Why Has CEO Pay Ballooned? - Daily Markets

Why Has CEO Pay Ballooned?

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As
the recent “Shareholder Spring” furore has highlighted, executive pay
has increased very rapidly in recent years. A study by the Economic
Policy Institute found that CEO pay in the US grew 127 times faster than worker pay between 1978 and 2011. This pattern is largely mirrored in the UK. The High Pay Commission notes that, at BP Plc (LON:BP) , the top executive earned 63x the amount of the average employee in 2011, versus 16.5x in 1979. In the case of Barclays
(LON:BARC), top pay is now 75x that of the average worker, versus 14.5x
in 1979. In the last ten years alone, average CEO pay for FTSE 350
companies has increased by 108%!

Why is this? How can we explain
the unprecedented explosion in executive compensation, which appears to
run far ahead of value and shareholders’ wealth creation? There appear
to be two main reasons for this.

The Lake Wobegon Effect

This
is the name given to one explanation as to why CEO pay is so high.  In
US public radio host Garrison Keillor’s mythical home town of Lake
Wobegon, Minnesota, the joke is that all the children are above average.
The same is said to be true of CEOs -  no firm wants to admit to having a CEO who is below average,
so each firm expects its CEO pay package to put him at or above the
median pay level for comparable firms. Researchers Bizjak et al.
reported in 2008 that 73 out of 100 randomly selected firms “mention targeting at least one component of pay at or above the peer group median or mean.”

By
definition, not every CEO can be paid more than average, and the result
is that we see ever-increasing levels of CEO pay. The reasoning behind
this effect was perhaps best summarized by former DuPont CEO Edward
Woolard at a 2002 Harvard Business School roundtable on CEO pay: 

 “The
main reason compensation increases every year is that most boards want
their CEO to be in the top half of the CEO peer group, because they
think it makes the company look strong. So when Tom, Dick, and Harry
receive compensation increases in 2002, I get one too, even if I had a
bad year…. (This leads to an) upward spiral.” 

Linked
to this is a popular argument linked to globalisation that pay has had
to rise in order to attract the best talent from abroad to UK companies.
Interestingly, though, the High Pay Commission however found that this
explanation is a myth, in reality:

“global
mobility is limited, with only one successful FTSE 100 chief executive
officer poached in five years – and even this person was poached by a
British company”. 

The Rise of Options and Equity-based Compensation 

The
other – and perhaps more important – explanation for the spike in CEO
pay relates to the rise of variable compensation, option awards amp;
equity incentives for management teams which are tied to share price
upside. This is actually a surprisingly recent phenonenon.

It harks back to the rise of economic agency theory and a 

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