The question of whether CEOs of America’s major companies are overpaid has been a perennial subject of interest for many years. Are the compensation practices for these elite men and women fair and appropriate? Do these compensation practices provide proper incentives? Or do they reward excessive caution or risk taking?

CEOs not only make a lot of money in terms of raw numbers, they make a lot of money relative to the people who work outside the executive suite. According to one study, CEO pay relative to that of the average employee has soared in recent decades from a level of 30 to 1 in 1970 to 120 to 1 in the year 2000. What’s more, the compensation of CEOs in one sector, financial services, outpaces that of CEOs who head non-financial companies. One study looked at a very select group — the people in the top 1/10th of 1% tax bracket. Executives of non-financial companies comprised 3.9% of this bracket. In contrast, investment bankers comprised 5.2% and fund managers 4.8%.

The amount of salaries and bonuses paid to the top executives on Wall Street has been much in the news in the past year or two, and the debate over the compensation levels for these people shows no signs of abating. Of special interest on the part of many is whether the government should regulate executive pay in the financial services sector.

Wharton accounting professors John Core and Wayne Guay have just completed a study on this topic titled, “Is There a Case for Regulating Executive Pay in the Financial Services Industry?” Although Core was unavailable for an interview, Guay and colleague Chris Armstrong sat down with Knowledge at Wharton to discuss executive compensation in today’s business climate.

Knowledge at Wharton: Wayne and Chris, thanks for joining us today. This is a timely topic. It is one that has been around for a while and apparently will never go out of style given the state of the pay scale among CEOs and other executives. So let’s get started, Wayne, in talking a little bit about the paper that you have written. Can you take a minute or two to summarize why you wrote the paper and what its findings were?

Wayne Guay: I’m happy to be here and happy to do it. This was a paper that we wrote for a conference this past fall at Wharton. The conference was titled, “After the Crash, the Future of Finance.”

As many of you know, during a good part of last year, there were a lot of regulatory issues and regulations proposed surrounding executive pay — not just in the financial services industry, but even potentially more broadly. In this paper, we try to put executive pay in some kind of a context, try to look at it in the financial services industry as compared to some other industries. Then, almost point-by-point we go through a series of the different proposals for regulating pay that have been put forward and discuss some of the strengths and weaknesses of those proposals.

Knowledge at Wharton: You conclude in the paper that there really is no reason to regulate executive pay in financial services because one, either the kind of the general overarching principles espoused by regulators are already in place in many of these companies, or, two, because the proposals that regulators and others have made probably would not achieve their stated objectives. Wayne, can you talk a little bit about that?

Guay: I should note that the paper was jointly written with [accounting professor] John Core who is also here at Wharton. We certainly don’t want people to think our view is that executive pay should not be regulated at all, that it should not be regulated in the financial services industry. Our point here is that many of the sorts of overarching general guidelines that regulators and others have put forward regarding executive pay, in many cases are already being largely followed by most firms. I think there is some room for improvement. There is always room for improvement. Some of the proposals that have been put forward are a step in the right direction.

Other proposals seem less likely to us to really get some serious change…. Our point here is that we need to really exercise caution and recognize that pay has been evolving in many industries and in many firms for decades. There are good reasons why we see [certain pay proposals]. The [idea] that the whole thing should be thrown out and we should start over again, I think, is wrong. We probably want to take what we have … and make some changes to it but not throw the whole thing out.

Knowledge at Wharton: Let’s talk about some of those specifics in a minute. Chris, do you generally agree with the conclusion of the paper in its totality?

Chris Armstrong: Yes. I think the conclusion that they reach is reasonable. I think it is a very well laid out argument where the [authors] walk through the proposals step-by-step. I generally agree with most of their conclusions.

Knowledge at Wharton: Wayne, you mention in the paper that Treasury Secretary Tim Geithner has proposed five ideas that he said would better align compensation practices with the interests of shareholders, and also promote stability of individual financial firms and the financial system as a whole. I’ll just list a couple of those.

One is that compensation plans should properly measure and reward performance and should be aligned with sound risk management. Just take those two examples for a minute. Do you think that most financial firms, most Wall Street firms, are doing that at the moment?

Guay: Yes. I think there is this general notion that there isn’t any pay for performance at these firms, that these firms have largely ignored any attempt to tie pay to performance. Looking at the data — any objective viewing of the data — indicates that there is a substantial amount of pay for performance and, in fact, if you compare the U.S. system with any of the other executive compensation plans in any other countries around the world, the U.S. plans tie pay to performance much, much more than any other country.

Within the financial services industry, specifically, what we ask in this paper is, do we see any wide-spread differences in the pay of top banking executives as compared to the pay of top executives in other industries? We really don’t see much that is that different. So if people want to levy an argument against executive compensation, levying it against the pay for top executives in banking firms of the financial services industry … it doesn’t seem like there is anything specific to that industry that we could find.

Knowledge at Wharton: Chris?

Armstrong: Just to interject for a second, I think the term “pay for performance” is somewhat misleading. [The paper’s authors note] that it is change in wealth we should be looking at as a measure of incentives and focusing on the annual flow pay — the salary the CEO gets. That might not be as sensitive to performance, but their overall equity portfolio is much more sensitive. Those changes represent real changes in CEO wealth.

Knowledge at Wharton: So you’re saying that if a company does not perform well in a given period of time, that its stock will decline in value and, therefore, the CEO’s [wealth will decline]?

Armstrong: His portfolio will decline as well.

Knowledge at Wharton: And that’s how he or she takes the hit.

Guay: I think Chris is right. That is one of the biggest misconceptions about pay for performance. Oftentimes people will look at the CEO’s annual bonus or their salary and they’ll say, boy, the company didn’t do that well this year. The bonus didn’t drop by as much as I think it should have. There doesn’t seem to be any pay for performance. But what we are missing in that analysis is that the executive, the CEO, might have tens of millions of dollars of stock and options that he is being required to hold in the organization. Then if the firm’s stock price drops by 30% or 50% or more, there is a substantial decline in the value of that individual’s wealth. That’s where he really does take the hit.

Also, recognizing to a large extent that the whole point of pay for performance is to provide executives with incentives, I think people often can get almost a little emotional about pay for performance. What immediately comes to mind with pay for performance are rewards and punishment — that we should be rewarding and punishing people. But shareholders don’t care so much about reward and punishment unless those rewards and punishments provide incentives for the executives to do a good job. So the whole notion of pay for performance and rewards and punishments should revolve around [the question], does the executive have incentives to do what’s in the best interest of shareholders? That’s where the stock and the options — and all the equity pay that the executive has been getting and accumulating over time — provides the incentives.

Knowledge at Wharton: In the paper’s introduction, Wayne, you mention that the controversy over executive pay, not only in financial firms but in all U.S. corporations, has been debated for many decades. But as we all know, it came to the fore within the last 18 to 24 months because of the calamity on Wall Street and the public outcry over CEO salaries and bonuses. It seems to me that taxpayers and politicians and others disapprove of these levels of compensation precisely because the leaders of these firms, in the words of Treasury Department officials, nearly caused the financial system worldwide to collapse. Do you think it is a reasonable question for anyone to ask why are these people still making $5 or $10 or $15 million a year when they engaged in such irresponsible activity?

Guay: I think there are a couple of things there. It is certainly the case that the reason CEO pay attracts so much attention is because it is a lot of money. There is no way of getting around this — that the CEOs of large corporations make an awful lot of money and that dollar values are extremely high. That by itself doesn’t tell us anything in particular about whether the CEOs are overpaid. Lots of professions are paid a lot of money. Doctors, lawyers, hedge fund managers, actors and musicians get paid a lot of money. So to put that in perspective, we need some kind of a benchmark. Where do you find benchmarks for how much is the right amount to pay a CEO? In the paper, we try to come up with a few of the benchmarks.

One thing we show that has been [noted] by many other authors is that the pay of CEOs tends to go up with the size of the organization that they are running. So as firms have gotten bigger over time, executive pay has gotten bigger because it is a much harder job to run a very complex global large organization. We also try to put it in context with, say, hedge fund managers or private equity fund managers, and try to benchmark their pay levels, which are largely dictated outside of the regulatory eye and outside of having shareholders that are involved in the pay setting process. We also try to benchmark the U.S. executive’s pay with pay around the world and other countries. In the paper, we come up with various arguments for why it is just not so clear that the pay levels are completely out of whack. But at the same time, there is just no getting around that it will attract attention. [The fact that] the income disparity between the highest paid individuals and the typical worker has been increasing over time has drawn a lot of attention. And maybe it should. But we want to think carefully about what we do about that.

Knowledge at Wharton: Do you have any personal views on whether the aggregate numbers — the aggregate level of CEO pay — just from a common sense standpoint is too high? In the paper, you focus on financial firms, but CEOs in non-financial firms sometimes make $50 million and $60 million a year for the services they provide. Those numbers rattle around in the minds of average citizens who think that, on its face, it is incomprehensible because, as you mentioned a moment ago, the ratio of CEO pay as a multiple of worker pay has skyrocketed in recent years. Chris, do you want to talk about that for a second?

Armstrong: At first glance, it might seem like a pretty high number, but when you stop and put it into perspective and consider the types of decisions that these executives are making, [these decisions] can have tens or hundreds of millions of dollars of impact on shareholder value — even billions of dollars of shareholder value. So from that perspective, it is a fraction of the value that they are potentially creating, or in some cases destroying. It is actually a relatively small percentage.

Knowledge at Wharton: Have compensation practices changed in recent years to reflect the concerns of people that CEO pay has perhaps gotten too high in some cases?

Guay: The levels of CEO pay certainly have not gone down over the last couple of decades. In fact, they have gone up, as we show in the paper. In the last couple of years, they have come down in part as a response to the poor performance of a lot of firms both in the financial services industry and outside. But pay has changed over time — not the level so much as the structure of pay, the transparency about pay, the pay setting process…. If we think that CEOs are overpaid, the natural thing to think about is, well, why is that? One of the common reasons put forward is that the process the board goes through to set pay is flawed, that boards are not independent of the CEO, that CEOs are entrenched; they control the board; CEOs set their own pay; it is not an independent process.

But that’s where I think tremendous inroads have been made over the last 10 or 20 years. Boards are largely independent, much more independent now than they were 20 years ago. Compensation committees are completely independent, the amount of advice that the boards are getting from outside consultants and elsewhere [has gone up], benchmarking is a much more common thing to do, and the disclosures and the transparency about what the board is doing have increased tremendously. Through all of those changes, we haven’t seen the levels of pay go down for CEOs. So my interpretation of this is that the level of pay is not really the problem in the sense that the process by which pay is set seems to be getting better and better and better, and still we don’t see the level of pay going down. That says to me that the level of pay is largely dictated by market forces as opposed to being something that is flawed.

Knowledge at Wharton: Some people would say that there is no real market among CEOs. We are talking about a relatively small number of people, [many of whom] know one another. In addition, boards of directors share members among large companies. So is it a true market or not? Is there real competition among the men and women who vie for these positions…?

Guay: Well, I can tell you that every MBA who graduates in the United States would love to have one of these jobs. These are the top 5,000 or 10,000 jobs that just about every business student and non-business student strives to attain. There certainly isn’t a lack of people competing for these jobs. With respect to the issues you talk about with there being a fairly small community, it is certainly the case that board members are typically CEOs at other firms.

But the system is fairly cognizant of that and tries to be transparent with respect to independencies or dependencies between those executives. There has been some research on the extent to which that is an issue.

Armstrong: The flip side of this — and this is just anecdotal — is that the average tenure of a CEO is not that long. I think it has declined slightly over time. Do you have a good estimate of what that is now?

Guay: I think it’s in the ballpark of five to seven years.

Armstrong: Okay. To me, that looks like a pretty competitive labor market.

Guay: I think the point you are raising is that boards are much more likely to throw out a bad CEO today than they were 20 or 30 years ago. So if you want to keep your position as a CEO, you need to do a good job knowing that the board is, in all likelihood, going to throw you out if you don’t.

Knowledge at Wharton: Talk a little bit if you could about the role of Ken Feinberg, the so-called pay czar, within the Treasury Department, and what he is trying to do at this point vis-à-vis executive compensation.

Guay: Sure. So, Feinberg was appointed by the Treasury Department to oversee compensation for some of the TARP [Troubled Asset Relief Program] firms that had received special assistance and to try to overhaul some of the pay practices there. Some of the things that were proposed — like clawing back bonuses that were shown to be received through fraudulent accounting or those types of issues, reducing severance packages was another big thing, increasing some of the disclosures and transparency, making sure that compensations committees are independent — are maybe a little less controversial.

But the big thing Feinberg was trying to do is get executives in the U.S. to hold more stock, to hold it for a longer period of time, to have less of their pay in the form of cash and more of their pay in the form of equity. And really focus on getting these executives to hold more equity with the idea that by holding more equity, their interests would be more closely aligned with the shareholders. Although it is a perfectly reasonable end point to have the executives align with shareholders, one of the things we point out pretty clearly in the paper is that U.S. CEOs and top executives already have a tremendous amount of their wealth invested in equity.

Feinberg’s plan, as we have shown in the paper, would not add very much equity to what these executives already have. The U.S. executives already hold many times more stock and options than CEOs of any other country in the world. So it is just not clear to us that that’s really one of the problems that is out there. We would suggest focusing on other things besides trying to get these executives to hold more equity.

Knowledge at Wharton: Let me throw this open to both of you: What sorts of changes would you like to see made in the way executives, CEOs and others are rewarded each year? You mentioned at the beginning of our conversation that you weren’t totally against changes or totally against maybe some new regulations, but what would you personally like to see? What do you think would be some good steps for corporations to take along these lines?

Guay: I’ll just give one and then I’ll turn it over to Chris. One of the things that I think should be a focal point is that over the last 10 or 15 years, the SEC and others have tried to get firms to have more transparent disclosure about how much they are paying their CEOs. What they really haven’t spent a lot of time on is transparency and disclosure with respect to incentives.

So right now, one of the big issues is, do CEOs have too many risk-taking incentives? Do the financial services CEOs have incentives to take undue amounts of risk? Mr. Geithner’s and Mr. Feinberg’s proposals have talked about making sure that you’re not encouraging risk taking among your executives. But there is almost no disclosure in the corporate filings about risk-taking incentives. So as a researcher, economist, academic, I can go try to compute some measures myself, but … the transparency isn’t fully there with respect to estimating incentive structures. So I would ask the SEC to think carefully about this, in large part because it is very difficult to know whether an executive has too much or too little of any type of incentives unless you know how much they have and how much they should have. Until we know that, it is going to be hard for anyone to figure out whether they have too much or too little.

Knowledge at Wharton: Chris?

Armstrong: I would like to echo Wayne’s comments. I think that increased disclosure is clearly the first place to start. Increased disclosure can put more information out there and let the market forces go to work if executive pay is “too high.” The market would more easily see that. It is just difficult to regulate by making blanket statements that pay should be such-and-such at all firms without taking into consideration certain differences that you might want to affect across firms.

Knowledge at Wharton: Wayne Guay. Chris Armstrong. Thank you very much for joining us today.