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CEO Sticker Shock

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Do investors get what they pay for?

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Aside from Congressional scrutiny, the conductor of a symphony orchestra and the chief executive officer of a major corporation have a lot in common.

The conductor is responsible for interpreting the music, setting the tempo, determining the proper volume for each instrument and keeping all musicians in balance. The conductor, like the CEO, is directly responsible for the success or failure of the final product.

No one, least of all Congress, frets that conductors are paid more than the first violinist, yet it routinely wails that CEOs are overpaid. Henry Waxman (D-Calif.), chairman of the House Committee on Oversight and Government Reform, recently said working Americans struggle to pay the bills on limited pay while "our nation's top executives seem to live by a different set of rules."

Nonsense.

CEOs are paid more than middle managers and line workers who turn the wheels because top executives have unusual talent, greater responsibility and their decisions can make or break a company. This means their pay isn't out of line.

Executive pay at major U.S. corporations has increased about sixfold since 1980. In 2006, the average pay for a CEO of an S&P 500 company was $15.06 million. Waxman says CEOs' fat paychecks raise basic questions about the "fairness (of) executive pay."

However, Xavier Gabaix and Augustin Landier, professors at New York University's Stern School of Business, say the sixfold increase in CEO pay between 1980 and 2003 about tracks the increase in market capitalization of major U.S. companies over the same years. The researchers say market cap and executive pay have risen and fallen almost in parallel with the broad market's fluctuations.

In a cut-throat environment, little things can make a huge difference in a company's performance and the CEO's pay.

"If we rank CEOs by talent, and replace CEO number 250 by the number one CEO, the value of his firm will increase by only 0.016%," the researchers said in a study published in Quarterly Journal of Economics. "These very small differences in talent translate into considerable compensation differentials, as they are magnified by firm size. Indeed, the same [calculation] delivers that CEO number 1 is paid over 500% more than CEO number 250."

If the company's market cap is $500 billion or so like ExxonMobil (XOM), 0.016% works out to about $80 million. The basic assumption: The bigger the company, the bigger the CEO's potential effect on performance and the higher the pay. The pool of talented CEOs capable of helming a major company is small. Like symphony conductors or star athletes, this drives up the price because several companies bid for a talented few.

In a 1998 study, Harvard economists Brian Hall and Jeffrey Liebman noted, "If there's no meaningful link between CEO pay and company performance, it is doubtful that the trillions of dollars of assets in public corporations are being managed efficiently."

The potential problem: A CEO's desire to cash in on a quick payday may conflict with the long-term interests of shareholders. This is called the "agency problem."

The solution: "The most direct solution to this agency problem is to align the incentives of executives with the interests of shareholders by granting (or selling) stock and stock options to the CEOs," the researchers found.

In many cases, it's stock and stock options that drive up a CEO's pay and give critics of executive pay like Waxman the vapors.

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No positions in stocks mentioned.
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