Knowledge@Wharton Finance and Investment Research Article

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Although mammoth executive compensation packages at hedge funds -- hundreds of millions of dollars a year for some managers, with a select few topping $1 billion -- have recently been skewered in the business press, public outrage over soaring CEO pay has been growing for years. Is the situation really that bad? And if top executives are overpaid, what's to be done about it?

As Thomas Dunfee, Wharton professor of legal studies and business ethics, puts it: Do executive compensation figures reflect an efficient market, or a failed one? Are pay levels adequately disclosed? Should shareholders have more say? "Are there issues of fairness and justice?" he asked.

Dunfee posed those questions as part of a panel discussion on "Current Controversies in Executive Compensation" at the 2007 Wharton Economic Summit. The panel included Adam D. Zoia, managing partner of Glocap, an executive search company serving hedge funds and other investment firms; Lawrence Zicklin, a business professor at New York University's Stern School of Business; and Wharton professors Thomas Donaldson and Wayne R. Guay.

Today, said Zoia, some hedge fund managers make $500 million a year or more through arrangements that typically bring their firms 20% of the fund's annual profits, plus yearly fees of 1% to 2% of the assets under management. "You do that year after year, and you become a billionaire pretty quickly." Investors, Zoia added, know how much the firm is compensated overall, but not what individual executives are getting. "For the most part, there is very little transparency."

Somewhat more transparency exists at publicly traded firms, leading to considerable controversy in recent years as critics saw executives getting richer while pay for lower level workers remained relatively stagnant. Studies by BusinessWeek and other publications show that compensation for big company CEOs was more than 400 times the pay for average workers last year, up from a 42-to-1 ratio in 1980. If the minimum wage had gone up at the same rate, it would have been more than $22 an hour in 2006 instead of $5.15.

"I can't think of an issue that's more important, when we speak of business organizations, than how you compensate," Donaldson said. "It's a system that's designed to have periodic failures." Egregious cases of executive greed, such as the Enron-era scandals involving 13 or 14 companies, can lead to damaging over-reactions like the 2002 Sarbanes-Oxley law, which dramatically increased regulatory costs for many companies, he noted. In addition, a business can be undermined when the ratio of executive pay to worker pay gets too high. "I don't know what the magic number is, but if it gets too high, it has an adverse impact on the ability of the person to lead." Morale falls as employees resent being asked to make sacrifices not shared by their bosses.

Avoiding "Draconian" Remedies

Corporate board members deserve much of the blame, since they set pay levels, according to Zicklin. Some simply do not know what they are doing, he said, adding that while many professions require tests of proficiency, "to be a director you can be anybody off the street."

Zicklin argued that institutional investors, such as mutual funds and pension funds, now have the clout to curb excessive compensation. In the past, unhappy shareholders were advised simply to sell the stock. But more and more institutional investors are becoming activists. In recent years, one-third to one-half of the activist investors who asked for board seats got them. "This old business of voting with your feet ... no longer holds."

Donaldson predicted that if companies do not get executive pay under control, they face the threat of further "Draconian" remedies like Sarbanes-Oxley. He suggested directors adopt strategies on their own, such as a rule that prohibits compensation consultants from doing other business with the firm. Critics say dual roles make consultants try to curry favor with top executives.

In addition, boards should get pay advice from more than one consultant and should change their stable of consultants every five years, Donaldson said. They also should set pay limits before searching for new executives, and they should be more skeptical of data showing pay at similar companies. Finally, boards should insist on contracts that make it easier to fire executives, and they should not include golden parachutes. "I'm not sure we should have severance packages," Donaldson said. "These are rich people."

Guay suggested that severance should be available only for the first two or three years after an executive joins a firm -- just long enough to compensate for the risk of losing the new job shortly after leaving the previous one. Zoia noted that compensation plans that are heavy on stock and options allow executives to profit by "free riding" as their stock simply floats up with the market. At many volatile hedge funds, profits often are huge one year and non-existent the next, but despite the poor performance the second year, executives get to keep everything they were paid during the first, he said. Some private equity firms have solved this problem with a "claw back" that requires executives to return part of their pay if the company does poorly in subsequent years.

Perhaps, Zoia said, executive compensation should be based not on the company's stock returns but only on returns exceeding the market average. "I want to make sure it's some sort of rolling average" of performance measures over several years, said Zicklin, arguing that executives should not profit from short-term spikes in gauges like stock price.

$2,500 an Hour

While many studies have shown that executive pay has grown far faster than inflation or worker pay, the compensation figures don't look so out of line from another perspective, according to Guay, who pointed out that among the approximately 7,000 firms listed on the major stock exchanges, the median CEO receives about $1.5 million a year. Assuming a 70-hour workweek for a busy executive, that comes to about $450 an hour, comparable to the earnings of top doctors and lawyers.

That may seem like a lot to some, "but it doesn't strike me as particularly high," he said. CEO compensation at the 7,000 firms totals about $20 billion, or 1/10^th of 1% of the firms' combined $20 trillion in market capitalization. Also, Guay said, the typical CEO holds stock and options worth 10 times his annual pay, giving him a strong incentive to make the company prosper -- to the benefit of all shareholders.

He noted, however, that pay is considerably higher at big firms -- $8 million to $9 million a year, or $2,500 per hour, for CEOs of Standard & Poor's 500 companies.

What drives executive pay so high? A chief cause, said Donaldson, is the soaring use of stock options. In the 1990s, the typical chief executive received 80% of his compensation in cash, with options making up the remaining 20%. Those figures are now reversed. As for hedge funds, said Zoia, compensation is rising because the enormous growth of these lightly regulated investment pools has heightened competition for talent.

Part of the problem, Zicklin noted, is that shareholders have long had a hard time determining how much their executives are paid, so there has not been much pressure to hold compensation down. Enough information is scattered through corporate filings for one to determine executive pay, "but you might have to be Sherlock Holmes to do it," he said.

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