Chapter 3. Executive Compensation and Incentives

Corporate executive behavior is the result of many factors. These factors include the relationship between the board and the CEO and between auditors and the firm, regulators, and executive pay structures. Boards, auditors , accountants , analysts, regulators, investors, and others in the corporate system are discussed in other chapters. Here, we focus on the incentives induced by modern executive compensation.

The SEC requires that the pay of the CEO in public firms be disclosed. Therefore, anyone can obtain and know the pay of the top executives of a firm. Many people take an interest ”particularly stockholders , employees , labor unions, the media, and even Congress. However, executive pay did not really come into the public debate until the early 1990s. Stories about CEO pay aired on 60 Minutes and Nightline in 1991. Then, Graef Crystal's book In Search of Excess was published in October 1991. Time came out against the excess pay to executives in 1992. ^[1] Congress also heard the beat of the drum and (in an election year) proposed bills that limited the tax deductibility of excessive pay. These bills never become law, but the SEC and the IRS enacted policies with similar spirit.

However, this attention did not seem to change the trend of increasing executive pay. The pay of CEOs escalated in the mid-1990s while firms were downsizing. That is, the CEOs were paid more while the rank-and-file employees were laid off. The base pay of CEOs was nearly 100 times greater than that of the average production worker. If incentive awards like stock options were included, CEO pay was more than 200 times higher. Again, the media clamored about the injustice.

In the late 1990s, the bull market increased the value of executive stock and stock options further. The gap between realized CEO pay and the income of average employees grew even more. While the controversy continued , it also seemed to lose some strength. Employees were finding that they, too, could profit by owning the company stock. Instead of anger at CEOs who made millions, the media reported more stories about secretaries at dot-com firms who received stock options and became rich. However, by late 2000 and 2001, the stock market fell and employees no longer felt rich. Instead, it appeared that the executives had cashed in their stocks and options before the stock prices fell. The impression is that the CEOs are still rich, while the employees lost significant portions of their pension money and are now making plans to retire later than previously anticipated. Through the good times and bad times, the pay of executives has continued to increase.

We now examine executive compensation and illustrate how the structure of the compensation provides incentives for specific CEO behavior. Unfortunately, the behavior induced by some compensation plans is not the kind valued by shareholders or society.