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Image Credit: <www.depressedfan.com

Image Credit: <www.depressedfan.com>

Neil Weinberg (Editor-in-Chief at American Banker) wrote an interesting article on CEO Pay over at LinkedIn.

In the article he talks about the ratchet effect and its impact on driving CEO 1. Also herepay up over time. I’ve written about this topic before 1, and you can also read more about it in Weinberg’s article (so I won’t rehash here in any great detail).

Really quickly for the benefit of newbies to the topic, though: Long story short? CEO’s received median raises of 11% last year in an economic climate in which the median for most people is 3%. CEO pay is 1,800 times that of the average worker, and this all more or less happens because the market for executives is different than that of other employee populations. Companies more or less benchmark their executive’s pay against one another, and because all of them are paid at p50 or higher, pay continually escalates (since no 2. There are studies that make the argument that the ratchet effect is overstated, since much of CEO pay is tied to stock options that only have value if the share price rises. In my opinion this argument is flawed, however, since for most payouts the option to exercise falls across such a long period of time that executives will almost always make money on them over the long run. compensation committee pays their executives beneath p50). 2

Everyone cannot be the best (or even average or better)  Image Credit: <www.chipscholz.com

Everyone cannot be the best (or even average or better) Image Credit: <www.chipscholz.com>

With all that said, Weinberg make an argument for why shareholder caps on executive pay (like the one’s in Europe) won’t work that I don’t entirely agree with.

In his article he says:

A final force exerting itself on pay is Europe. There, the trend is toward capping executive pay outright, either via shareholder say-on-pay votes that directors are obliged to heed or bureaucratic fiat, notes Romanek.

If you think that sounds appealing consider a sports analogy. Would your favorite team be well advised to keep down ticket prices by capping pay and performance incentives for top athletes? Or would it end up with a bunch of scrubs and empty seats? Similarly, do you want the B Team running the company that issues your paycheck or the shares in which your retirement savings are invested?

As a huge sports guy this analogy immediately caught my attention.

At the heart of his argument, Weinberg is taking the postion that if executive compensation were capped in the U.S. that executives would leave the market – presumably to work somewhere else. Curiously, he does so by making a sports analogy that disproves his point.

Pro sports leagues like the NBA, NFL and NHL have salary caps that see top performers paid dramatically below their fair market value. Furthermore, many of these athletes could earn even more money by leaving their professional sports leagues and going to play overseas. As an example, numerous economists have pegged Lebron James value at $40 million+ dollars a year. This is more than twice what he actually makes. Further, James knows he is underpaid. In a February 2013 interview he said:

“I have not had a full max deal yet in my career – that’s a story untold,” James said. “What I do on the floor shows my value. At the end of the day, I don’t think my value on the floor can really be compensated for, anyways, because of the (collective bargaining agreement).”

In regards to his salary, James added, “if this was baseball, it’d be up, I mean way up there.”

Lebron James makes only a fraction of his fair market value. Image Credit: <www.nba.com

Lebron James makes only a fraction of his fair market value. Image Credit: <www.nba.com>

That same article goes on to say that Lebron has been offered up to $50 million dollars a season by at least one team to play in Europe.

James situation is not unique to professional sports athletes. But in truth (as James goes on to talk about in the article above), there are countless intrinsic reward based reasons that people work beyond money, so this is not all that surprising.

Still, in addition to intrinsic rewards there are (often) extrinsic reward based reasons that professional sports stars stay in the United States (as opposed to going overseas to obtain higher salaries) as well. Much of the time the money athletes make in endorsements eclipses what they earn playing their respective sports, and this money might dry up if they leave the (big brand) sports leagues they play for in order to get pay days overseas.

…Or perhaps pro athletes are simply wired differently (on average) when it comes to the pursuit of maximizing earnings than their high earning corporate executive counterparts (though I doubt it).

Neither of these possibilities are arguments for why an executive “salary cap” in the United States (akin to the ones showing up in Europe) couldn’t work, though. If binding shareholder say on pay votes or (conversely) legislation limiting bonuses to a certain multiple of worker pay existed in the United States, where would executives go in the world to earn more? There are only so many private large cap companies and private equity firms out there, and very few executives would leave the labor market entirely simply because average pay across the market went down.

Ergo, I disagree with Mr. Weinberg. My take is that if a “salary cap” on executive pay existed in the United States that lower paydays would simply become the new normal.

Someone has to take home the profit. If you're working hard and adding value make sure you get your cut. Image Credit: <profootballtalk.nbcsports.com

Someone has to take home the profit. If you’re working hard and adding value make sure you get your cut. Image Credit: <profootballtalk.nbcsports.com>

Closing, I would like to point out that I don’t particularly care what 3. As I’ve said before people should earn every penny they can (the days of corporate paternalism are quickly dying if not already dead).executives make. If anything I think they should earn all they can. 3 There probably is a need to make worker incomes more strongly correlated with corporate earnings (corporate profits are rising much faster than worker wages), but this isn’t an executive compensation problem. 4 I don’t know that 4. As Ira Kay points out on page 32 of “Executive Pay at Turning Point”, (paraphrasing) “…if all executive’s pay was cut by 50% and transferred to others via higher taxes, its impact would be far less than .1% of the total output of the U.S. economy.” it’s necessarily a corporation problem, either. The market is pretty good about paying for in demand skills (Computer Programmers at Google and Facebook are making an average base salary $125,000 a year), so if one wants to make more money they need only time and the discipline to develop a hot skill (the resources to learn are now abundant and free)

I’m over 1,000 words and about to start on another tangent, so let’s wrap it here.

As always, please share your thoughts in the comments section below.

Best,

Rory

If you have questions about something you’ve read here (or simply want to connect) you can reach me at any of the following addresses: 

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