Are CEOs Paid Too Much? The role of disclosure, institutional monitoring, incentives and size Economic Society of Australia Lunchtime Seminar, Wednesday 8 November 12.30–1.50 Presented by Peter Swan and based on joint work with a number of co-authors University of New South Wales

2 Outline of the talk I begin by summarising many claims that CEO pay in both Australia and the US is both “excessive” and not performance related The suggestion is that CEOs earn “rents” as a result of “board capture” by appointing “their mates” to the board and reflects poor corporate governance practices such as large boards with too many insiders Disturbingly, statistically, the main explanation for CEO pay levels is company size with pay levels rising about 27% for each doubling in size Towards the end of my talk I put forward two possible explanations for this robust finding

3 Outline of the talk CEOs are (in theory) subject to a ‘participation constraint’- should not receive ‘rents’ If interests are aligned with shareholders, are risk averse, unable to diversity, then pay will increase when incentives are enhanced-compensation for added risks CEO pay subject to two types of monitoring, in addition to board,  With public disclosure, shareholders are in a better position to monitor CEO pay  Institutional investors are in a strong position to monitor CEO pay levels

4 Outline of the talk Monitoring, far from reducing pay, actually increases it Both disclosure and institutional monitoring result in higher performance pay-executive option allocations and holdings These raise pay-performance sensitivity and performance but raises total pay-additional undiversifiable risk Explains why CEO pay has risen so dramatically No evidence that CEOs in general are overpaid

5 Outline of the talk If rising CEO pay is due to incentives and risk aversion, why is pay so much higher in large firms?  Explanation 1, cloning effect due to Rosen: The CEO of the largest firm commands the most assets and clones himself multiple times via the hierarchy and subordinates.  Hence the largest firm must attract the most able manager with the highest opportunity cost by paying him the most

6 Outline of the talk  Explanation 2, careers effect due to Sung and Swan: randomly some agents work for small firms early in their career and others for large firms.  There is no difference in the abilities of the agents.  When agents evaluated, larger firms will prefer to employ those experienced in the large firm and will pay them more

7 Growth in executive pay and claims that it is excessive During the 1990s the real pay of Australian CEOs (882 CEOs of 772 largest firms- Merhebi, Pattenden, Swan and Zhou Accounting and Finance 46 (2006), , rose 85% (Mean) and 67% (Median). Graph is in 1990 dollars. The mean is influenced by high salaries for a number of large companies Excludes severance payouts to retiring CEOs (e.g., Grasso’s departure from the NYSE) In 1992, CEO of an S&P 500 firm earned $2.7 million. By 2000, increased 400 percent, to $14 million. In 1992, CEOs paid 82 times blue-collar workers; in 2004, paid 400 times – Robert Daines (Stanford) Larry Ellison of Oracle cashed in $700 million worth of options in 2001

8 Growth in executive pay and claims that it is excessive "If you look at the numbers, it is accurate to say the more you pay a CEO the worse the company performs and the less you pay the better it performs," - Dr John Shields ---If true pay for non- performance and penalise performers CEO pay going up relative to average workers but this does not mean that it is excessive. Are shareholders are getting value for the increasing amounts they have been paying CEOs?

9 Australian Real CEO Pay Growth (Salary Bonuses and Benefits), , in 1990 Dollars based on Merhebi et al (2006)

10 Pay-size relationship puzzling-does not appear performance based For a 10% increase in size (firm revenue), Australian CEO pay increases by 2.74% (Merhebi, Swan and Zhou findings) Following table shows similar findings for most countries -Italy and Spain less pronounced Pay-size relationship evident to researchers for decades but reasons are not clear I put up two possible explanations

11 Merhebi et al (2006): Firm size determinant of pay with same pay size elasticities for most countries

12 Merhebi et al (2006) show Australian PPS similar to US and other countries 20.1 cent cash pay increase per $1,000 increase in Shareholder Wealth $1.82 per $1,000 including shareholding 1.16% increase for a 10% increase in shareholder wealth (semi-log specification) Shows that claims that incentives low or negative in Australia are false as these results are comparable with other markets

13 Working paper by Gallagher, Smith and Swan (2006) Study covering approx 100,000 exec years over 2550 firms ( for the US) shows option incentives add to market value (Tobin Q) Pay Performance Sensitivity of Option Holdings measured by the equivalent proportional equity share holding of executive Conditional on options, higher total pay has negative impact on performance, as do conglomerates Due to added total pay -compensate undiversified executive for added risks

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15 What could be the cause of high and rising executive pay levels? Optimal incentive contract must satisfy:  Executive’s participation constraint -not worse off relative to outside opportunities  Incentive compatibility constraint - minimises cost to the executive of providing costly ‘effort’ Undiversified risk averse agent requires higher pay if forced to bear idiosyncratic risk borne by an undiversified shareholder Would expect pay levels to go up as a higher fraction of his pay is tied to shareholder performance

16 Evidence from Swan and Zhou (2006) Disclosure of pay of Canadian CEOs in October substantial pay rise over next four years (even relative to US) If CEOs already overpaid in Canada would expect shareholder scrutiny to result in fall, not a rise Pay levels rose -value of incentives-option grants-rose substantially Performance sensitivity rose from negligible to almost US levels Increased sensitivity and risk averse CEOs explains increase in pay Performance pay increased substantially -fixed pay did not vary

17 Impact of pay disclosure in Canada on pay levels and matched US firms

18 Explanation for differences in pay levels between Canadian and US CEOs First two columns of next table shows no significant difference between Canada and US after controlling for performance but semi- elasticity model shows a rise in total pay after disclosure in Canada No significant change in intercept (fixed pay). Pay increase in Canada due to rise in performance pay

19 Explanation for pay levels- Canadian incentives improved due to disclosure

20 Swan and Zhou (2006) show impact of disclosure on CEO pay in Canada

21 Swan and Zhou summary of estimates of CEO incentive parameters

22 Swan and Zhou show option grants and stock holding rose in Canada due to disclosure

23 Role of institutional investors in monitoring executive pay Large investors, such as institutions, can play an important role in controlling the errant behaviour of executives. Institutions focus on compensation to control executive behaviour. Institutional influence designed to increase incentives- rewards for maximizing firm value. Actions by institutions to better align interests of executives with shareholders desirable.

24 Findings of Gallagher, Swan and Smith (GSS) (2006)on monitoring by institutional investors Hartzell and Starks (2003), hereafter H&S, examine the issue of institutional monitoring of executive compensation. Findings of H&S:  Institutional investor influence increases option grant pay-for-performance sensitivity.  Institutional investor influence reduces compensation level H&S conclude “institutions serve a monitoring role in mitigating the agency problem between shareholders and executives”.

25 GSS: Invalid measure of institutional influence H&S measure institutional influence as institutional concentration. Defined as shares held by the five largest institutions divided by shares held by all institutions. Firm A – top 5 institutions own 30 percent of shares outstanding while all institutions own 60 percent of shares outstanding. Institutional concentration is 0.3/0.6=0.5 Firm B – top 5 institutions own 10 percent of shares outstanding while all institutions own 20 percent of shares outstanding. Institutional concentration is 0.1/0.2=0.5. Institutional concentration does not reflect ownership structure or influence of institutional investors.

26 GSS: Questionable use of control variables Institutional concentration is highly negatively correlated with firm size. H&S use the level of market capitalization as a control for firm size. They do not use the natural logarithm! H&S may not be reliably controlling for size effects. Any relation between executive compensation measures and institutional concentration may be reflecting a size effect rather than institutional influence.

27 GSS: What do we find? Institutions do still play an important role in increasing sensitivity of pay to performance via higher option grants and holdings Institutions, contrary to findings of H&S, raise salary levels but, by increasing incentive pay, reduce salary as a proportion of total compensation  Salary rise consistent with compensation for higher risk borne by executives when incentives raised Share ownership incentives are reduced!  Consistent with encouraging management to take higher risks

28 GSS: Data Data sources:  Executive Compensation – S&P’s ExecuComp.  Institutional Holdings – Thomson Financial CDA/Spectrum. Sample:  Data is collected for fiscal years corresponding to  The firms included in the sample are those in the S&P1500. This represents a total of 2559 firms.  Our matched sample covers 97,679 executive years.

29 GSS: Institutional influence variables Three Measures of Institutional Influence 1. Institutional Concentration-  Shares owned by top 5 institutions divided by shares held by all institutions-misleading H&S measure 2. Top 5 Ownership-  Shares owned by top 5 institutions divided by total shares outstanding-size related control used H&S 3. Ownership Measures derived from factor analysis-  Bushee (1998) employs factor analysis. We capture institutional propensity to have large holdings and short term holdings  Ten variables reduced to two factors that are not size related

30 GSS: Institutional influence variables capture highlighted types of institutional investor  Partitions of institutions based on factor scores. Institutions with small long term holdings. Institutions with small short term holdings. Institutions with large long term holdings. Institutions with large short term holdings.

31 GSS: Pay-for-Performance sensitivity computation Our study uses the Yermack (1995) approach to measure option and stock PPS. PPS = Delta * (No. shares divided by total shares outstanding in firm). For option grants the option delta computed using the Black-Scholes formula adjusted for dividend. For stock, the delta is 1. PPS gives a dollar change in executive wealth for a $1000 change in shareholder wealth.

32 GSS: PPS of option grants as a function of institutional influence Model 1 replicates the HS methodology- yields same conclusions as the HS study. Model 4 replicates HS except using log market capitalization- institutional concentration is now insignificant. Top 5 Ownership and Large Short Term Institutional Ownership both have a positive relation with PPS of option grants. Changing transformation of market capitalization affects Large Long Term holders in model 3 and 6.

33 GSS: Pay-for-Performance sensitivity of option grants as a function of institutional influence

34 GSS: Impact of monitoring on salary level HS Specification (Model 1) shows significant fall in salary level Correcting for mis-specified size control (Model 4) reverses HS findings Models 2 and 3 with better measures of influence show that salary increases but not by much With appropriate size control, Models 5 and 6 still show positive and significant impact on salary

35 GSS: Salary as a function of institutional influence

36 GSS: Impact of institutions on Salary Proportion Ratio Model 1 with H&S Specification suggests that SPR increases in institutional concentration (but not ownership) Model 4, correcting size control measure, reverses finding on institutional ownership as it is now positive. Better constructed measures (Models 5 and 6) all show a strong negative relationship

37 GSS: Salary Proportion Ratio (SPR) as a function of institutional influence

38 GSS: Salary and Salary Proportion Ratio of Total Compensation as a function of institutional influence Using the Log of Market Capitalization changes the H&S results dramatically- the institutional concentration coefficient changes from negative and significant to positive and significant. Top 5 Ownership and our Factor Analysis derived measures are less sensitive to changes in the transformation of market capitalization- they consistently yield a positive and significant relation with salary and total compensation.

39 GSS: Conclusion with respect to institutional monitoring Institutions exert upward influence on option grant and option holding PPS However, a negative relation exists between institutional influence and private share holding PPS by CEOs Institutional influence is positively related to both salary and total compensation Institutions prefer equity characterised by lower levels of PPS and higher total compensation These findings are inconsistent with the belief that CEOs are overpaid

40 Oetomo and Swan -Rosen’s cloning hypothesis Examine 663 executive movements between companies Mostly executives move from smaller to bigger companies Tend to be paid more in larger company Receive more of their pay in incentives such as options Performance of the initial (smaller) company tend to be better than current company

41 Oetomo and Swan, Executive movements: firm in initial employment (Firm1), subsequent employment (Firm 2)

42 The size difference between the new and old company is explained by: The better the performance of the old company the greater the absolute and relative size increase Existing CEOs move between similar sized companies CEOs at small companies move to non-CEO position at large companies Non-CEOs at larger companies move to CEO positions at smaller companies

43 Oetomo and Swan: Relationship between firm size, past performance and nature of executive move

44 Sung and Swan career path agency model Agents have identical abilities but some spend early career in a small firm, others in a large firm Agents are then evaluated on performance with some hired with high pay in large firms and others at low pay in small firms-large firms mostly hire CEOs from other large firms, according to the model Taking account of higher managerial ability in large firms significantly reduces but does not eliminate pay-size relationship-leaves room for Sung-Swan explanation

45 Oetomo and Swan: augmented pay-size relationship and conventional pay-size regression

46 Conclusion Pay-size relationship explained in part by the movement of talented managers from smaller to larger companies Accompanied by increases in performance pay When control for talents of managers at firms of different sizes the true pay-size relationship smaller than estimated one Pay levels rise as CEOs better monitored indicates that CEOs are not over-paid Pay will rise further as incentives are relied on more heavily by boards with size mattering less Outcomes preferable for shareholders as performance enhanced