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Are Ceos Overpaid Essay Format

That CEOs are overpaid is something, as Leonard Cohen would say, “everybody knows”; including the directors and shareholders who ultimately decide their pay. Yet firms are unwilling to do anything about it, because to do so would damage internal relations, undermine status and run against the norms of the system.

Across Europe, the US and Australia,, four fifths of people believe business leaders in their countries are overpaid and/or that executive salaries should be capped.

In Britain, the head of the Institute of Directors said the “current rate of executive pay is unsustainable”. Several global business leaders have criticised “excessive compensation”. Paul Anderson, then retiring chief executive officer (CEO) of BHP Billiton, saw “no way to justify the incredible compensation” of CEOs.

An Australian survey showed a majority of directors considered CEOs were overpaid – yet boards of directors set CEO pay. In-depth interviews with non-executive directors brought out comments like “I don’t think any individual is worth that much”.

The retiring global CEO of Royal Dutch Shell conceded:

“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”.

This disaffection is founded in reality. From the mid 1980s, real executive salaries grew substantially faster than average real wages.

Yet that difference in growth rates has not always existed. In America, Britain and Australia, series on executive pay and average earnings tracked each other fairly closely through the 1970s and early 1980s; but from the mid-1980s they diverged. CEO pay helps explain the [rise in top income earners’ share](http://andrewleigh.org/pdf/TopIncomesAustralia%20(ER.pdf) of national income, which in turn is only evident since the early 1980s.

Yet evidence shows the link between CEO pay and performance is often either negligible or negative - though there is some evidence of a weak, positive link, but this may be only in particular periods, such as boom times.

The issue that bothers the public most, though, is not CEOs being out of line with shareholders (interested in performance) but CEOs being out of line with society. Even if a link existed between CEO pay and performance, this should not in itself create the recent pay divergence. There has not been the substantial improvement in economic performance necessary to explain it.

What then drives executive pay? This recent study shows several influences.

Size and asymmetry

The first is size. Large firms have greater power. Executives of larger corporations command more resources and have greater opportunities for “value skimming”, with “proximity to large flows of revenue and fees”; so high executive pay reflects “the advantages of position”.

The second key element is the unbalanced (“asymmetric”) nature of “bargaining”. Rather than having opposing identities to executives, the members of boards or committees setting CEO pay are from the same social milieu with broadly similar interests, precluding “arms length” bargaining.

As in all markets, supply and demand are relevant. But in labour markets for executives and directors, social norms are a critical institution. These norms can be summarised by seven behavioural rules.


First, the status of a corporation depends in part on the status, and hence pay, of its CEO. As Warren Buffett argues, “No company wants to be in the bottom quartile as far as CEO pay goes”. Firms like to have “celebrity” CEOs, and “celebrity” status may boost CEO pay, even though shareholder returns typically decline after a CEO reaches “celebrity” status.


The ability of CEOs to extract rents - “the extra returns that firms or individuals obtain due to their positional advantages”, is influenced by their social capital or networks. So CEO compensation includes a “social circle premium”, boosted by “golfing in the same exclusive club, sharing directors who understand the local pay norm and displaying luxury mansions”.

Being a CEO in a company well connected to other company boards increases CEO pay.

Women typically are less integrated into ruling class old boys networks, and this helps explain the substantial gender pay gap amongst executive directors and CEOs.


CEO pay is heavily influenced by comparisons. This is known as relative pay deprivation (or, as Buffett says, “envy is bigger than greed”). Executives typically believe they are above average and hence deserve to be paid above average. Many firms try to pay above average, almost no-one wants to pay below average.

Observers talk of the domino effect, the Wobegon effect (after a mythical place where every child is above average) or even the “Wal King effect”. When business lobbyists claimed that pay disclosure rules caused a surge in pay growth, they conceded the relevance of relative pay deprivation. There is statistical evidence of it in Australia.


Institutions emerge to help this asymmetric pattern bargaining. Leapfrogging happens with or without disclosure rules. Private institutions take advantage of relative pay deprivation concerns. Pay surveys, a recent development, create reference points for CEO pay. Remuneration consultants have gained prominence in the last three decades. They “are only seen to be doing their jobs if remuneration rises”. Remuneration committees on boards provide the appearance of independent review, setting “undemanding targets” while “ratcheting” pay.


The incentive structure of executive pay adjusts over time. It does this to minimise the risk that pay falls to match performance, to justify high growth and to deflect shareholder concerns.

There has been a major change in composition of CEO pay towards greater use of incentive pay. If this was just about aligning pay and performance, base pay would reduce as incentive pay increased, and total CEO pay on average would change little. Instead the growth of incentives has been central to the growth of total CEO pay.

The inflation of CEO pay, and its high level in the USA, has principally occurred through expansion of incentives. Incentives give the appearance of tying pay to performance and can mask its level as “only relatively few individuals with technical insight are able to understand what an executive is being paid”.

However, CEOs resist pay reductions. If incentive formulas would cut remuneration, then a restructuring of CEO packages (eg to increase the base or revise incentives) might prevent this. So a study of restructures of CEO pay packages found many amendments leading to higher pay, but no amendments if packages paid above expectations.


Different norms shape pay in different segments, though references will be made to other segments to justify increases. The general factors inflating US executive pay tend to be at work in Australia, but that does not mean Australian and US CEO pay are determined in a single global labour market. While beneficiaries have long used international comparisons as a justification for high growth, recruitment of Australian CEOs from overseas was not common.

Manufacturing workers’ pay varies less between industrialised countries than does CEO compensation. The 20 highest paid US CEOs received three times the average remuneration of their European equivalents, but on average ran smaller businesses by turnover. Cross-national differences in CEO pay are “an expression of deeper social values”, including differences in tolerance of inequality (including amongst economic elites) and acceptance of “market” outcomes (though everywhere, inequality is worse than people want or perceive).


The ability of CEOs to ratchet pay upwards is contested. CEO power to shape pay is constrained by several factors. These include: shareholder activists (including superannuation funds); actual or threatened legislation to impose limits on CEO excess; and popular resistance. These wax and wane.

After world war two, an “outrage constraint” would “limit executive paychecks”. But from the 1980s, financialisation and the move towards market liberalism shifted, increased CEOs’ capacity to extract rents and the size and visibility of finance executive rewards, setting new benchmarks for others to follow. The growing “gap between the rich and the super-rich” gave CEOs motivation to aim even higher.

A few years ago corporate Australia was engaged in “a race against time to persuade politicians not to intervene”. The subsequent “two strikes” rule forced them to “adopt a more cautious and thoughtful approach” that was seen as “a genuine tightening”.

So it’s not quite the case that “nothing hapens”. But it only “happens” for a while, until the fuss dies down.

A more extensive version of this, with full references, is published in the Journal of Industrial Relations.

Oracle CEO Larry Ellison reportedly made $96 million last year, Tesla Motors’ Elon Musk made $78 million, while JP Morgan Chase CEO Jamie Dimon reportedly made just $23 million. The average pay of the chief executive of an S&P 500 company has risen markedly since 1980, reaching about 100 times the median household income by the early 1990s. By 2000, it hit a high of 350 times. Although it is down to 200 today (to about $10 million), that figure still suggests a huge discrepancy in incomes. Perhaps unsurprisingly, two-thirds of respondents to the Chicago Booth/Kellogg Financial Trust Index, a survey of a representative sample of US households, say business leaders receive too much income for the jobs they perform.

But while there is more anger than pity circulating for the corporate elite, Steve Kaplan,Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at Chicago Booth, is making a sometimes–unpopular but data–driven case in defense of high–earning CEOs. Kaplan has written a string of papers challenging the common views that executive pay isn’t tied to performance, that boards rarely punish underperforming CEOs, and that average CEO pay keeps going up. 

Instead, he argues, the market for talent largely determines CEO pay. This view puts him at odds with conventional wisdom, popular notion, and some of his colleagues down the hall. But the debate he is eager to have sheds light on questions about CEO pay, and his research suggests the issue is more complicated than is widely portrayed. 

CEO compensation, by the data

Kaplan, a driving force behind Booth’sPolsky Center for Entrepreneurship and Innovation, notes that the data do not support the popular narrative: in the United States, the pay of CEOs at publicly traded companies went down in real terms by 46% between 2000 and 2011, although it bounced back—as did corporate profits—in 2012, while still remaining well below the 2000 level. 

He also notes that comparing those executives’ compensation with median incomes misses that the former have risen and fallen in line with the pay of other highly paid professionals. “CEO pay went up more than it should have in the late 1990s and then came back down,” Kaplan says. “If you look at CEO pay compared to the average pay of people in the top 0.1%, it’s about where it was 20 years ago—in line with [that of] lawyers and private-company executives, and less than hedge-fund managers.”

It is not difficult to see how the widespread impression of roguish CEO behavior has been formed. Consider the options backdating scandal in the United States in 2005 and 2006. The University of Iowa’s Erik Lie discovered that in many cases, companies granted stock options to executives just before their stock prices spiked. The Securities and Exchange Commission and the US Department of Justice subsequently investigated more than 100 businesses, and companies’ own investigations led to dozens of financial restatements and executive dismissals. Although only 12 executives ultimately received criminal sentences, and only five were given prison terms (the others were sentenced to probation), the scandal helped reinforce the notion that CEO compensation often results from underhand means.   

The media tend to focus on these titillating scandals of egregious pay, outlandish profligacy, and failures of corporate governance. Such tales make fascinating stories, but they are not the norm, Kaplan says. “There are outliers and bad actors,” he acknowledges. But, “What you’ve seen in the past 15 years is those outliers have come way down. The median CEO pay hasn’t changed much, but the mean is down a lot, so it tells you that the big outliers have come down.”

Paying for performance?

Research by other Booth faculty takes a different tack. Work by Amit Seru, professor of finance at Chicago Booth, suggests some CEOs manipulate performance measures that are used to determine their pay. In a paper cowritten with Adair Morse, formerly of Chicago Booth and now at Berkeley, and Vikram Nanda of Georgia Tech, Seru analyzed more than 1,000 companies from 1993 to 2003, finding that CEOs influenced measures used to assess their performance. The evidence suggests that powerful CEOs may pressure boards to use gauges that show the CEOs’ performance in the best possible light. CEO compensation correlates well with the better performing performance measure, but only for powerful CEOs (those who chair the company’s board, or appointed a large number of the board’s members). 

The researchers cite the case of former Home Depot CEO Robert Nardelli. A footnote in the company’s 2004 proxy statement given to shareholders stated that Nardelli’s long-term incentive pay would be calculated based on the total return to shareholders over three years, compared with a peer group of retailers. “By that measure, Nardelli had bombed,” write the authors. A year later, they point out, the proxy stated that Nardelli would receive incentive pay if the company achieved a certain level of average diluted earnings per share, a measure by which Home Depot looked far more successful. 

Up to 30% of the fluctuation of incentive pay based on performance can be explained by rigged performance measures, the researchers estimate. “Incentive contracts are at best only partially effective in compensating for weak corporate governance,” Seru, Nanda, and Morse write.

Kaplan acknowledges that there have been corporate governance failures and pay outliers where managerial power is exercised, but he observes that Seru, Nanda, and Morse’s research suggests that CEO pay should have risen along with increasing corporate profits from 2000 to 2011. Instead, the opposite happened. “The puzzle is that profits have gone up but pay has gone down,” Kaplan says. “Everybody’s complaining that something’s broken, but if you look at those trends, that complaint makes no sense.” Seru, Nanda, and Morse argue that such aggregate trends may mask the cross-sectional differences uncovered in their study. Moreover, they say, some of the patterns they identified in their paper may have been ameliorated after the Securities and Exchange Commission sent several companies letters in 2007, critiquing the disclosure practices of their executive pay contracts. 

Pay and corporate governance

While Kaplan sees the increasing use of equity-based pay such as stock options and restricted stock in executive compensation packages as a positive development, other Booth faculty argue that stock options can become very valuable even though a company is only performing in line with the rest of its rivals in the same sector. A study by
Marianne Bertrand, Chris P. Dialynas Distinguished Service Professor of Economics at Chicago Booth, written with Harvard’s Sendhil Mullainathan, finds that the CEOs of the largest oil companies in the United States received big rewards between 1977 and 1994 for improvements in company earnings and stock returns, even when these increases were caused by factors beyond the CEOs’ control. 

Specifically, the authors find that oil bosses’ pay was very sensitive to increases in oil prices, which arguably wasn’t influenced by any individual CEO’s efforts. That CEOs were apparently paid for luck appears to undermine the effectiveness of incentive contracts in tying pay to performance. 

Bertrand and Mullainathan find that “pay for luck” is strongest among poorly governed firms, specifically, in companies without large shareholders who own at least 5% stake. In another paper, they find that firms with weak and strong corporate governance reacted differently when several US states in the mid-1980s passed laws that made hostile takeovers more difficult. Antitakeover laws removed an important check on companies, because the threat of a takeover kept managers on their toes, thus giving them an incentive to increase the value of the company. 

In firms that had no large shareholders, Bertrand and Mullainathan find that average CEO pay increased after antitakeover laws were passed, suggesting that such laws made it easier for CEOs to pay themselves more. CEO pay in firms with large shareholders did not go up, and, without the discipline offered by the threat of a hostile takeover, shareholders made sure that CEO pay was more strongly tied
to performance. 

Kaplan is skeptical of the notion that companies with no large shareholders pay their CEOs differently. He notes that Bertrand and Mullainathan’s pay-for-luck research only examined public companies, not private equity–funded ones. Including these data from companies that have one very large shareholder, the private equity firm, challenges Bertrand and Mullainathan’s basic thesis, Kaplan says. “He has one proxy for governance, we have another,” says Bertrand, maintaining that her research finds systematic differences in the level of pay between companies with and without large shareholders.

Supply and demand

Instead of bad corporate governance or skewed pay incentives, Kaplan argues that the big paychecks executives receive are mostly determined by the demand for and supply of talent. If the market rate of compensation reflects what a CEO’s time is worth, CEOs are not overpaid but rewarded appropriately—or otherwise punished with a pink slip. 

In Kaplan’s view, there are two ways to measure CEO pay, which are sometimes used misleadingly. The first is estimated pay, which includes a CEO’s salary, bonus, restricted stock, and the estimated value of stock options at the time they were granted. This measure is useful for looking at how much boards awarded their CEOs in a given year. The other measure is realized pay, which values options when they are exercised. Realized pay is what the CEO actually took home and is therefore more useful for analyzing whether CEOs are paid for performance.

CEOs may earn a lot, but most of them deserve their pay for increasing the value of their companies, he says. A paper by Kaplan and Joshua Rauh of Stanford finds that the highest-paid CEOs in terms of realized pay—the top 20% out of 1,700 firms—generated three-year stock returns that were 60% higher than those of other firms in their industries. The bottom 20% of CEOs, on the other hand, underperformed other companies in their industries by 20%. 

CEOs who don’t perform get fired, and they’re being tossed out more frequently than in the past. Kaplan says that the average S&P 500 CEO today can expect to stay on the job for six years, down from about eight years before 1998. In a paper with Bernadette Minton at The Ohio State University, Kaplan finds that since 1998 about one out of six Fortune 500 CEOs lost their jobs, compared with only one out of 10 in the 1970s. 

Bertrand argues that the fact that CEOs stick with their jobs, even though average pay has fallen and employment conditions have become more precarious, indicates that CEOs may have been overpaid. “It’s another sign that you can retain those guys with less pay and on worse conditions, so pay probably was too high,” she says.

She also observes that corporate governance has improved markedly since 2000, in part because of accounting scandals such as Enron. That improvement in governance combined with the increased debate about the subject, Bertrand says, could also be a big factor in helping to explain why CEO pay has dropped in real terms.

A global context

One purported reason executive pay has become so fraught is due to the economic downturn and the perception of the growing inequality between the elite “1%” and the rest of society. Policymakers fret about the public’s frustration. The United Nations warned in June that widening disparities in income have created a “disturbing picture” in Europe that’s leading to heightened social tensions. 

Kaplan says he shares those concerns, but argues it is not executive pay that causes social tensions so much as high unemployment and a weak economy. “That’s caused by bad government policies,” he says. “Europe has the worst, most rigid labor laws, and therefore you have high unemployment, which causes unhappiness.”

The share of national income held by the top 1% was higher in 1999 than it is today, and income inequality has decreased since 2007. And yet nobody was protesting between 1999 and 2007, he points out, because the economy was growing. People become unhappy when unemployment is high and the economy is stagnant, as became the case after 2007. And data suggest median incomes in the United States have been stagnant for decades. To Kaplan, anger of CEO pay is merely a symptom of this stagnation, aggravated by the economic downturn.

Kaplan is interested in looking at trends in the global labor market. Technological change has shaped the global economy over the past three decades in three important ways, he says. First, it has spurred the growth of corporate profits and benefited the executives who run big companies. Secondly, it has harmed the middle class in industrialized countries, who have seen blue-collar job opportunities diminish. Thirdly, it has pulled millions of people out of poverty in emerging economies.  

“Technological advances have allowed lawyers to do more work faster and on bigger deals, investors to trade large amounts more efficiently, and CEOs to better manage large global organizations,” Kaplan wrote in an article this summer in Foreign Affairs. “As firms have grown larger, so, too, have the returns for leading them.”

But the poor, too, have benefited from these changes. “The big beneficiaries of technology have been corporations, the people at the top, and people in countries such as India and China,” Kaplan says. “The people who’ve been hurt to an extent are the middle class in the United States because some of those jobs have gone away. That’s the source of some of this angst, but income inequality is the residual, not the driver. The driver has been technological change and the success of the corporate model in generating value.” 

Just as the worries over the fate of the middle class in industrialized economies overshadows the story of the emerging middle class in developing countries, Kaplan thinks the public concern over CEO pay masks a positive narrative about the success of corporations.  

“On the one hand, people complain about corporate governance. On the other, they say companies are hoarding cash,” he says. “But how do you get too much cash? By being successful.” The real story, he says, is about the growth in recent decades in labor productivity, the rise in stock markets, increasing corporate profits, and the expanding global economy. Others may see executive pay as a sorry tale of greed and excess. For Kaplan, it is a symptom of a much bigger success story. 

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