Terminate Me, Please!

**Warning: The following blog may cause hypertension, nausea, and/or strong feelings of indignation. If symptoms persist longer than four hours, too bad.**

Times are tough. As we all know, our economic downturn has led many middle-class Americans to lose their jobs, their retirement savings, and even their homes. Many more are hanging on by a financial thread, their income lowered from forced furloughs and pay cuts.

And don't think that this misery is confined to the middle class. Nosiree! According to a recent report by Forbes financial magazine regarding 2009 CEO salaries:

For the third consecutive year, the chief executives of the 500 biggest companies in the U.S. (as measured by a composite ranking of sales, profits, assets and market value) took a reduction in total compensation. The latest collective pay cut, 30%, was the biggest of the past three years (11% and 15% declines in the prior two years). This marks the first time in the past 20 years that total compensation declined in three consecutive years.

So there you go.  These guys are suffering, just like the rest of us.

Or maybe not.  According to the same Forbes report, "In total, these 500 executives earned $4 billion in 2009, which averages out to $8 million apiece."  (You can see the complete list here.  About 1/3 of the average compensation was in the form of exercised stock options.) Though certainly a cut from the average $14 million a few years back,  these CEO's are not exactly in the same dire straits that many of their workers find themselves in.  A study by UCSC professor G. William Domhoff cites some recent data that breaks this down more finely: 

...the median compensation for CEO's in all industries as of early 2010 is $3.9 million; it's $10.6 million for the companies listed in Standard and Poor's 500, and $19.8 million for the companies listed in the Dow-Jones Industrial Average. Since the median worker's pay is about $36,000, then you can quickly calculate that CEOs in general make 100 times as much as the workers, that CEO's of S&P 500 firms make almost 300 times as much, and that CEOs at the Dow-Jones companies make 550 times as much.

Thirty years ago top CEO's salaries were 30 times the average worker's.  In 1992 that ratio had risen to 82 times the average worker's salary,  and in 2004 it was 400 times .  Even with the recent economic downturn, top CEO compensation is still 344 times the average worker's salary.

Oh, and although the CEO's have suffered reductions in their direct compensation, during the latest period their retirement benefits (deferred compensation) have actual gone up 23%.  Well, that's some solace for them, at least.

It is often argued by those who defend this kind of disparity that CEO compensation is justified by the performance of CEO's in enhancing the profits of their companies, and that their pay is linked to how well the company is doing relative to its peers.  Unfortunately that argument doesn't hold water.  Data presented in the UCSC paper mentioned above shows that over the past 15 years the increase in CEO compensation is nearly independent of corporate profits, but instead is closely correlated with the stock market as measured by the S&P 500 Index.  (The average production worker's pay, which has increased only about 4-5% in the same period, isn't related to either corporate profits or the performance of the stock market.)

A number of other analyses reach the same conclusion regarding the lack of connection between executive pay and performance.  A 2010 Business Week article describes the work of  compensation consultant Graef Crystal, who examined last year's pay of 271 chief executive officers. His conclusion was that  "companies don't pay for performance."  According to the article, no matter how he parsed the numbers, Crystal discovered no relationship between shareholder returns and CEO compensation.  Another example is an analysis by business columnist Jeffrey Pfeffer, who has himself has served on executive compensation committees.  Pfeffer reports two key findings from his research:

First, the relationship between pay and performance is astonishingly small. One meta-analysis found that firm performance accounted for less than 5% of the variation in CEO pay, while company size explained about 40% of the variation. Second, there is no evidence that attempts at reform, such as more disclosure or ensuring that the compensation committees of publicly traded companies are comprised solely of independent directors, has had any effect... The problem: nothing in the process of setting CEO compensation produces a pay-performance link.

As disturbing as all this is, there is more to ponder.  As we know, many people have lost their jobs as a result of the downturn.  The average worker can expect a period of unemployment benefits that are barely enough to live on, and thanks to some recent government interventions, a continuation for a while of health benefits (COBRA) at reduced premiums.  Though helpful, this assistance hardly represents a windfall.

For the CEO's we've been talking about, however, termination is often quite lucrative.  One specific case in the news most recently is Mark Hurd, the CEO of HP who "stepped down" after a company investigation of sexual harassment charges against him.  The harassment allegations were not substantiated, but the company found he had falsified expense account records on numerous occasions to cover up his relationship with the woman involved, who was an independent contractor working with HP.  As Hurd admitted when he resigned, "I realized there were instances in which I did not live up to the standards and principles of trust, respect and integrity that I have espoused at HP."  He will lose his $24 million a year compensation package, of course.  But it may be hard for the average person to feel too sorry for him.  Hurd's termination agreement totals about $40 million --12.2 million in cash and the rest in HP stock.  Oh yes, and he'll get the government health benefits, for which HP will pay the premiums.

Although Hurd's termination package is considerably higher than the $5.8 million average for CEO's, it isn't nearly as large as some other high-profile cases.  As the Kellogg School of Management reported in 2007, Robert Nardelli, the former CEO of Home Depot, received $210 million, Disney’s Michael Ovitz received $140 million (after a mere 14 months on the job),  and Conseco’s Stephen Hilbert received $72 million.  Hurd did, however, do better than his predecessor at Hewlett-Packard,  Carly Fiorina, who received only $21 million when she was terminated.

According to the Kellog report,  three reasons why firms grant such lucrative severance packages to CEOs within their initial employment contracts are:  (1) to encourage risk-taking, (2) to provide insurance for an incoming executive, and (3) to compensate CEOs for entering into confidentiality agreements. The argument regarding risk taking is that since CEO compensation is 30-50% stock options, a CEO would hesitate to do anything that might drive down the stock price without a guaranteed cash severance package.  The insurance angle goes like this:  CEO's need to be protected against company downturns not under their control, which of course would lower the stock portion of their annual compensation.  The confidentiality compensation argument is that the terminated CEO may be hampered in future jobs because he or she can't use the specific information about a previous company in their new positions -- the severance package compensates for a possible lower salary due to such restrictions.

These arguments seem to me to imply a rather negative view of the average CEO.  That is, that CEO's are so attached to their salaries they will only work for companies who remove the negative consequences of risk (both risk resulting from their own actions and from factors not under their control), and who promise to compensate them in advance for possible future jobs where their proprietary knowledge might be relevant.  But then BP's Tony Hayward comes to mind, who certainly fulfilled the company's wish for risky behavior.  Hayward's severance package is estimated to be around $18 million.

We seem to have created a corporate world where performance and compensation are unrelated at the highest levels of management, and where those at the highest levels reap the rewards of risk and proprietary knowledge but do not suffer the potential downsides.

I've said before that I believe in meritocracy and that someone with a special, unique talent or skill or knowledge that is beneficial to society can be rewarded extravagantly and I don’t mind.  But this is something else, and it is something that isn't healthy for either our economic system or for the fabric of our society.