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In their book Working Capital: The Power of Labor's Pensions, the authors argue that by chasing short-term return, pension funds ignore the long-term interests of workers. This excerpt looks at the issue of how CEO compensation damages pensioners.
In the 1980s, major corporations were cheered on by Wall Street as they went cost cutting with a vengeance. The announcement of mass layoffs generally sent stock prices soaring. Efforts to get cheaper labor through outsourcing or moving operations to developing nations raised short-term share prices. The market's rationale was that these measures would mean higher corporate profits, and higher profits should mean higher stock prices.
Whether these moves always led to higher profits in the long term is debatable. For example, many firms lost highly productive workers in downsizing. However, firms don't apply the same meat axe to all expenses. Although the wages of workers have been stagnant or declining since the 1980s, the wages of corporate chief executive officers (CEOs) have been soaring. The average compensation of a CEO at a major corporation in 1995 was $4,367,000 (Mishel, Bernstein, and Schmitt 1996). This compares to average CEO compensation of $971,000 in 1965. (Both numbers are in 1995 dollars.) The ratio of the compensation of CEOs to that of an average worker increased from 39.5 to 1 in 1965 to 172.5 to 1 in 1995. CEOs in the United States receive far higher compensation than CEOs anywhere else in the world. Even before counting the value of stock options and bonuses, which account for the bulk of CEO pay in the United States, CEOs in the United States on average received pay that was more than twice as high as the average of other industrialized nations. Factoring stock options and bonuses would make the CEOs in the United States appear even more highly paid.
The reality that CEO compensation is much higher in the late 1990s in the United States than it was in the recent past, or in comparison to other industrialized nations at present, should raise serious questions. Have CEOs become so much more productive relative to other workers over the last quarter century? Are U.S. CEOs that much more productive than CEOs in Europe and Japan?
There is no evidence to indicate that this is the case. In fact, numerous studies have examined whether there is any link between CEO pay and corporate performance. These studies have looked at the simplest measures of success, such as the increases in share prices and the growth of profitability. Studies cited found little or no link between CEO compensation and corporate performance (Barkema and Gomez-Mejia 1998; McGuire 1997).
This remarkable finding suggests that high levels of CEO compensation cannot be justified by productivity. It would be comparable to finding that a firm paid its autoworkers 30 percent more than the standard wage although they were no more productive than the average autoworker. Overpaying autoworkers in this way would never be tolerated; management would demand pay cuts or look to outsource work. If the existing management didn't pursue this route, the stockholders would almost certainly revolt and attempt to replace it with new management that would.
The downside of stock options
Yet financial markets do not react the same way to excessive CEO pay. In fact, the markets have been willing to tolerate deliberate acts of deception to hide the true cost of CEO pay. Much of CEO compensation comes in the form of stock options, the right to buy shares of stock at a below-market rate. This has a clear cost to the corporation, because it involves issuing new shares of stock, thereby lowering the value of the existing shares. In 1992, the Financial Accounting Standards Board (the organization of professional accountants that determines proper accounting practices) ruled that the cost associated with these options should be treated like any other expense and be directly deducted from corporate profits. Corporate executives intensely lobbied Congress, arguing that accurate accounting of CEO stock options would significantly lower their share prices. The lobbying effort was successful: It prevented the Financial Accounting Standards Board's ruling from being implemented. Corporations can continue to hide the true cost of stock options issued to CEOs and other executives from their shareholder. 6
The difference in the way financial markets treat the cost of CEO compensation and the wages of ordinary workers can perhaps best be explained by the human element in the working of financial markets. Corporate CEOs and the corporate boards that hire them and determine their pay are likely to have much in common. They tend to be among the richest members of society. They often interact socially and, in many cases, are personal friends. Under such circumstances, it perhaps should not be surprising that corporate boards do not attempt to cut CEO compensation with the same vigor as they would the wages of ordinary workers. The CEO is one of them, and ordinary workers are not.
It is important to realize that the sums involved are quite large. Even though the CEO is only a single individual, pay packages that run into the tens or hundreds of millions are a major expense even for large corporations. ...
At Occidental Petroleum, the company with the largest CEO tax, an average worker would have received a pay increase of $8,199 if the CEO's pay had instead been divided among the workforce. The … pay increase could have been as much as $16,398, if excessive compensation going to other top executives also had been divided up among the workforce.
To be fair, it should be noted that these are the largest CEO compensation packages for 1997. Most pay packages take a somewhat smaller bite out of workers' pay or corporate profits. Nonetheless, for most major corporations, the compensation that goes to the CEO and their top executives would be a significant sum if it were either distributed to workers or added back to profits.
Also worth noting is a pernicious side effect of excessive CEO pay. As mentioned above, the years since 1980 have seen a considerable increase in wage inequality, with those at the top gaining enormously at the expense of workers at the middle or bottom. It is likely that outlandish CEO pay encourages this trend not only because of its direct effect in shifting income upwards, but also through an indirect effect in creating new standards for corporate executives. If the CEO can make $20 million a year, then his or her assistants might believe that they should earn $1 million a year, and maybe that the employees just below them to earn $600,000 a year. High CEO pay can push up the whole pay scale at the top end of the spectrum to the detriment of ordinary workers and the long-term well-being of the company.
Workers can force change
Fortunately, CEO pay is an area in which workers can act directly through their union pension funds. Arguably, CEO pay is a direct deduction from corporate profits. This means that, insofar as CEOs receive excessively generous pay packages, the excess comes directly out of money that should be going to shareholders. In such a situation, the fiduciary responsibility that pension fund managers have to the fund not only allows them to try to rein in CEO pay, but also legally obligates them to make such an effort. Unless it can be shown that high CEO pay has somehow led to better corporate performance (the existing research indicates the opposite), pension fund managers are obligated to bring this pay under control to increase the returns to the fund.
| Union pension funds are large enough actors in the market that if they began to demand such caps, it would have a substantial impact. |
| — Dean Baker and Archon Fung |
It is often argued that CEO pay cannot be controlled, because it comes mostly in the form of stock options. In some cases, stock prices go up enormously, and the CEO benefits along with all the other shareholders. In fact, it is a simple matter to cap the gains that a CEO can earn from rising stock prices. Contracts can be structured to ensure that CEOs have plenty of incentive to work hard to raise stock prices but prevent them from gaining unlimited wealth if they happen to get lucky and the stock price escalates. For example, the total gains from stock options could be capped within the contract at $3 million per year, with any additional gains being returned to the firm.
Proponents of the current system, in which CEOs can earn tens or hundreds of millions of dollars through stock options, often argue that these packages are necessary to tie the CEO's interests to those of the shareholders. They raise the concern that CEOs may otherwise attempt to further their own security as top managers rather than maximize the price of the company's stock. Although there is a legitimate concern here, no one has produced evidence that these sorts of packages are necessary for that purpose. Even if the potential gains were measured in the millions, instead of in the tens of millions, CEOs would still have enormous incentives to increase stock values. Furthermore, even if a CEO reached a cap on the value of options in an existing contract, he or she would still have incentive to perform well, because in most cases he or she would be in search of another contract, either from the CEO's current firm or from a new one. That firms have felt the need to evade standard accounting procedures (as determined by Financial Accounting Standards Board in their treatment of options) points to the fact that CEOs did not get their fat packages through the natural operation of the market.
Union pension funds are large enough actors in the market that if they began to demand such caps, it would have a substantial impact. In principle, other investors could also gain from imposing such caps. Only the elite few who see the CEO as a friend rather than a cost will be bothered by this approach. If nothing else, union pension funds should be able to ensure that CEOs and other top executives are treated just like all other workers.
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Six Questions for Archon Fung
Mallory Stark: You use the term "collateral damage" in your book. Could you explain how it relates to the worker-owner view and proactive use of pension fund investments?
Archon Fung: The basic idea of "collateral damage" is that the ordinary operations of pension fund investing and other kinds of investing in capital markets can generate negative social and economic externalities. Within the existing rules of the financial game, seeking the highest risk-adjusted rate of return can result in myopic investment, undue "churning," investment gaps, and unnecessary job loss. The aim of the worker-owner view and socially active pension fund investment generally is to recognize these defects and self-consciously correct them.
Related to the concept of collateral damage is collateral benefit. Many investments generate social returns above and beyond their narrow and direct market returns. Investments to build affordable housing, for example, can lead to more stable communities and work forces. It is a tragic irony when pension fund investments—which are after all the deferred wages of current workers—are deployed in ways that generate collateral damage that harms those workers rather than collateral benefits for them.
Q: You argue that market and corporate focus on short-term investment decisions harm workers, especially those lower on the salary scale. How so?
A: When investors chase what they perceive to be the highest rate of return on a short-term basis, the choices they make often reflect fads and poor, or poorly analyzed information about particular investment options. These choices will often be less attentive to important medium- and long-term considerations such as the skill, health, and morale of workers.
Q: What has Enron taught us about management of retirement funds?
A: One major lesson of the Enron debacle is that making wise investments that are economically and socially productive requires close and difficult-to-obtain information about the actual practices of firms and their broad consequences. In Working Capital, we offer many examples of investment funds from the United States and abroad that pay very close attention to the firms in which they invest and the economic and social consequences of those firms. These examples, in which investors and analysts have much deeper knowledge of their sectors and a broader view of the purposes of investing, show one way in which future Enrons can be avoided.
Q: You advocate a securities transaction tax. How would that benefit workers?
A: This is an old idea and most nations that have active securities markets impose some kind of securities transactions taxes. We argue that the main benefit of such a tax would be to reduce short-term trading and so increase the reliance of investors on medium- and long-term information about securities and so become less speculative. We then argue that workers stand to benefit when investors focus on the sources of medium- and long-term organizational health.
Q: From an investment perspective, should pension funds be thought of or treated differently than other types of investment vehicles?
A: Pension funds are special, and this is reflected in part by the degree to which they are legally regulated. Pension funds consist of the collective capital of current public and private sector workers, which is held in trust for them to provide a stream of income after they complete the working portion of their lives. The argument of Working Capital is that there is great potential for workers and society at large to also enjoy some benefits—namely the collateral benefits of appropriately guided investments—from these savings here and now.
Q: If in fact pension funds are not paying off for workers, what can they do to change the situation?
A: Working Capital argues that pension funds are not paying off as much as they could for workers, and the book contains many proposals for improving matters. These include socially responsible investing, education and guidance for pension fund trustees, shareholder activism and corporate governance activities, democratizing pension fund management and governance, as well as reforms to the rules of capital markets themselves. These reforms will require a shift in the mind-set of ordinary workers, investors, managers, and activists. They must come to see that there are real choices and real stakes involved in pension fund investing. These decisions need not be driven by a solitary logic of return-seeking (though they must of course generate returns). Other goals, values, and methods can, and should, come into play. In addition to arguing for this enlarged perspective, many contributions in the book offer examples of how it has been embraced successfully by various investors and funds. We hope that Working Capital will provide tools and insights that advance this perspective in practice.
— Mallory Stark, HBS Working KNowledge