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February 13, 2001

Justification for High Executive Pay Loses Footing

While fairness remains the major issue, two studies and a growing trend among executives also cast doubt on the effectiveness of huge compensation packages. -- According to a report last year by the Institute of Policy Studies and United for a Fair Economy, CEO pay jumped 535 percent in the 1990s, dwarfing the 32 percent increase in average worker pay. This inequity has been a concern of social investors for years. When asked about executive pay, many companies claim that high compensation packages are needed to foster loyalty, and that stock options effectively tie executive performance to corporate financial performance.

The results of two studies, as well as a growing trend among executives, raise some doubt about this reasoning.

Maria Hasenhuttl and H. Richard Harrison of the University of Texas recently researched the relationship between pay level and a CEO's likelihood to change jobs. The study was based on the examination of CEO turnover in 1233 companies between 1995 and 1997.

The authors found that relative to average CEO pay in the same industry, the level of a CEO's total compensation had no significant effect on turnover. When measured separately, salaries, bonuses, stock options and raises also had no significant effect. This led to their conclusion that relatively high-paid chief executives were as likely to change jobs as relatively low-paid chief executives.

While large stockholdings by a CEO was found to increase loyalty, one surprise concerned restricted share grants. Restricted share grants are awards of stock that are conditional on the CEO's remaining with a company for a certain period of time. The authors found that the more restricted stock grants a CEO received relative to other CEOs in the same industry, the greater the chance the CEO would move elsewhere within the next two years.

Another recent study questioned the efficiency of stock options as a form of compensation. Entitled "Stock Options for Undiversified Executives" and published by the National Bureau of Economic Research, Inc., the study incorporated risk into executive compensation analysis.

The authors, Brian J. Hall of Harvard Business School and Kevin J. Murphy of the University of Southern California, confirmed that executives place a relatively low value on stock options because of the options' inherent risk. Yet, stock options are an expensive form of compensation for corporations. The authors therefore recommend that companies give more consideration to costs and incentive benefits before employing stock options.

With regard to the uncertainties involved with stock options and restricted stock grants, executives have found a way to hedge their risk. As reported by Louis Lavelle in the January 15th edition of Business Week, executives are increasingly employing what is called a "zero-cost collar." Executives "collar" their stock by selling a call option and buying a put option, which establishes a minimum and maximum price range for the stock. If the stock tanks, the executive is protected because he or she has already established a minimum price for the stock.

The problem with zero-cost collaring is that it can break the tie between compensation and stock performance. Shareholders do not know if executives are zero-cost collaring because such information is not being fully disclosed. Executives may be perceived as having their compensation strongly linked to stock performance when in reality the tie may not be so strong.

Huge compensation packages do not ensure loyalty, stock options themselves potentially can be ineffective, and the tie between share price and stock options and grants can be broken. These points weaken corporate justification for skyrocketing compensation packages.

But the biggest weakness remains the equity issue. Scott Klinger of United for a Fair Economy puts some numbers into perspective: "In 1960, the average CEO made twice the $100,000 salary paid to President Kennedy. In 1970, the average CEO made three times the pay of President Nixon. In 2001,the average CEO makes 31 times President Bush's salary, even after it was doubled to $400,000."

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