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Management by the Numbers: Executive Compensation and Shareholder Return

The media frequently evaluates whether or not management earns its pay. Comparisons of salaries to corporate performance often appear once the latest compensation figures are made public in the spring.17 Does extraordinary compensation correspond with high stock returns? Increasingly, the answer appears to be no. In 2002, three of the top six wage earners all worked for Tyco, a company that in the prior year was under intense scrutiny for corporate impropriety and greed. Despite the 22% stock market decline in 2002 for the S&P 500, the executive compensation for Fortune 100 executives rose 14% to $13.2 million. This has created outrage among shareholders and as one pay consultant has put it, "not only does executive pay seem more decoupled from performance than ever, but boards are conveniently changing their definition of performance." As famed investor Warren Buffet noted: the "acid test for reform will be executive compensation."18 This suggests that going forward management actions will perhaps need to be more closely linked to total stakeholder performance.

But, compensation experts are divided on the problems related to management excess. Since greater than 90% of all executive compensation is now in the form of long-term stock options, many experts contend that the problem is self-correcting.19 Executives don't earn benefits related to stock options unless they help the stock price rise. The argument contends that if executives earn exceptional compensation, it is only because they have lifted the stock price to which their interests are directly aligned.

There are, of course, counter-arguments that are relevant for our purposes. The first one addresses timing. If executives can "game" the stock price such that it rises high enough to exercise some of their options in the immediate term, they will gain. If, later on, the stock price ultimately plummets, they will have gained at the expense of the shareholders, though their future options may expire without value. All of this presumes that management can help influence the price movement of the stock. In actuality, management's behavior may be completely unrelated to any stock price movement. In a strong "Bear" market, even Herculean management efforts may be insufficient to move the stock price up. Similarly, in a rising "Bull" market, the stock price may benefit irrespective of management's mistakes.

Critics maintain that stock options are best applied when they are measured or calibrated relative to some meaningful benchmark. This, they suggest, eliminates extraordinary levels of compensation for mediocre performance or uncontrolled externalities. Critics worry that compensation boards tend to be lax with their controls, and that CEOs have far more power and influence over their own salaries than they should be entitled.20 Statistics back up the critics' claims. During the decade 1990–2000, CEO compensation increased by an average of 1,300% compared to the average employee salary increase of 43%.21 Moreover, the gap between U.S. and international CEO pay continues to widen.

Aside from the question of whether such a differential is appropriate, there are other questions concerning the market's response.22 Can executives who reap these enormous financial rewards keep their companies going strong? The data suggests that they can't. Further, the most highly compensated executives tend to pursue above-average M&A activity. Some executives may be using transaction activity to demonstrate growth and help justify their salaries for personal benefit. Future growth models need to ensure that the interests of all stakeholders are more closely aligned for both short- and long-term considerations.

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