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Podcast

When CEO Pay Exploded

Planet Money

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  • Pay For Performance Rationale
    • Economist Kevin Murphy argued CEO pay should be tied to company performance rather than company size alone.
    • He warned fixed big pay made CEOs complacent because pay didn’t reflect yearly performance. Transcript: Stacey Vanek Smith There was this economist named Kevin Murphy, and he was looking at this and he wasn’t so much concerned with how much CEOs were getting paid as he was with how they were getting paid. He thought a lot of CEOs were getting paid a lot of money basically to just sit around. Jacob Goldstein The biggest sole determinant of your compensation was how big of company you were running. And it turned out to be just a lousy way to do business. If a CEO had a great year, they got paid. CEO had a terrible year, also got paid. Didn’t really matter. So as a result, Murphy says, there was this tendency for CEOs to just kind of be on autopilot. You know, go to work, take home a nice big paycheck. Stacey Vanek Smith So Murphy co-wrote this really influential paper where he basically argued that the way CEOs were being paid was wrong. CEO pay, he said, should be based on performance. If the company does well, the CEO should get more. If the company doesn’t do so well, CEOs should get less. (Time 0:03:54)
  • Clinton Tax Cap On Deductions
    • The 1993 tax change capped deductible executive pay at $1 million per person for corporate tax purposes.
    • That cap created pressure to restructure compensation toward forms exempted by the rule. Transcript: Stacey Vanek Smith Here is how the tax code works. If you’re a company, to figure out how much income you have to pay taxes on, you need to take all the money you make and then subtract your expenses. If you rent office space, you can subtract that. If you buy a bunch of computers, you can subtract that. And all of the money you pay your employees, including the CEO, you can subtract that too. It’s an expense like anything else. Jacob Goldstein And with the help of Congress, Clinton made a little change to the tax code. He put a limit on how much CEO pay companies could subtract. He limited how much they deduct. That limit? One million dollars. (Time 0:06:04)
  • Performance Pay Exception
    • The tax code exempted pay ‘‘tied to performance’’ from the $1 million deductible cap.
    • This exemption effectively encouraged companies to switch to performance-linked compensation. Transcript: Jacob Goldstein Was also a second nudge in this new of the tax code. And this one was tied to the idea that that economist, Kevin Murphy, had been pushing. The idea that CEOs should be paid for performance. That made it into the tax code, too. Specifically, it is in subparagraph 4C. Stacey Vanek Smith Perhaps the most important subparagraph in the history of taxes? Sure. Jacob Goldstein Let’s say CEO pay. Stacey Vanek Smith OK, CEO pay. And that subparagraph says, this million-dollar cap does not apply to pay that is tied to performance. Jacob Goldstein So the government here is like, hey, you want to keep paying those multi-million salaries for CEOs just showing up and collecting a paycheck? You’re going to pay a tax penalty for that. But you want to try out this new idea, this pay-for performance thing? We like that. As long as the pay is clearly tied to performance, there is no limit. (Time 0:06:53)
  • Boards Shifted To Options
    • Board compensation committees reacted by redesigning CEO pay and leaning into stock options.
    • Don Delves recalls that moving to options was the obvious response to the new law. Transcript: Jacob Goldstein Law that created this rule, was that a big deal? You know, at the time, it probably didn’t look like it, but in retrospect, it was huge. Don Delves Huge! Huge! Well, it was huge because it changed the way that, you know, we compensate our top executives. Stacey Vanek Smith Bill says compensation committees, the part of the board that sets the pay for the CEO, looked at this new tax code and said, okay, let’s tie our CEO’s pay to performance. Don Delves The compensation committees where I served immediately started thinking about how we will change the pay system for our top executive, for our CEO. Jacob Goldstein And the obvious way to move was to was to move to stock options. Because of that law. Correct. Stock options. (Time 0:07:54)
  • Options Fueled Rapid Pay Growth
    • After the law, stock-option grants surged and average CEO pay for large firms rose sharply in the 1990s.
    • Between 1992 and 1996 average S&P500 CEO pay roughly doubled due largely to options. Transcript: Stacey Vanek Smith But that other part, the cutting the base pay part? Jacob Goldstein No, that’s not going to happen in the real world. Why not? Stacey Vanek Smith This is Bill White, the former CEO and board member. Jacob Goldstein It’s a very nice concept. Don Delves But if you’re a CEO, you’re not going to want that to happen. And if you’re on the board of directors and you have a good CEO, the last thing you’re going to do is go to them and say, you know, we’re going to take away some of your base comp. Jacob Goldstein Now, the rise in payments through options, this was not like just happening at one company here and another there. It was happening at lots and lots of companies. Stacey Vanek Smith Don Delves was a compensation consultant at the time. And before, options payments to CEOs had been growing at a couple percent a year. After Bill Clinton signed that tax law, they exploded. He remembers looking at this one survey in the mid-90s. Don Delves We looked at the survey and said, oh my gosh, stock options have gone up by 40 percent. And we were kind of floored. And we said, this must be wrong. Jacob Goldstein So you’re saying you actually looked at this number and you thought, no, this must be a typo or somebody must have made a math error. Don Delves Right. Right. Yeah, This must be a mistake. Jacob Goldstein It wasn’t a mistake. Stacey Vanek Smith Between 1992 and 1996, average pay for CEOs at 500 of the biggest U.S. Corporations roughly doubled from $4 million to $8 million. (Time 0:10:28)
  • Options Were Treated As Free
    • Many corporate leaders believed stock options were effectively free because accounting rules didn’t record their true cost.
    • That misconception made options appear costless and widespread as compensation tools. Transcript: Stacey Vanek Smith Thought they were free. We thought they were free. Five words. Jacob Goldstein This is Barbara Franklin. She has served on corporate boards for decades. She went to Harvard Business School. She’s also a former secretary of commerce for the United States of America. And she told me what a lot of people told me. Back in the 90s, almost everybody thought options were free. We thought they were free. That was the bottom line. And did you really think they were free? Stacey Vanek Smith Well, sure. I think we did. The idea that options were free had nothing to do with that tax law passed under Bill Clinton. It has to do with an accounting rule that had been in place for decades. Under that accounting rule, When companies issued their financial statements, they didn’t have to account for stock options the way they had to account for other kinds of pay. Jacob Goldstein Yeah, under that accounting rule, options kind of were free. And you can sort of see why. Like, think about it like this. If you’re a company and you pay someone a salary, you write them a check, you are giving them money. That is obviously not free. But a stock option? I mean, a stock option, I don’t have to take any money out of the company bank account to give it to you. And if you decide to use it in the future to buy that share of stock, I can just create a new stock for you out of thin air. That also doesn’t cost us anything. Of (Time 0:12:56)
  • Options Dilute Shareholder Value
    • Options dilute existing shareholders because new shares reduce per-share value when issued.
    • The real cost of options was borne by existing shareholders, including retirement funds. Transcript: Stacey Vanek Smith Course, the truth is that does cost something. Stock options are not free. Someone ends up paying. Specifically, every other person who owns stock in the company. Every time a new share is created, all of the existing shares of stock are worth a little less. Jacob Goldstein So if, say, you have a retirement fund, some of your retirement fund is in stock, this extra pay for the CEO, these options, they are coming from you. Stacey Vanek Smith Don Delves, the compensation consultant, said he kept trying to explain this to people at the time. Don Delves First of all, we built this fairly elaborate model to try to show people, look, this is what’s happening. You know, you’re hurting your shareholders. You’re hurting the value of the company. You know, they’d look at it and they’d say, nah, we don’t need that. They’re really free. The options are really free. Stacey Vanek Smith He finally found one company that was willing to listen, that really wanted to understand what was going on. Don Delves We took them through it in detail. Look, this is what your stock options are costing you. This is what they’re costing your shareholders. (Time 0:14:13)
  • Silicon Valley Protests Save Options
    • Silicon Valley workers protested FASB attempts to make companies expense options more transparently in 1994.
    • Political pressure forced FASB to back off and options stayed unexpensed for years. Transcript: Jacob Goldstein Here is a local news broadcast from 1994 covering a protest in San Jose. Stacey Vanek Smith If the marching band doesn’t get your attention, maybe the signs will. Jacob Goldstein A couple of thousand Silicon Valley workers are fighting mad about losing their stock options because of the FASB or FASB. FASB is the Financial Accounting Standards Board, that group that wants to change the rules. And all these people are coming out to protest because stock options were not just being given out to CEOs and executives, especially in the tech industry. They were being given out to lots and lots of workers. And in this news spot, you see people marching with signs that say stock options equal jobs. Stacey Vanek Smith You see people wearing these red buttons in the shape of stop signs that say stop FASB. And they did stop FASB. There were enough protests and enough political pressure that FASB backed off. Options were still treated as free and CEOs (Time 0:15:48)
  • CEO Pay Peaked In 2000
    • CEO pay peaked around 2000 as options-driven compensation soared during the market run-up.
    • Average CEO pay rose from $4M in 1992 to $19M in 2000 before later falling. Transcript: Stacey Vanek Smith Pay for CEOs at big corporations, which had been at $4 million in 1992, hit $19 million in the year 2000. It had almost quintupled in less than a decade. Jacob Goldstein And then it (Time 0:18:02)
  • Market Crash And Rule Change Reined In Pay
    • After the dot‑com crash and shareholder scrutiny, accounting rules changed to expense options and CEO pay fell.
    • Boards cut excessive pay once they saw detailed reports of option-driven costs. Transcript: Stacey Vanek Smith Eventually, CEO pay did start to come down, and this happened for a bunch of reasons. Jacob Goldstein The dot-com bubble popped, the whole stock market plunged, and shareholders finally started noticing and caring about all those stock options companies were giving out. They started saying, hey, that’s our money you’re giving away. Stacey Vanek Smith Suddenly, boards of directors were a lot more interested in what Don Delves, that compensation consultant, had to say. Jacob Goldstein He remembers this one call he got around this time from a board of directors that was starting to worry about how much they’d been paying their top executives. Don Delves They came in and they said, can you just show us a little bit? And so, you know, they just wanted like a page report. We gave them a hundred page report and we started calling it the holy moment because they’d kept flipping the pages and each one, they’d go, oh, holy. Flip the page again and go, oh, holy. Jacob Goldstein Meaning what? Don Delves Meaning they didn’t realize how vastly overpaid their executive team was and how it had gotten out of control. Stacey Vanek Smith That board wound up cutting its CEO’s pay in half. And also FASB, the accounting rules people, finally had the support for what they wanted to do. They changed that accounting rule so companies could no longer treat stock options as free. The (Time 0:20:00)