank act in 2010, and it was first effective in 2011. And it's called a precatory or non binding vote. So each year shareholders get a chance to go thumbs up, thumbs down whether they approve CEO pay. And it's kind of interesting since we've been doing it now since 2011, sort of the average level of support for a Fortune 500, an S&P 500 type company, is a favorable vote by investors of about 90%. And if you lose below 50%, that's usually 1 to 2% of companies most shareholders approve quite overwhelmingly and support executive pay.
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Kurt Nickish
And what does that say?
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Charlie Tharp
First of all, I think it says that since for a lot of big companies, institutional investors own a lot of the stock, they get advice of Proxy advisors, which is a third party sort of analyst for compensation and other governance issues and they make a pretty informed decision. So it says to me that they think the form of executive pay really works.
- [11:48]
Kurt Nickish
Yep. That it's worth it essentially.
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Charlie Tharp
Exactly.
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Kurt Nickish
But the fact that it is now a requirement means that. You see these new stories about Tesla shareholders recently. They voted on Elon Musk's pay package.
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Charlie Tharp
Recently after it was rejected by a court. Interesting. In fact that was just re reviewed and the court said, well that's interesting, but shareholders don't get to reverse court decisions. Tesla, which is a great company and Elon Musk has been a very successful leader of that. I don't know if he's worth that amount of money or not, but what they had was a flawed governance. The approval of that was by what they call conflicted directors. They had too much of a personal interest in it and relationship with the CEO and that's why the judge thought that that wasn't an appropriate process. I don't think the judge had a reason to say he was overpaid. The judge just said that that was not a legitimate process. And the proxy, which is what shareholders read to vote on, was flawed because it wasn't quite accurate on the requirements for earning that money.
- [13:02]
Kurt Nickish
This Tesla story may be a little bit of a red herring, but it sounds like it does speak to this public perception that boards are a little buddy Buddy and reward CEOs and then directors of boards get benefits from that relationship later.
- [13:17]
Charlie Tharp
Yeah, that's one where I think there's often a lot of skepticism that it's a rig system. I will tell you, most of the individuals on boards spend a lot of time trying to get it right. They have external advisors, consultants that are independent, that don't do other work for the company, that really just work for the board. And one thing, when I'm doing my director education and when I'm working with boards on compensation, I always remind them that they're renting their reputation to the company. And compensation's an area where in fact it would be pretty easy to soil your reputation by not being thoughtful on how pay's developed. And I think boards do spend a lot of time looking at a lot of competitive data, setting hopefully aggressive targets. Again, it's an art.
- [14:12]
Kurt Nickish
Yeah. What has the effect of Dodd Frank been on executive compensation?
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Charlie Tharp
Well, first of all, I think it's created more transparency because of say on pay and shareholders have a chance to vote. Companies are a little more cautious, especially on non performance elements of pay like perquisites clubs, personal use of the company aircraft, tax preparation, things like that. So we've seen a decline quite a bit in perquisites. And that really is because it's not shareholder friendly.
- [14:52]
Kurt Nickish
What's this word?
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Charlie Tharp
Perquisites.
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Kurt Nickish
So here's it's not perks.
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Charlie Tharp
Well, perks is the abbreviation, but it's.
- [14:59]
Kurt Nickish
Perquisites is the forward. Oh, that's funny.
- [15:02]
Charlie Tharp
That's where you get perks. Perquisites are supplemental benefits. In essence. I will give you a company car. I'll let you, if you want to go on vacation, fly in the jet. You don't see that much anymore.
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Kurt Nickish
Got it.
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Charlie Tharp
And one of the ones now that is thought to be a perquisite, which companies are now looking at pretty hard, is the idea of security for executives after that horrible shooting of the United Healthcare executive. So there's been a lot of interest and that is a quote unquote perquisite.
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Kurt Nickish
Okay, so let's talk a little bit more about this overall package.
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Charlie Tharp
You've got base salary, like we all get base salary is 10 to maybe 15% of total pay.
- [15:49]
Kurt Nickish
Okay. It pays the mortgage.
- [15:51]
Charlie Tharp
It's about a million and a half. So while 10% sounds small, it's a big number. Then the annual incentive, which is primarily based upon financial metrics and some non financial metrics like DEI or environmental concerns. For a small portion of that, that's probably 20 to 25% of a CEO's pay. That's real money. Salary and annual incentive are real money that you can go spend. But about 60 to 70% of pay are awards that are contingent on future performance. They're either stock options which can run for 10 years based upon what happens to the stock price. If it appreciates, you make money, if it doesn't, you don't. There are also what's called performance shares, which is stock that's granted and it usually has a three year performance cycle.
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Kurt Nickish
Okay.
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Charlie Tharp
And there'll be something like growing compounding earnings per share, 15% a year for three years. If you do that, you get the award. If it compounds at 10%, you only get a portion of the award. And so it's really performance based, like the short term, but spread over three years. The reason being that you want to encourage sustained performance, not just short termism. And if it were only short term annual pay, why would I invest in new facilities? I might let the maintenance slip on my factory.
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Kurt Nickish
So yeah, it's trying to close some factories even.
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Charlie Tharp
Yeah, exactly. And the other sometimes is just stock that is not performance based but requires that you stay with the company. It's called restricted stock, usually vests in three to five years. And that's really to retain executives and to give them an ownership stake. The whole basis of executive compensation is really the idea of what's called agency theory. Shareholders don't manage the company. They can't observe what executives do every day. So they rely on a board to use compensation to try to align the interests of CEOs and other managers with the people who own the company, the shareholders. And how do you do that? By making a lot of their pay contingent upon increasing the value of the company stock over time. And for, I would say the vast majority of companies, they require executives to personally own a significant stake in the company shares they actually own. For a CEO in a big company, the requirement's usually six times salary. So a CEO would have to hold, While they are CEO, personal ownership of at least $9 million, as an example, in company stock. So you've got incentives aligned with shareholders. You have skin in the game through ownership by CEOs, and it's all meant so that they're doing things that are in the best interest of shareholders. Again, agency theory, they're the agents of the owners.
- [19:01]
Kurt Nickish
So just to kind of close that circle, what percentage of this overall pay package then is stock?
- [19:09]
Charlie Tharp
Probably about 60 to 70%.
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Kurt Nickish
I was going to say it was even more than. Yeah, it was more than 50%.
- [19:14]
Charlie Tharp
And it gets back to your original question of maybe why has CEO pay increased so much that percent is increased as investors and shareholders want more based upon equity. So I think we've seen sort of a mixture of factors. And the other thing is you almost have had an opposite trend for the average worker. As we've moved more to a service industry which is lower paying, we have decreased unionization. Percent of the civilian workforce that's unionized has dropped from being around 35% back in the 50s to probably about 10% or under. I don't know the exact number, but it's not very high. And many jobs have been moved to lower wage economies where in fact, for the company, they get cheaper labor, so to speak.
- [20:07]
Kurt Nickish
You've painted a picture of a kind of a finely tuned, sophisticated package that tries to encourage a lot of things from. It's just. I mean, the same way that companies have gotten more complex. It sounds like the pay package for.
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Charlie Tharp
Executives, it's incredibly complex.
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Kurt Nickish
It's gotten complex. Right. And you're basically trying to set up a system where to make it hard for an executive to simply engineer one outcome, because that's what's the best for them.
- [20:37]
Charlie Tharp
Exactly. And so there's another factor in that too is you want to mitigate risk. You know, we had this financial Crisis back in 2009. There's no real academic support for this, but it's thought that many of the pay arrangements in the financial industry may have contributed to that through these collateralized mortgage obligations and things like that as the basis of incentives. So now companies are required, boards are required to disclose if they have done an analysis as to whether compensation would cause excessive risk to the company.
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Kurt Nickish
Interesting. Okay.
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Charlie Tharp
And so many of the factors in pay are meant to provide risk mitigation. I mentioned the requirement that CEOs own stock. If you own stock, you're more likely not to have such a short term view. You can't really sell the stock. You have to own a multiple of your salary. The long term incentives help mitigate risk of short termism. More equity mitigates the risk of financial engineering to try to get a higher payout because over time that won't sustain and the stock price will reflect that. So there's, I think balance is the word I would use. However, I think it's gotten overly complex.
- [21:57]
Kurt Nickish
If you talk to somebody on the street. I mean, one common public perception is that CEOs are paid a lot by stock. That encourages short term engineering to goose the stock price for them for their benefit and that there isn't a lot of risk for them because if they fail, you know, there's a sweet severance package for them. There's a golden parachute, no skin off their back. Any truth to that?
- [22:26]
Charlie Tharp
Well, first of all, executive severance, if you get terminated, except for cause, it's a very attractive payment, usually two times salary and target incentive. If it's a change in control, a golden parachute, so to speak, that's when your company's taken over, that's usually even more generous. Although it's pretty much to the shareholders benefits to have a nice change in control. So if my company and I'm CEO and we're going to be taken over by another company, I'm probably going to resist that like crazy because the new company is only going to have one CEO. They're not going to have two. There's not going to be two CFOs. And so if I think that's going to be to my disadvantage greatly, I will probably not paint a very positive picture to the board of the benefits of that merger. And boards get a lot of information of them. So golden parachutes are meant to have a financial cushion. So presumably you'll do the right thing when it comes to just plain severance. You're terminated. Maybe you weren't doing a good job, you get terminated. It does sound like a lot of money, but you know, there's not a big market for fired CEOs. So while it sounds like a nice thing to get 2 years pay, chances are you'll never be a CEO of a company that size and you'll never make that money again. So it's not really, you know, heads I win, tails I win. There's a significant future earnings penalty of being terminated, for sure.
- [24:01]
Kurt Nickish
Gotcha. Let's talk about another example of how the US Federal government has tried to regulate executive compensation. And one of that's through restricting buybacks or putting an excise tax, basically taxing stock buybacks. The idea there being that companies, if they have a lot of excess cash, should be investing that in new factories or paying workers more. And not just buying back stock, which can raise the stock price for shareholders, but also essentially by default, it ends up raising the compensation packages of executives because it's raising the value of those stock options that they hold. What's your assessment of that effort to keep executives from using stock buybacks as a tool to sort of improve their own compensation?
- [24:56]
Charlie Tharp
Yeah, that's one that over the years has received a fair amount of criticism. And in fact, I think it was President Biden who encouraged and was passed a 1% penalty to a company on buying back shares to try to discourage it. Let's talk about share buybacks. Why does a company buy back shares? I think they buy back shares because they think their stock's undervalued or I would say during the period we had very low interest rates. You know, companies want to have the lowest weighted average cost of capital they can. And when debt is real cheap, equity's still pretty dear. You'd probably prefer to change the balance toward a little more debt and less equity financing of your company, especially if you're paying a high dividend because dividends aren't deductible but debt interest on debt is. So the extent to which your dividend was higher than your borrowing rate economically, you'd probably want to buy back more shares so you're not paying so much dividend. It's kind of a double edged sword though. If I'm buying back shares, then if I were a shareholder, I'd say, don't you have better use of the money? I mean, is this really predicting future growth?
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Kurt Nickish
Aren't There any growth companies you could go by with that?
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Charlie Tharp
Yeah. And unless you're really loading up on debt, that's a really good question. So it's sort of a double edged sword because it may suppress the stock price. A stock price is really the discounted present value of projected future cash flows. And if you're not showing that you've got a lot of ideas to grow the company, that probably doesn't help. So that's one aspect. But to the compensation specifically, boards usually set goals like earnings per share, which is the one that would be most impacted by buying back shares because it's the denominator which is pretty powerful. They use either an average during the year or they use a budgeted rate which takes into account planned buyback. So to say that it's going to drive the metric that determines a payout probably isn't true. But to stock options, to the point you made, the academic research shows that companies that do a lot of buybacks versus those don't, they don't have much difference in terms of what happens to their stock price over a very short period of time. There's often a blip initially but then it settles back. So it doesn't really help that much. And secondly, as we pointed out, stock options aren't one year awards. Most of them vest over four years and they have a life of 10 years. So a one time buyback probably has a little impact. And if you're a shareholder and you own a multiple of your salary in stock, it may initially increase the stock price, but it tends to come back down.
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Kurt Nickish
Got sounds like there's a lot of effort to have more transparency around CEO pay for sure hasn't necessarily limited. It hasn't sort of solved this income inequality problem. There might be measures to try to get workers to be paid more. There are problems with that. What's the current status of this issue? What's the enduring problem here and do you see potential for addressing that or is it really that struct?
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Charlie Tharp
Yeah. So first of all, I think executive compensation I don't think is the real issue. The real issue is the difference between executive pay and that of the average worker. And let's just do a thought experiment for a second. I'm a CEO making $15 million. I run a company that has 50,000 employees. I'm going to be magnanimous. I'm going to take my pay and give it evenly spread across all the employees. That means each employee would get a $300 a year raise. So there you have what I think people would say what a nice thing the CEO did. It didn't change anybody's life. That's like a Starbucks latte a week or something. Now step back and say, is the issue really how we get the denominator up, not reduce the numerator? What can we do to improve the earnings of the average worker? What can we do in our education system? What can we do in skills training? What can we do in apprenticeship programs? Companies are investing quite a bit in trying to upskill employees. That, to me, is the issue. And I think executive compensation's a red herring. No matter what you do with executive compensation, when I, as an average employee go to the grocery store, it isn't going to change my situation. How do I change that? That one's hard.
- [30:04]
Kurt Nickish
Charlie, thanks so much for talking.
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Charlie Tharp
That's just fun. Thank you.
- [30:12]
Kurt Nickish
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. What's their role in this issue and how does it determine CEO pay? That's next week. To get that episode and more, please follow the show on Apple podcasts, Spotify or wherever you listen. Thanks for listening to Is Business Broken? I'm Kurt Nickish, SA.