The person(s) that create/own organization(s) are often far from the place because these owner(s) have created a separate entity which gives them reduced transaction costs but its day-to-day coordination is done by manager(s) which then creates a principal–agent problem. “A Manager is someone who directs resources to achieve a stated goal” (Baye, 2014). Part of this problem is the uncertainty as to whether there will be profit or otherwise for the owner, in that case: who has earned the accolades for the profit or reproof for the loss. The owner(s) knowing manager(s) get compensation whether work is done full time, part time or not at all as owners are not present to see manager’s actions; these degrees of attendance has various effects of profit (Baye, 2010).
Knowing salary is fixed, despite effort level put in by manager, hence the owners look for a way to ensure more work and less leisure is done by the manager and in comes the incentive contract, where compensations are performance based, that is; profit sharing to include the manager (e.g. 5% of annual profit can go to the manager). In this scenario, manager can either get 5% of zero profit (due to no time spent working) or 5% high profit (due to full time spent working), it’s one of the best forms of supervision afforded the owner, alongside things like stock option and other profit based pay.
At big public companies, boards of directors are usually in charge of the expensive decision of how and what to pay their CEOs.
According to research by Susanna Gallani, “Compensation theory says that in order for compensation to be effective, you need to create a compensation package in a way that facilitates an alignment between the goals of the executive and the specific goals of the corporation” (as cited by Nobel, 2015).
Ideally, pay package motivates employees even the C.E.O. in decision-making that is beneficial to the company and self. It is commonly referred to as, “having a stake in the organization”, this is believed to increase the C.E.O.’s desire for company success more than any fixed salary could do. Especially in traded companies where the C.E.O.’s stock options from the organization also increases the drive for higher stock market price per unit/share which can be attained from achieving better financial results. This will raise the dividends which will in turn drive the board to increase the C.E.O.’s émoluments in recognition of achievement.
B.
Yes, it has been effective but not in all instances.
As far back as the years “through the 1970s—when the ratio of CEOs’ pay to that of the average worker was much lower, between 20:1 and 30:1 the lodestar was “internal equity,” or how an executive’s pay compared with that of other employees in the company: there has been a switching to “external equity,” since then, meaning compensation would be based on what other CEOs were paid. External equity became the foundation of the series of pay practices and procedures that guarantee CEO pay will continue to skyrocket and as of 2014, 500 of the highest-paid senior executives at U.S. companies made nearly 1,000 times as much money as the average American worker, after taking into account salary, bonuses, and stock-based compensation” (Clifford, 2017).
The number of organizations with increased annual earnings has gone up, in several instances some C.E.O.s have taken their organizations to new financial heights, hence they have earned the astronomical compensation packages paid while some others have received their pay from external equity or industry standards without earning it.
Excessive, yes it has been excessive in several instances, as with any idea abuse is possible. In stock options inclusive compensation packages, C.E.O.s benefit when the company’s stock price goes up, but doesn’t lose money if the share prices go down. Giving the C.E.O. the right (but not an obligation) to purchase company’s shares at a pre-determined price within a specified period of time (Lam, 2015).
A research led by Adam Wowak, looked at the performance of 386 CEOs from 286 F.D.A. regulated companies the 7 years prior to 2011 to investigate whether the magnitude of option pay correlated with the frequency of product recalls; it did, as the higher the stock options, the more prone towards aggression not thoroughness, the C.E.O. tends to be, leading to product recall. Though it was observed that C.E.O.s with longer job tenures are less susceptible to the higher option pay-higher aggression effect, note that these were founder-C.E.O.s. (as cited by Lam, 2015).
Also, business-judgment rule protects most directors knowing there is no personal liability no matter what is paid to the C.E.O.s even when unprofitable choices are made. Safety in numbers. Directors can reassure each other that the actions are as all other Fortune 500 board members do. (Clifford).
Rock Center for Corporate Governance at the Stanford Graduate School of Business did a survey involving 1,202 person on opinions if C.E.Os. make too much relative to the average worker, and 74% were in agreement. (as cited by Freeman, 3rd of July 2017). It can be said then, there are elements of excessiveness in what C.E.O.s earn.
Wowak (as further cited by Lam), says that many company boards have already started to see these downsides of option pay, and thus it has become less common in the past decade. Instead, companies are turning to stock grants that come with a set of requirements such as the number of years in tenure and performance targets, in order to balance the reward structure in a way that favors the long run.
Despite complaints from media and general public on seemingly unfair compensation packages for executives especially C.E.O.s, it is essential to note that these forms of reward work pari passu with owners, who also gain more from higher profit driven by high C.E.O performance.
Reference
Baye, M. R. (2010). Market Forces: Demand and Supply. Managerial Economics and Business Strategy. McGraw-Hill Irwin. 7th Ed. Pp 219-223
Baye, M. R., (2014). Managerial Economics And Business Strategy. McGrawhill-Hill Companies, Inc. New York, N.Y. 8th ed. Pp 3
Clifford, S. (2017, June 14th). How Companies Actually Decide What to Pay CEOs. The Atlantic. Retrieved from https://www.theatlantic.com/business/archive/2017/06/how-companies-decide-ceo-pay/530127/
Freeman, M. (2017, July 3rd). Do these CEOs deserve their high pay packages? The San-Diego Union Tribune. Retrieved from http://www.sandiegouniontribune.com/business/sd-fi-ceo-compensation-20170627-story.html
Lam, B. (2015, September 18th). How Paying CEOs in Stock Options Leads to Unsafe Products. The Atlantic. Retrieved from https://www.theatlantic.com/business/archive/2015/09/ceo-stock-options-recalls/405910/
Nobel, C., (2015, November 18th). Who Really Determines CEO Salary Packages? Forbes Magazine. Retrieved from https://www.forbes.com/sites/hbsworkingknowledge/2015/11/18/who-really-determines-ceo-salary-packages/#7912fc451a32
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