Measuring the Value of Executive Pay

Here’s a very useful piece by economics prof Thomas F. Cooley, writing in Forbes: The Real Bank Pay Scandal.

Cooley notes (and sympathizes with) the pattern of outrage over executive compensation. But he also reminds us that, when designed properly (which it isn’t always) compensation packages are designed to give executives incentive to build long-term shareholder value. That’s why, for example, the modern trend is towards paying CEO’s predominantly in stock options: it aligns the interests of CEOs with the interests of shareholders.

Of course, CEOs are humans, and humans are complicated. Motivating them is not straightforward. So different companies use different combinations of salary, stocks, stock options, and other perks. Well-organized Boards of Directors have “compensation committees” set up to figure out how best to incentivize senior execs, and there are consulting firms available to offer advice.

Well, how well do firms generally do? Cooley’s research (with his colleague, Gian Luca Clementi) suggests that, over all, CEO compensation is in fact pretty strongly correlated with gains for shareholders.

The first figure shown below is a plot of net shareholder gain in billions of 2005 dollars (the horizontal axis) against total compensation in millions of 2005 dollars (the vertical axis) for CEOs of all publicly traded companies…
What one would hope to see in such a plot is that the observations would lie in the lower left and upper right quadrants, which by and large they do. …There are some [exceptions] and one can identify them by name, date and company. The important point is that there are very few.

So, with a few exceptions, it looks like firms are doing pretty well at aligning executive compensation with the interests of shareholders. But in an age characterized by massive government bailouts, that’s not the whole story. Cooley’s concluding paragraph:

At the heart of the anger about bankers pay is the very legitimate concern that the bankers and their shareholders and debt holders benefit from a subsidy paid for by taxpayers–the subsidy that is implied by the notion that they are too big to fail. That subsidy empowers them to take bigger risks and earn bigger returns for themselves and their shareholders with all of the down side risk born by Main Street. That is the real outrage.

9 comments so far

  1. John M on

    Sheila Bair, perhaps the most gutsy regulator on the US federal scene came up with an innovative proposal last week on compensation, and she may have the clout to make it happen.

    “FDIC considers plan to penalize banks whose pay practices encourage risky moves”, by Binyamin Appelbaum, Washington Post, January 8, 2009.

    Compare that with our recent transcript of a seminar on regulatory reform held last September, where investor / analyst John Makin notes that Goldman Sachs and J.P. Morgan, in particular, have been diving into risk since they got famously bailed out of their AIG counterparty problems.

    Quantitative evidence for how well chosen compensation can enhance shareholder value is very good, but among my colleagues who are in general highly critical of management practice in Professor Cooley’s FIRE sector, our consensus is simply that when it comes to greed, too much is too much.

  2. Chris MacDonald on


    Thanks for your comment.

    What you say about consensus among your colleagues would have more impact if you said what expertise your colleagues have. It’s not that I’m doubting them — I just don’t know (and readers here won’t know) what the basis is for your consensus.



  3. John M on

    I’ll ask around. We bubble bloggers are a bit light on formal training and qualifications, it’s more like raw observation and increasing outrage.

  4. John M on


    Did you see Harry Bruce’s column today in our local Halifax newspaper? Anyway, I put the question to our readership in the form of a post “Does Mere Blogger Outrage Matter?” and so far I’ve gotten one long response from one commenter who’s also been a long-time polite flame war opponent: “… And to answer your headline question: Yes. But yes mostly because passions and prejudice can overwhelm rational fact based discussions, guided by real expertise, especially on this still new thing we call “blogs”, which could lead to far worse mischief down the road than a few overcompensated investment bankers during a recession.”

    So I’ll take that ‘yes’ as an affirmation 😉

  5. Chris MacDonald on


    Your commentator “Old Mike” is off target when he refers to “MacDonald’s rather snooty response”. My response was far from snooty. It was a request for clarification. You mentioned “colleagues” in your original comment (above) but didn’t say “blogging colleagues.” So I was simply asking who you were talking about.

    I even said, in my query, “It’s not that I’m doubting them…”

    Your friend Old Mike needs to read more carefully.


  6. John M on

    … and write more carefully, I know. Such are the joys of ex post peer review. As a blogger I myself often feel compelled, frankly, to “feed the goat” before things have quite settled down. Fortunately there’s lots of eyeballs out there to improve on the initial impressions.

  7. Mark Edwards on

    I find Cooley’s graphs to be cause for concern rather than consolation on the executive pay issue. If executive remuneration was positively related to shareholder welth wouldn’t we expect the results to be a positive linear relationship going from the bottom left to the top right? I think the bar is set at a very level indeed if we are just looking for plots to be predominantly in the lower left and uppoer right quadrants.

    In fact we see a much more complex relationship with a very significant proportion of the data in all the scatterplots showing that there is actually a negative relationship betwen pay and shareholder wealth.

    The hourglass pattern to the scatterplots also suggests that there are some confounding ceiling effects present and it would be very interesting to know what they might be.

    Overall I find these graphs do not support the thesis that there is a positive linear relationship between executive pay and the creation of shareholder wealth. There seem to be two lines of best fit in all the plots with one along the pay scale and one along the shareholder wealth scale. They appear to be rather independent of each other from just a simple eyeball analysis.

    For me these research is very inconclusive to say the least.


  8. Chris MacDonald on


    This is well outside my expertise, but…
    I think it would only be fully linear if:
    a) all CEOs were compensated ONLY in shares, and
    b) if pay was not just based on, but directly proportional to, net gains to shareholders, and if the % cut going to the CEO were the same at all companies. But companies have the freedom to vary their deals with their CEOs, so (I think) you’re never, even under the best circumstances, going to have a perfectly linear graph.
    But like I said, I’m just going on intuition here, not expertise!


  9. southwerk on

    Quoting Mr. Cooley – “The observations cover the years 1992 to 2006. Our sample consists of information on 31,587 executives, employed by 2,872 companies, for a total of 33,896 company-executive matches and 167,822 executive-year observations.”
    It’s a very nice article and a convincing study but what we need to know right now is how these financial institutions are managing their bonuses. I’m very surprised he didn’t break down his data to set out the numbers for the current situation, perhaps the banking industry alone and since, say, 2006.
    I think there is a consensus that high performance should be rewarded but here and now before the nation we have a situation in which it seems there is little justification for very large bonuses. In the world of business ethics we need to know how far off the tracks these bonuses are, how they got there, and what size and kind of benefits should be substituted. James Pilant

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