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In Defense of CEO Pay – Part 1: The CEO Pay Ratio

Monday, October 17, 2011
By Dan

CEO’s have taken a beating lately.  Some of the criticism is deserved, but the argument that CEO pay is out of line simply because public company CEOs make 300 times what the average worker does, bears some analysis.  The implication, sometimes stated outright, is that workers deserve more pay, and CEOs deserve less.  That too, is a false premise.  In Part 1, I will look at the CEO compensation ratio often cited, but rarely understood.

The CEO Pay Ratio
You may have seen this chart:

Politifact looked into the chart, and its source is a student paper from 2005, which contained no source or citation for the 475:1 ratio.  So, unless you’re the type of person to rely on the unchecked accuracy of students, it’s not a reliable source of information.

The far-left Institute for Policy Studies (IPS), in 2010, did, however, claim that the average CEO pay ratio was 325:1 (see page 2, above the cartoon).  There are few issues with the ratio:

  1. CEO Pay is inflated:  IPS says the average CEO pay they use is $10.8 million.
    1. Included in that number is the value of stock options and restricted stock, valued at grant, along with bonuses and other compensation.  In the trade, this is known as “proxy comp,” the (often over-estimated) amount of compensation a publicly traded company is required to disclose by the SEC in its annual proxy statement to shareholders.
    2. This is an overstatement because, at the time of grant, the shares are not vested (the executive may or may not actually receive them), and if the stock price goes down, they may be worthless (or worth a lot less).
    3. This is also unfair, because well run companies will intentionally tie CEO pay to stock price.  The criteria on which public company’s CEO are (rightfully) measured, is improvement in stock price, earnings and profit margin.  This translates into equity and bonus-heavy compensation.  In other words, if the board wants to keep the CEO focused on what is good for the company, they will pay less in salary (less guaranteed), and more in stock grants and year-end bonus (more incentive-based).  More on this in part 2.
    4. It is unclear whether it is included in the $10.8 million number, but proxy comp must, under SEC regulations, include fringe benefits, like retirement plans, healthcare benefits, etc.  You can argue about whether or not this is compensation, but it is not cash handed over for pay.
  2. Worker Pay is understated: The IPS paper cites “average worker pay” of $33,121.
    1. Unlike with CEO pay, the “average workers pay” does not include benefits, like stock options, 401(k) contributions, medical, dental and vision insurance premiums paid by the employer, or even bonuses.  Any other compensation received by the employee is excluded.  As noted in the IPS paper (page 37, endnote 3), “worker pay” is simply an average hourly rate for “production workers” ($19 per hour) multiplied by 33.4 hours over 52 weeks.  Why 33.4 hours?  I suppose the proletariat get 90 minutes a day for lunch, and the evil cleptocrats don’t pay them for it.
    2. In contrast, according to the federal government, the average wage index (most recent year available is 2009) was $40,711.62.  That would yield a ratio of  265:1, not 325:1. Again, even this larger number does not include bonuses, retirement contributions, medical, dental or other benefits paid by the company.
  3. The CEO compensation study only looked at S&P 500 companies. There are thousands of very sizable US companies not on that list.  The S&P 500 only represents about $325 billion in earnings ($10.16T/31.3), globally (about 0.6% of global GDP) and only employs a total of 25.6 million people–globally.  (In contrast, there are over 130 million total people employed by all employers in the US alone–5 times what the S&P 500 employs globally.)  These are the largest and most powerful international public companies in the world–not a place to look for modestly compensated executives.
  4. Finally, “production workers,” the basis for the low-ball $33,121 number, are not the sort of workers employed by most S&P 500 companies.  Companies like Google, Apple, Microsoft, GE, McDonalds (the franchisor company, not the burger restaurants–there’s a difference), Visa, MasterCard, Pepsi (again, franchisor, not bottler), etc., do not employ a lot of production-line workers, much less workers paid hourly.  Most of these companies employ salaried workers in the fields of finance, sales, legal, engineering, computer technology–most are college entry level companies.  So most of these “overpaid” CEOs are not leading companies full of “production workers.”

To give a concrete example of proxy comp versus reality, the 2010 proxy statement for Google shows that, in 2009 their CFO received a (relatively modest) salary of $450,000 (see summary compensation table at page 59).  This would put him in the 10:1 range for (relatively well compensated) Google employees.  (The CEO received only $1 in direct compensation).  When you include his bonus, stock and option awards (awards that may never vest, and may be worthless when they do), he received $24.7M.  Now, no one should feel sorry for Mr. Pichette–he took home over $3 million in cash, which even after taxes, is a nice living wage.  But his “proxy comp” is inflated 12 times larger than what he actually took home.  Similarly, the evil Goldman Sachs CEO, Lloyd Blankfein had a salary of $600,000 in 2010, but his proxy comp number was over $14 million (page 29), the bulk of which is in stock awards.

In sum, the oft-cited ratio is based on false premises and comparing narrowly selected groups to inflate and understate, respectively, both sides of the equation.  It is like comparing apples to apple pies.

Tags: , ceo pay, , income inequality, , , misleading

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