Executives and their Income

I’ve blogged a number of times about what is commonly and loosely called “executive compensation.” The term is woefully imprecise. In point of fact, most “compensation” is not, in fact, compensation. The carrot dangled in front of a horse is not compensation; it is motivation. Compensation is what you give someone after the fact as reward for a job well done, or at least for a job that met contractual requirements. If I hire the neighbour’s kid to mow the lawn, and he does so, then I should compensate him. Most of the money garnered by senior executives at publicly-traded companies these days is not, in fact compensation. It’s money they get from selling shares in the company, shares granted to them as part of an effort to align their interests with the interests of shareholders.

The looseness of use of that word in the realm of finance is not at all unique. Witness the “bonuses” paid to AIG employees two years ago, which were not in fact performance bonuses at all but rather retention payments designed to keep key employees on what seemed at the time to be a sinking ship.

See more recently this piece by Peter Whoriskey for the Washington Post: With executive pay, rich pull away from rest of America. Here’s just a taste:

The top 0.1 percent of earners make about $1.7 million or more, including capital gains. Of those, 41 percent were executives, managers and supervisors at non-financial companies, according to the analysis, with nearly half of them deriving most of their income from their ownership in privately-held firms….

Notice that (contrary to the article’s title) the key factor in the growth of executive income here is not in fact “pay.” The key factor is investment income. And it’s not even “pay” in the loose sense of ‘money given by an employer,’ since there’s no indication here what portion of that investment income comes from shares in a CEO’s own company, say, versus a diversified portfolio. But it’s hard to hold Whoriskey to blame for the linguistic imprecision here; confusing pay and compensation and income is altogether standard.

The other point to be made here is about justice. According to Whoriskey, “…executive compensation at the nation’s largest firms has roughly quadrupled in real terms since the 1970s, even as pay for 90 percent of America has stalled…” Setting aside imprecision of language, that suggests a significant disparity — not disparity of outcomes (which are a given, here) but disparity of rate of improvement.

Now according to Leslie McCall, a sociologist quoted in Whoriskey’s story, people become concerned about such inequality “…when it seems that extreme incomes for some are restricting opportunities for everyone else.” And that may be true about people’s reactions. But of course, it’s very hard for people to tell when it is actually the case that extreme incomes for some are restricting opportunities for others. As economists often point out, income is not a fixed pile, waiting to be handed out. The way you distribute income actually changes the size of the ‘pie’ due to the way money incentivizes. Incentivizing executives with stock and stock options may on the whole be a failed experiment, but that doesn’t change the fact that it is impossible to know whether the average worker would be better or worse off had those incentives never been offered.

11 comments so far

  1. Michael Walker on

    A failed experiment yes, but are we really going to be able to wind it back? It seems to me that the top-level executive class holds all the keys.

  2. jpbauer on

    A cynic would likely view and categorize “ëxcessive” executive compensation/remuneration as nothing more than a legal loop hole to what some people ( i.e., the Chicago Judge in Conrad Black’s case) would. in certain blatant and opportunistic instances consider outright corporate misappropriation/theft and or a derivative form of bribery.
    What is the moral of the story? If you get paid the big bucks you had better deliver or else. .

    • rich on

      I’ve heard that last bit before. The idea being that somehow executives have more to lose. But isn’t it true that the line and staff employees must also deliver? If a corporation is well led, then there will be expectations placed on the lowliest employee. The lowest guy on the corporate hierarchy has his entire personal fortune in play, too. That individual probably has no severance package to speak of, either.

      • Chris MacDonald on

        No, I didn’t say (or imply) that executives have more to lose, although in numerical terms that’s clearly true. The point in that last paragraph is merely that there isn’t a pre-existing fixed pile of money waiting to be distributed. Instead, how you pay, and hence incentivize, various players, affects the size of the pie. It’s an open question, I guess, who is more susceptible to incentives. But I think it’s pretty clearly true that the guy in the unique situation (i.e., the CEO) matters more than the guy who is just one of a thousand other front-line employees.


      • rich on

        I won’t argue the comparative values of individuals, although I take issue with your phrasing. My point is that in terms of percentage of personal wealth, the line worker risks at least as much as the executive. The line worker must also “deliver”.

  3. Kirk Emery on

    I see no meaningful distinction between stock and cash with respect to paying any employee for their work. Both have financial value as purchasing power, and both are quid pro quo for work done. In other words, both compensate the employee for fulfilling his obligations in the employment contract. And whether or not the compensation comes before the employee renders the services is also be meaningless. You can pay the neighbour’s kid before he mows your lawn, or he can mow your lawn before you pay him; the law and the market and philosophy are indifferent to which party’s obligation is fulfilled first, provided that the exchange takes place as promised.

    Will you clarify your position with respect to compensation? I understand that the employee eyes may prefer payment in cash over stock for various reasons, and that the employer may prefer to pay in stock over cash. This aside, both stock and cash are quid pro quo for the employee fulfilling his obligations, and because it doesn’t matter if the units of purchasing power come before the work or not, both seem like compensation.

    • Chris MacDonald on


      Good question.

      The difference lies in the variable value of stock and stock options. The fact that the value of stock varies, and that that variation is at least partly within the control of the CEO, is supposed to give the CEO incentive to work harder. “Compensation” brings connotations of justice. There is no sense in which $100 million in equity realized through exercising stock options is “compensation” for the CEO’s hard work. It’s the result of an entirely instrumental attempt to get the CEO to work hard.


  4. Kirk Emery on

    Chris, thanks for the reply. It helps clarify your view, and leads me to these questions:

    1) why does the variability of the financial value of stock options make stock options non-compensation?

    2) Can a pay increase for the bank teller be an instrumental attempt to get the bank teller to work hard? If so, and because the bank teller’s pay varies in terms of purchasing power according to the rate of inflation, is the bank tellers pay non-compenation too?

    • Chris MacDonald on


      1) If you promise someone a million dollars in return for a year’s work, you’re saying that’s a reasonable payment for a year’s work. If you give someone stock, they don’t know how much it will be worth when they finally sell it. If you given them what is today a million in stock, and they end up selling it for 5 million, you didn’t “compensate” them to the tune of 5 million, any more than giving someone a winning lottery ticket lets you say you “gave” them the money that resulted.

      2) No, I don’t think the bank teller’s situation is the same. Yes, you can give her a raise in order to motivate her. But if it works, the motivation comes from her desire to keep that raise, not from the future value of the current payments. And the rate of inflation is not within the bank teller’s control — she’s a victim of it like the rest of us. So she can hope that the rate of inflation swings sufficiently to increase her purchasing power, but that hope cannot motivate her. It can only compensate her.


  5. Kirk Emery on

    2) Your bank teller disanalogy is a good one.

    1) Stock options are compensation. Against your argument, I have 3 (ish) points:

    (A) You said that stock options aren’t compensation because they fluctuate in price, presumable unlike cash. But cash fluctuates in price too. For example, investors with lots of money make small percentage gains trading currencies. George Soros does this quite well.

    (A2) Stock options aren’t non-compensation by virtue of the CEO’s ability to influence its value. This is because the value of payment in cash, which is uncontroversially compensation, can be influenced by the CEO, if the firm is big enough. For example, consider the recent failed take-over attempt of Potash Corp by that Australian firm (whose name escapes me). This lead to the CDN currency fluctuating, at least with the initial bid due to the size of POT relative to the Cdn economy. Another example is George Soros shorting the British currency in the early ’90s. This contributed to the pound depreciating. As such, executives can influence the value of cash they’re paid in – just like they can influence the value of stock they’re paid in. And in both cases, the CEO influencing the true value of her pay, be it cash or stock options, takes place within regular business operations. The only difference is that, in terms of my two examples, the fluctuations in the value of the cash the CEOs are paid in is incidental to the business operations and is not designed, by the firm, to align the shareholder’s interests with the CEO’s. But in consequence the net effect felt in the CEO’s pocketbook can be the same.

    (B) There’s no fundamental difference between stock options and cash with respect to compensation. Both are pecuniary. You’re right that a $1million capital gain made from stock options is not compensation, but the initial payment of $1million is compensation. Stock options, like cash, have a market value. Stock options that the CEO must hold for x # of years is compensation with strings attached; and it is conceivable that some stock options can be sold immediately.

    (C) Suppose I accept that stock options are not compensation. Now suppose that the CEO has a salary of $0 and gets stock options worth $10million. In light of the $10million worth of stock options, it is incorrect to say that the CEO isn’t compensated for her work. Even if the CEO doesn’t exercise the options, she can get a loan secured to those options and live more richly than most other people, a necessary condition being the stock options she’s paid in. Pay her in cash, or pay her in options she can use to get a loan – in both cases the CEO earns money in exchange for her work at the firm.

    Thus the differences between cash and stock options is cosmetic: they’re both compensation or quid pro quo for work done.

  6. […] problem of how much to pay CEOs from this point of view, and what combination of kinds of payment to offer (cash, stock options, etc.), is hotly debated by top business scholars […]

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