What’s the best way to set CEO pay?

At a time of massive job losses, high unemployment, wage cuts and weakened economic growth, executive compensation has returned to, and in some cases exceeded, pre-recession levels.

Article | 03 June 2013
© ILO Photo / K. Cassidy
At a time of massive job losses, high unemployment, wage cuts and weakened economic growth, executive compensation has returned to, and in some cases exceeded, pre-recession levels.

Between 2007 and 2011, increases in executive pay were particularly acute in Germany and Hong Kong and China, where average chief executive officer (CEO) pay among the largest firms grew by more than 25 per cent. As a result, the ratio of CEO pay to average compensation in the economy grew from 155 to 190 in Germany and from 135 to nearly 150 in Hong Kong, China.

In the United States, average CEO pay among the largest firms grew by 10 per cent over the same period and in 2011 was 508 times larger than compensation of the average employee.

In both the Netherlands and the United Kingdom, at 69 and 228 times average employee compensation, respectively, average CEO earnings in 2011 had returned to levels comparable to 2007. Only in Switzerland did the ratio fall significantly, from 129 to 87; it also fell moderately in the United Kingdom.

In terms of the firm’s performance, concerns have been voiced that the level and structure of executive pay can lead to a search for short-term profits, without necessarily promoting the long-term prospects of enterprises. This risk is particularly acute when incentive programmes for executives focus on short-term goals. For example, among the largest firms examined, short-term-oriented bonuses account for more than one-third of total compensation on average – and more than two- thirds when combined with share-based compensation.

Share-based compensation is an important indicator of corporate performance as improvements in stock prices may represent increases in shareholder value. However, unless well-designed, it may create incentives for executives to focus on raising stock values in the short term, creating a disincentive for long-term investments and have economy-wide impacts.

A recent study found a negative correlation between short-term focused executive compensation and corporate social performance, measured by indicators such as product quality, employee relations and protection of the environment.

Such high levels of executive compensation also raise concerns about income distribution. For example, in the United States, 93 per cent of growth in average real household income in 2010 was captured by the top 1 per cent of the population.

A number of countries have adopted or initiated reforms with a view improving the alignment of executive compensation. These initiatives vary widely both in terms of content and approach, ranging from restrictions on the amount of compensation to a strengthening of the shareholders’ role in this regard.

Switzerland has engaged in a reform of compensation systems that will give a company’s shareholders, among others, the right to a binding vote on executive pay and bonuses. For Danish limited liability and financial companies and Indian financial companies, the variable compensation of executives may not exceed 50 per
cent and 70 per cent, respectively, of their fixed remuneration.

An EU proposal which caps bonuses for financial firms at double the annual salary could enter into force at the beginning of 2014. A number of other, less robust measures have been taken elsewhere. For instance, executives at banks in Spain that received bailout money are subject to compensation limits; the United States gave shareholders a non-binding vote on compensation; France introduced an absolute cap of compensation for state-owned enterprises and Germany issued new compensation guidelines. Several countries, such as Australia and the Netherlands, have introduced or are considering “claw-back policies”.