Does Executive Pay Make Sense? Kenneth E. Foster

K e n n e t h E. Foster is Di rec to r of Compen- sa t ion P lann ing for Towers , Perr in, Fors ter & Crosby in New York .

After considering a range of selected indi- cators, the author can demonstrate that pay levels of top executives do reflect perfor- mance and responsibility.

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I n the past few years, several articles in business publications have questioned the rationality

of executive pay. They suggest that executive pay is not determined by level of responsibility and perfor- mance, but by politics, power, and influence.

William S. Albrecht and Phillip Jhin, for example, tested the rela- tionship between pay and responsi- bility for the 148 highest paid executives in the United States by using five variables--total assets, to- tal sales, total number of shares of the company, total value of the shares, and total corporate profits-as surrogates for responsi- bility. The companies in the study included manufacturers, retailers, public utilities and banks, and other financial institutions.

Using regression analysis, Albrecht and Jhin correlated all possible combinations of the re- sponsibility variables with executive pay and found only small positive relationships. They concluded "that the level of executive responsibility (as measured by the five size vari- ables) is not an important variable in determining executive compensa- tion. ''1

Albrecht and Jhin also hypoth- esized the existence of a relation-

1. William S. Albrecht and Phillip Jhin, "The Million Dollar Men," Business Horizons, August 1978: 9-14.

ship between chief executive officer performance and compensation in the "belief that astute shareholders will not permit executives to divert to themselves valuable resources that could otherwise be used in the productive capacities within the firm." To test this hypothesis, they used two different measures of re- turn to shareholders-stock price return and earnings per share. In both cases, the results of their analyses revealed little relationship between executive pay and execu- tive performance.

In a similar study, K.R. Snirvasa Murthy and Malcolm Salter also found no statistically significant relationship between CEO pay and business results after comparing the changes in pay of fifty-three CEOs of major corpora- tions over a six-year period with changes in earnings per share and return on stockholder equity?

On the basis of their empirical analyses, Albrecht and Jhin con- cluded that "neither the level of an executive's responsibility nor his performance strongly influences compensation." On the other hand, they believed that they had identi- fied three factors that did influence executive pay.

2. K.R. Snirvasa Murthy and Malcolm S. Salter, "Should CEO Pay Be Linked to Re- sults?," Harvard Business Review, May-June 1975: 36-43.

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The first of these is the nature of the industry. Some industries appear to pay their executives more than others. The second is the corporate power structure. Because executives play an important role in determining both the membership of the board of directors and the compensation policy of their firms, " they are, to a large degree, dicta- tors of their own destiny." And the third factor influencing executive pay, according to Albrecht and Jhin, is the bargaining skills of execut ives- they "find ways to jus- tify their huge salaries,"

John C. Baker believes that ex- ecutive pay scales are chaotic. He defines executive pay rather broad- ly as "an ever-increasing flood of complex-somet imes bizarre-plans exceptionally favorable to top man- agement. ''3 Thus he covers the gamut of compensation plans, in- cluding stock options, perquisites, employment contracts, and consult- ing fees.

Baker attributes this perceived disarray in executive compensation to five elements: corporate power structure; company directors; wide- ly accepted fictions about executive motivation; executive character; and government and taxes. Two of these e lements-corpora te power structure and executive cha rac te r - are similar to the factors identified by Albrecht and Jhin.

A Rationale for Compensation

I f these findings and opinions were substantiated by other em- pirical studies, they would con-

stitute a significant indictment of executive pay practices. They would indicate that little justifica- tion exists for executive pay levels, which, in turn, would confirm pub- lic and stockholder mistrust of the compensation practices of large cor- porations. These findings, however, do not apply to the entire executive compensation picture, as we will demonstrate after clarifying a few points.

First, when Baker and Albrecht and Jhin refer to the corporate power structure, they seem to focus primarily on the CEO or, at most, on the top two or three executives in the corporation. This implies that the pay of these top executives is set independently of that of other executives.

Further, in any study of execu- tive compensation, it is important to differentiate between relative pay levels across organizations and relative pay levels within organiza- tions. Conclusions can differ mark- edly depending on which aspect is under investigation. A study of pay levels across organizations primarily considers economic aspects of pay relationships, while a study of pay levels within an organization is more concerned with the sociologi- cal aspects of these relationships.

In their discussions, neither Albrecht and Jhin nor Baker sorts out these issues, and this omission clouds their conclusions. For exam- ple, the Albrecht and Jhin study

3. J o h n C. Baker, "Axe Corporate Execu- tives Overpaid?" Harvard Business Review, July-August 1977 : 51-56.

was designed to find an acceptable rationale for differences in pay across organizations. However, their conclusions imply certain things about pay relationships within orga- nizations, even though they pre- sented no data on these relation- ships.

Internal Relationships. Two lines of evidence run counter to the conclusions of Albrecht, Jhin, and Baker. First, strong evidence sug- gests that the total cash compensa- tion 4 of chief executive officers and chief operating officers of large corporations has not increased dis- proportionately in comparison to that of other executives and manag- ers.

The accompanying Table, based on data from the American Manage- ment Associations' Top Manage- ment Reports for 1969, 1975 and 1978179, shows the ten-year histo- ry of the relationship between the total cash compensation of the CEO and the total cash compensa- tion of fourteen executive positions in a typical durable goods manufac- turing firm with sales of between $500 million and $1 billion.

As the table shows, the relative standing of the COO has actually declined significantly over the past ten years. The relative standing of almost all of the other positions has remained constant.

4. In this article, pay or total cash c o m p e n -

s a t i o n refers to base salary and annual bonus , whether paid currently or deferred. It excludes stock options, other long-term incentive plan payouts , perquisites and benefits. Base salaries w e r e those in effect in the first quarter of 1978 and the b o n u s e s w e r e those paid in 1978 for 1977 business results.

Does Executive Pay Make Sense?

External Relationships. Analysis of external pay relationships fur- nishes our second line of evidence opposing the findings of Albrecht, Jhin and Baker. We found that multiple regression analysis of the total cash compensation of the CEOs of a highly diverse sample of 129 companies* strongly indicates that CEOs are paid for both respon-

*Aladdin Industries, Allegheny Ludlum Indus- tries, Allied Chemical, Allied Tube & Conduit, Alumax, Amax, American Broadcasting Cos., American Can, American Cyanamid, American Hospital Supply, American Ship Building, American Standard, American Tel. & Tel., Arcata National, Armstrong Rubber, Atlantic Richfield, Bendix, Bourns, Bristol-Myers, Cer- tain-teed, Champion International;

Champion Spark Plug, Chrysler, Cincinnati Milacron, Cities Service, Clorox, Clow, Colt Industries, Continental Group, Continental Oil, Crown Zellerbach, Cutler-Hammer, Diamond Shamrock, Dillingham, EG&G, Eaton, Emhart, Engraph, Envirotech, Ethyl, Exxon;

Fairchild Industries, Ferro, Foremost- McKesson, Foxboro, Franklin Mint, General Cable, General Dynamics, General Electric, Gerber Products, Globe Union, W.R. Grace, Gulf & Western, H.J. Heinz, Hershey Foods, Hexcel, Hoover Universal, ITT, IU Interna- tional, Indian Head;

Inmont, Insilco, International Minerals & Chemical, International Paper, Johnson & John- son, Keene, Kraft, LTV, Leesona, Leigh Prod- ucts, Marathon Oil, Martin Marietta, Mattel Toys, McDonnell Douglas, McGraw-Hill, Merck, Midland Ross, Mobil Oil, Monsanto, NL Indus- tries, Newell ;

Nibco, Northrop, Northwest Industries, Olin, Omark Industries, PCA International, PACCAR, Parker-Hannifin, PepsiCo, Pfizer, Philadelphia Quartz, Philip Morris, Pitney Bowes, Pullman, Quaker Oats, Ralston Purina, Reliance Electric, Revlon, Rexham, Rohm & Haas;

Sanders Associates, Schering-Plough, Scott & Fetzer, Sealed Power, Sheller Globe, Signal, SmithKline, Sperry Rand, Squibb, Sunmark, Sybron, TRW, Tenneco, Texas Eastern Trans- mission, Thomas & Betts, Time, Timex, Trans Union, UMC Industries, Union Camp, Union Pacific, United Technologies, Wallace-Murray, Warner & Swasey, Western Union, Westing- house Electric, Whirlpool, Xerox.

sibility and performance. All of the companies studied,

except AT&T, are primarily bonus- paying manufacturing organiza- tions. Although the companies overlap with those in the Albrecht and Jhin investigation, our sample contains no banks or financial insti- tutions or retailing firms. There- fore, the measures of responsibility, (sales, assets, and stockholder equi- ty) are much more homogeneous than those in the earlier study.

In our study, sales (S), assets (A), and stockholder equity (E) were combined into one overall measure of responsibility (SAE) be- cause no one element can properly

describe an organization's size, and because from organization to orga- nization the ratio of sales to assets differs considerably. Moreover, combining these responsibility mea- sures minimizes statistical complex- ities in the analyses. Because both assets and stockholder equity tend to increase as corporate sales in- crease, it is difficult to use indepen- dent variables meaningfully in a multiple regression analysis. For ex- ample, sales and stockholder equity may be positively related to pay, while assets are negatively related once the two other factors are taken into account, making it hard to interpret the results intelligently.

Relat ionship o f Total Cash Compensa t ion (TCC) of CEO to C o mpensa t ion o f

14 Other Posi t ions in a Typical Durable Goods Manufactur ing Company

Percent of TCC to TCC o f CEO

Posi t ion 1969 1975 1978/79

Chief Executive Officer

Chief Operat ing Officer

Execut ive Vice President

Top Financial Execut ive

Top Market ing Execut ive

Top Manufactur ing Execut ive

Top Legal Execut ive

Top Industrial Relat ions Execut ive

Control ler

Top Advertising Execut ive

Top EDP Execut ive

Top Purchasing Execut ive

Top Tax Execut ive

Audi tor

Top Transpor ta t ion Execut ive

100% 100% 100%

92 79 72

59 54 59

48 46 47

41 39 36

35 33 35

36 30 32

26 27 28

27 27 28

19 18 21

* 19 20

20 19 19

* 18 18

* 15 15

* 15 15

*Data for this year were no t available.

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"It appears, from both internal and external standpoints,

that there are rational, acceptable, and abiding principles that govern the total cash compensation of top

executives in manufacturing firms."

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The second responsibility mea- sure we used was the number of exempt employees, which was pre- sumed to be a partial proxy for human resource accountability and the complexity of the operation managed. Suppose two CEOs were employed by organizations with equal sales, assets, and stockholder equity, but one had twice the num- ber of exempt employees as the other. It is our theory that the CEO in the company with the larger number of exempt employees would be paid more than his coun- terpart in the firm with the smaller number.

We looked at CEO performance in terms of the business results of the firm. Return on sales (ROS), return on assets (ROA), one-year return on stockholder equity (ROE), and a five-year average re- turn on stockholder equity (ROE-5) were tested. Finally, we considered how long a CEO had held the position. Some had been in the job for less than a year; others had been there for more than thirty years. We assumed, other things being equal, that the longer a CEO had been in the position, the more positively it would affect the pay.

Determinants of Executive Pay

W e found that regressing the log of total cash com- pensation against the log

of SAE accounted for 77 percent of the variation in CEO pay. This is certainly evidence that manufac- turing companies tend to recognize differences in responsibi l i ty-a find- ing markedly different from that of

Albrecht and Jhin. We also found that CEO pay

was related to the firm's business results. When the size of the organi- zation was held constant, ROE ex- plained an additional 3 percent of the differences in executive pay. Although the effect of business results may not be as great as one would like, there is little doubt that company performance affects CEO pay.

If time in position and the log of the number of exempts super- vised are added to the model, another 3 percent of the pay differ- ences can be accounted for. Thus, four compensable factors ac- counted for 83 percent of the differences in CEO pay, a correla- tion of .91. Let's examine the effect of each of these variables on CEO pay estimates.

Doubling the sales, assets, and stockholder equity (SAE) increases estimated CEO pay by 17 percent. Adding 10 points to a company's ROE increases estimated pay by 14 percent. Conversely, reducing ROE by 10 points lowers estimated pay by 12 percent. Thus, the estimated pay of two CEOs in companies of the same size could differ by as much as 26 percent if the ROE of the two firms differs by 20 percent- age points. Doubling the number of exempt employees supervised in- creases estimated pay by 6 percent. Adding ten years to a CEO's time in position increases estimated pay by 10 percent.

Simulating the pay of all 129 CEOs through this model produces total cash compensation estimates that comparatively are quite accu-

rate. On average, the actual total cash compensation of each CEO is within plus or minus 14 percent of his pay estimate. To put this in perspective, in well-designed con- ventional surveys the average per- centage deviation between actual pay and pay estimates for positions lower in the organization usually fails in the plus or minus 20-to-25 percent range. Therefore, under normally acceptable salary survey standards of measurement, our CEO total cash compensation mod- el is highly accurate.

I t appears, from both internal and external standpoints, that there are rational, acceptable,

and abiding principles that govern the total cash compensation of top executives in manufacturing firms. On average, at least, neither the CEO nor the COO has negotiated levels of compensation for himself disproportionate to those of other executives and managers. Further- more, manufacturing firms typical- ly recognize that job responsibility (as measured by the organization's size and complexity) is an impor- tant factor in setting the CEO's pay. To a lesser extent, these firms also vary pay with the CEO's per- formance (as measured by ROE).

There are, however, enough ex- ceptions to warrant vigilance over executive pay by the compensation committee of the board of direc- tors. Although our CEO pay model accounted for 83 percent of the differences in total cash compensa- tion, 17 percent was still left unex- plained. A good portion of this 17 percent is undoubtedly attributable

Does Executive Pay Make Sense?

to the company's pay philosophy. Some firms are convinced that there is value in paying above mar- ket rates; others are equally con- vinced that there is nothing to be gained from such a policy. Certain- ly, the power structure does influ- ence a firm's pay policy.

The fact that some port ion of CEO pay is attributable to business results is comfort ing but not neces- sarily reassuring. Perhaps a much larger percentage should depend on company performance.

But then, perhaps the CEO's pay depends more on company performance than the data reveal. To illustrate, some of the CEOs in our study had recently taken over the management of financially troubled firms. In these cases, turn- ing even a modest profit or re- ducing losses somewhat might rep-

resent the highest level of manageri- al achievement. Yet, this kind of success does not show up in any performance measure. Therefore, it may be precipitous to conclude that performance does not influ- ence pay more than it appears to.

However, suppose we could measure CEO performance accu- rately. What port ion of the CEO's pay should be tied to short-term business results? Some of the busi- ness literature implies that pay ought to be 100 percent perfor, mance-related. But, in our view, the primary determinant of CEO pay should be the size of the job. Most organizations consciously make job responsibility the sole factor for establishing position pay grades. In- dividual performance determines where the person fails within the

pay range established for the posi- tion. Why shouldn't this principle apply to the CEO's position?

Even if pay were based totally upon performance, what measure is appropriate for the CEO? Can a CEO's performance be adequately assessed over a one-, two- or even three-year period? In many in- stances, CEOs have inherited situa- tions that will take many years to alter significantly. Making pay en- tirely or even principally dependent on short-term business results could result in undesirable business deci- sions.

Finally, how long could any firm afford to retain an incompe- tent CEO at any pay level? If the CEO isn't performing well, reducing his pay will not be of much help to the organization. [ ]

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