Does Executive Pay Only Rise via Ratchet / LakeWobegon Effects?-Chapter 7 Summary

Chapter Summary
Many critics believe that there is an inexorable rise in CEO pay created by a ratchet effect from compensation committees supposedly being “slaves” to market data. In essence, if all boards chase an ever-rising 50th percentile, every CEO pay increase perpetuates the ratchet effect.  We think this is significantly overstated. Overall executive pay, especially realized pay, rises and falls with the stock market. In addition, a competitive market exists for executive talent that stems from the economic benefits of supply and demand and good faith arms-length negotiations of CEO pay.

Key Points
The ratchet effect theory of executive pay cannot exist in isolation. It would imply that a competitive labor market does not exist; that CEO pay only rises; and CEOs are not paid for performance.  None of the above are true.

A Competitive Labor Market: Evidence of a competitive labor market for CEOs can be seen in: 1) comparisons of the market characteristics of a commodity market, an executive labor market, and a regulated industry, such as electric power. The CEO labor market is much more like the competitive commodity market. 2) CEO pay for new incumbents hired from outside versus promote from within.  The internal promotions typically start out paid at 20% to 25% less than external hires.
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Change in Pay Over Time: While CEO pay has trended upward over the past 20 years, it clearly rises and falls proportionately with the stock market, especially the DJIA. We estimate CEO pay falls approximately 30% of the time.

Rising Value of CEO Human Capital: Many factors, including global competition and an increase in the size and complexity of organizations, have contributed to a rise in the value of CEO human capital. This increase has been faster than the rise in GDP, but has not outpaced the rise in the stock markets.

The general increase in CEO pay has also occurred in an environment of markedly improved corporate governance, involved shareholders, Say-on-Pay votes, and media pressure. This outcome would also tend to support the conclusion that the CEO labor market is competitive.

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