Why Has CEO Pay Ballooned?Stockopedia updated Jun 30, 2012TweetAt GET.com we maintain complete editorial integrity on our content & provide transparent & unbiased information. Companies don't pay us to include their products although we receive a compensation when you successfully apply to products from our partners. See how we make money here.At GET.com we maintain complete editorial integrity.As the recent "Shareholder Spring" furore has highlighted, executive pay has increased very rapidly in recent years. A study by the Economic Policy Institute found that CEO pay in the US grew 127 times faster than worker pay between 1978 and 2011. This pattern is largely mirrored in the UK. The High Pay Commission notes that, at BP Plc (LON:BP) , the top executive earned 63x the amount of the average employee in 2011, versus 16.5x in 1979. In the case of Barclays (LON:BARC), top pay is now 75x that of the average worker, versus 14.5x in 1979. In the last ten years alone, average CEO pay for FTSE 350 companies has increased by 108%! Why is this? How can we explain the unprecedented explosion in executive compensation, which appears to run far ahead of value and shareholders’ wealth creation? There appear to be two main reasons for this.The Lake Wobegon Effect This is the name given to one explanation as to why CEO pay is so high. In US public radio host Garrison Keillor’s mythical home town of Lake Wobegon, Minnesota, the joke is that all the children are above average. The same is said to be true of CEOs - no firm wants to admit to having a CEO who is below average, so each firm expects its CEO pay package to put him at or above the median pay level for comparable firms. Researchers Bizjak et al. reported in 2008 that 73 out of 100 randomly selected firms “mention targeting at least one component of pay at or above the peer group median or mean.” By definition, not every CEO can be paid more than average, and the result is that we see ever-increasing levels of CEO pay. The reasoning behind this effect was perhaps best summarized by former DuPont CEO Edward Woolard at a 2002 Harvard Business School roundtable on CEO pay: “The main reason compensation increases every year is that most boards want their CEO to be in the top half of the CEO peer group, because they think it makes the company look strong. So when Tom, Dick, and Harry receive compensation increases in 2002, I get one too, even if I had a bad year.... (This leads to an) upward spiral.” Linked to this is a popular argument linked to globalisation that pay has had to rise in order to attract the best talent from abroad to UK companies. Interestingly, though, the High Pay Commission however found that this explanation is a myth, in reality:"global mobility is limited, with only one successful FTSE 100 chief executive officer poached in five years – and even this person was poached by a British company". The Rise of Options and Equity-based Compensation The other - and perhaps more important - explanation for the spike in CEO pay relates to the rise of variable compensation, option awards amp; equity incentives for management teams which are tied to share price upside. This is actually a surprisingly recent phenonenon. It harks back to the rise of economic agency theory and a seminal 1976 Journal of Finance paper by Michael Jensen and William Mecklin. This theory recognised the inherent conflict that exists in a public company where ownership is separated from the day-to-day management of the firm. The managers of the firm are essentially agents of the shareholders, supposed to be running the firm in the shareholders’ best interests. However, they are largely free to act as they choose to, and shareholders have little opportunity to assess whether the managers are actually acting in their interests, as opposed to mis-using company resources and extracting corporate perks. Mis(Alignment) of Interest One solution proposed for dealing with shareholder-manager agency conflicts was to ensure that managers are compensated on the basis of changes of the value of the business. The idea is that, to limit the distortion of CEO decisions that benefit the CEO but reduce the value of the firm, a proportion of the capital should be given to the top managers. This should, in theory, produce a greater "alignment of interest" with the shareholder base, so they win and lose when shareholders do. In reality, though, the change in compensation has not had the effect intended, quite the opposite. Ironically, ideas like Value Creation and Shareholder Value were intended as disciplinary devices but have actually become tools to increase managerial power. As Robert Boyer notes: "What was supposed to be a rational method of generating value and wealth has become ‘a casino economy’ whereby everybody tries to get rich as quickly as possible, with little concern for the long-run viability of their strategy". Performance Pay doesn't Work... As we'll discuss in more detail in a subsequent article, there is actually very limited evidence of a link between so-called performance pay and company performance. There have been many studies that have explored this relationship. Recent UK research includes Eichholtz (2008), Girma (2007), Gregg (2005) and Stathopoulos (2005). To cite one conclusion by Stathopolous: “The overall impression one gains from this vast body of work is that a link between executive pay (including stock option payoffs) and corporate performance does exist. However, the link is quite weak, statistically significant, but far from compelling” .That's hardly the most persuasive basis for this huge outpouring of cash into CEO pay! As Jeroen van der Veer, Former CEO of Royal Dutch Shell has observed: "You have to realise: if I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse". The Cards are Stacked against Investors... Part of the issue is that options and other incentive awards have mostly been implemented via cosy arrangements by (supposedly objective but, in reality, not very) remuneration committees. This has usually been done in such a way that allows managers to enjoy the share price upside, with little or no downside Clawbacks are virtually unheard of. This creates an asymmetry where CEOs are motivated to focus on upside, without caring as much for the downside. One example of this is arguably Lehman Brothers, where management earned vast sums but took the sorts of big risks that ultimately sank the firm. The other problem is that the rise of options and so on has increased pay complexity. The range of elements making up CEO compensation - salary, bonus, stock options, fees for sitting on boards, special credit terms, severancepayment, pension contribution - make it difficult for investors to audit arrangements and make it easier for executives to ‘camouflage’ excessive executive pay. As the High Pay Commission notes: "Ever more complicated pay arrangements hidden within reams of remuneration reports appear designed to obfuscate as much as they reveal. This lack of clarity and decline in transparency, from shareholders and owners of businesses as well as from the public, encourages a sense of distrust when the truth comes out, as it so often does"A Way Forward? From an investor perspective, this issue of CEO pay is deeply troubling - as UK investor association, ShareSoc have rightly noted - with top executives are capturing an every increasing share of company value. The recent moves by Vince Cable - to force companies to have binding votes on executive pay every three years and to require firms to publish a simple figure every year showing how much executives have been paid - will help matters. However, it seems certain that much more will be needed to remedy this situation. Despite numerous attempt to change corporate governance - e.g. the Cadbury Report (1992), the Greenbury Report (1995), the Directors’ Remuneration Report Regulations (2002), the Higgs Report (2003) and the Combined Code (2003), UK company executives continue to be rewarded handsomely, even when corporate performance is poor or unimpressive.Further ReadingFrom Shareholder Value to CEO Power: The Paradox of the 1990sWhy has executive pay increased so drastically? Cheques With Balances: why tackling high pay is in the national interestShareSoc Submission of evidence in relation to the Enterprise and Regulatory Reform Bill Editorial Disclosure: Any personal views and opinions expressed by the author in this article are the author's own and do not necessarily reflect the viewpoint of GET.com. The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author's alone, not those of the companies mentioned, and have not been reviewed, approved or otherwise endorsed by any of these entities.