Executive Compensation as Lottery Prize

by Chidem Kurdas

Last week the WSJ published a list of the past decade’s best-paid chief executives. You might nod approvingly at some names but gag at others. In the former group is Steve Jobs of Apple, whose company’s share value grew by about 11-fold in the period from 2000 to 2009. In the latter category is Richard Fuld, the last chief executive of Lehman Brothers, whose $457 million compensation during the decade is hard to swallow given what happened to Lehman. 

It is notable that these compensation figures consist almost entirely of the value of company shares the executives received via stock options or as restricted stock. It is stock awards that account for the big numbers, starting with the $1.84 billion that won Larry Ellison of Oracle the top spot in the ranking. Cash salaries by comparison are miniscule.

The obvious argument in favor of stock options is that they  give executives incentive to work at boosting share value—thereby serving the owners of the company. But do they really have to be given such large blocks of stock? Smaller amounts of stock are likely sufficient incentive.

Giant compensation packages can’t really be justified as necessary to retain executives. It is not credible that Messrs. Ellison and Jobs would have jumped ship had they been paid less. I would guess that with smaller stock options they’d continue to do what they’re doing.

Neither is it plausible  that company boards, compensation committees and their consultants have a reliable way to estimate the contribution of an executive to a business, even assuming the best of intentions. Certainly Lehman’s board had no clue as to the future of the investment bank—nobody did until it collapsed. After the fact, Mr. Fuld’s compensation looks outrageous. Yes, hindsight is 20/20.

In any case, it is hard to argue that these people in some sense merit gigantic stock packages, especially as American executives tend to make much more than their counterparts elsewhere. Certain companies on the WSJ list did very well by their shareholders, but even then it is unclear whether the CEO had to be given that  much stock. Social norms as well as personalities and market psychology no doubt come to play.

As does chance. Others with similar abilities and drive competed for these prizes. They failed because of bad decisions but also because they were on the wrong side of Lady Luck.  Randomness, as Nassim Taleb reminds us, is a powerful force that we tend to overlook.   The top earners are the winners in a complicated sort of lottery. Their wealth is in part a result of happenstance.

Yet executive compensation has a crucial social function in fueling the engine of growth and innovation. The bigger the potential pot, the more participants in the race to build businesses and bring out new products. Only a few win huge awards, but the prospect of winning attracts capable individuals. The lottery needs to offer large awards so people will participate.

While executives could be paid less, the glittering prizes encourage their would-be successors. You want youngsters to aspire to be the next Steve Jobs. Many of them won’t succeed, but they’re the creative power in the economy.

The WSJ compensation data do not indicate whether an executive sold his shares. As I recall, Fuld did not cash out before the 2008 crisis, meaning he did not actually make all the money that put him on the list.  One could see that as yet another example of his poor judgment, but it is also another instance of bad luck.

15 thoughts on “Executive Compensation as Lottery Prize

  1. A very thoughtful post on a complex subject.

    Stock returns are increasingly correlated and, if stock options make sense at all, surely executives should earn only the excess returns. A pro-rata share in a stock-market bubble is not compensation for job performance.

    What does this say about corporate governance?

  2. An important factor when trying to get executive compensation right are strong shareholder rights. Oftentimes, the executives also sit in the board (or are friends with the board) who is can make up the compensation rules. In my country, these men often are also well-connected to managers of pension funds which might result in your stocks being used to vote against your interests. I think that’s where parts of the public outrage about high compensation comes from.

  3. Jerry,
    I think it makes a lot of sense for executives to get only the excess over the stock market return.

    I’m not sure how the options would be structured, though. It would complicate the compensation scheme, as a practical matter.

  4. Hermel,
    That probably happens to some extent in all countries. Board members are often cronies of the CEO and owe their lucrative appointment to him. No wonder they rubber stamp whatever he wants, including huge stock options.

    But the other part of the story is that board members are not inclined to work hard. One gets the impression people attend meetings and go through the motions, but don’t pay that much attention.

  5. That key difference is often ignored, isn’t it. However, the market does tend to impose some discipline in the long run on the executives of badly run companies.

  6. One cannot expect to make profit/progress without being held by the rules which govern the market. Sure there may be a little wiggle room for the high-ups to not be completely efficient, but that doesn’t mean it all falls to pieces. If they want to continue to get paid a lot, they will have to maintain the company they are in with sound practices or jump ship once their leisure starts to bring it down. They can’t switch companies indefinitely, so obviously, they are going to do the amount of work they view as being necessary for the company to be maintained. Being higher up doesn’t eliminate opportunity cost. If they don’t have to put in as much effort as a lower level person, then it is because they must have done something right. If that happens to be making friends with the right people, well, that’s what happens.

    If the system was stronger by having executives get paid only marginally more, then there would be more business springing up following such a model. Since there are not, then the rewards system currently in place must be working fairly well.

  7. Mostly true, Refraine. There is the troublesome fact that Fuld was given immense stock options for years as Lehman Brothers went to its doom, but you might argue that the end could not have been foreseen and people do make mistakes.

    And he did not sell off, so he did not in fact make the money he might have from the vested options. That certainly shows he was honest, if deluded.

  8. Re the opportunity cost, it is hard to believe that in all these examples the opportunity cost was so high. There are relatively few jobs that pay so much and the competition for them is fierce.

  9. As a shareholder, I’d love to see more transparency into the people on the boards of corporations.

    I’m amazed that in this internet age that there isn’t some Wiki out there with the real story on some of these people that answers questions like what’s their track record? What’s their philosophy on business? Who do they know? Why do they want to serve on a board?

    I’d also love to see transparency into what happens during the board meetings.

  10. i agree with Refraine and executive compensatio its really good for the companies to be maintained to well kept then only can it succeed in what it aims for, it needs to pay the workers what they really worth. i m sure apple pays really well for that reason they hire engineers that are top notch in creating products, by doing that it attracts more very skilled workers.

  11. Sri,
    Your point about engineers is important. It highlights a distinction–workers with specialized skills vs. executives whose skill is general management. The issue is the compensation of the latter. Technical personnel like engineers often do not get big stock packages.

  12. It would be interesting to see a comparison of how top execs vs. engineers are compensated in the same firm. My impression is that engineer salaries are not that lavish

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