Paying CEOs more than other CEOs results in stockholder dividends

Published: December 17 2009

Category:Business, Research

GAINESVILLE, Fla. — Highly paid CEOs are actually a bonus to the profitability of their companies and offer greater dividends to stockholders, a new study finds.

With the dramatic rise in executive compensation rates beyond average workers’ wages over the past three decades, there has been a growing public outcry that CEOs are paid far too much for the services they provide, said , a UF professor.

However, concluded Tosi, “CEOs who are paid better — above their market value — do better for the firm. So it would not seem to make sense for a firm to think about reducing CEO pay unless those effects are widespread because it may only hurt itself relative to other firms.”

Tosi did the study with Eric Fong at the and Vilmos Misangyi at , and it appears online this week in Strategic Management Journal. The study differs from others that examine whether CEO pay should be tied to a firm’s financial performance by looking at it in terms of the effects of compensating CEOs more or less than other CEOs doing similar jobs in the same industry.

CEOs paid more than their peers increased a firm’s return on its assets, a measure commonly used to assess company performance, the study found.

“We didn’t look at the issue of whether CEOs are overpaid relative to some ethical or moral standard,” he said. “We were interested in what happens when they are overpaid or underpaid relative to the labor market.”

The researchers determined a CEO’s market value from a formula that considered among other factors a firm’s size, profitability and location; and whether stockholders were strong enough to influence the firms’ compensation strategies. Their analysis included 932 CEOs across 30 industries between 1990 and 1999 and they drew comparisons from 2,955 CEO salaries.

Compensating CEOs less than the market rate resulted in CEOs either leaving the company or expanding its size as a way to increase their own salaries because company size is the biggest predictor of CEO earnings, Tosi said.

Despite the results, criticism about excessive CEO pay is not overblown, Tosi said. CEO pay is already being “ratcheted up” as part of a continuous cycle where compensation committees hire consultants to advise them how to set CEO salaries within the top 25 percent of the pay scale so they can be competitive, he said.

“To interpret our findings as a reason to overpay CEOs would only further contribute to the ratcheting effect that leads to excessive CEO pay,” he said.

The most damage to CEO departures occurred in owner-controlled firms, where at least one equity holder owns 5 percent or more of the stock, Tosi said. Underpaid CEOs in these companies were more likely to leave their jobs than were their counterparts in firms that were manager controlled or owner managed, he said.

Conversely, overpaying CEOs increased profits more for owner-controlled firms and owner-managed firms, where the CEO holds more than 5 percent of the stock, than manager-controlled firms, where no single equity holder has more than 5 percent of stock, he said.

The results underscore the importance of social comparison, Tosi said. “When CEOs compare themselves with other CEOs in similar conditions and find themselves overpaid or underpaid, they take action to rectify this condition,” he said. “Although previous studies have examined how boards of directors react to deviations in CEO pay and how overpaying CEOs affect lower-level managers’ pay and turnover, our study is among the first to investigate whether underpaying or overpaying CEOs has effects on CEOs themselves.”

The disparity between salaries at the top and bottom of an organization is part of a growing cultural phenomenon, Tosi said. In the 1970s, the average CEO pay was about 40 times that of the lowest worker, while today it is around 400 times that amount, he said.

Salary levels are egregious because CEOs are able to influence the selection of the boards of directors and structure their compensation packages and stock options in ways that personally favor them, including receiving golden parachutes worth millions of dollars when they fail, he said. “Is anybody worth that much and how does it happen?” he said. “I think the answer is simple. It happens because they set their own pay.”

management professor Luis Gomez-Mejia said the study is an important breakthrough in testing whether paying above market attracts better talent at the top executive level. “This is the only study I am aware of that directly attempts to measure the market value of executives and the implications of underpaying or overpaying the CEO,” he said.

Credits

Writer
Cathy Keen, ckeen@ufl.edu, 352-392-0186
Source
Henry Tosi, henry.tosi@cba.ufl.edu, 352-392-6147

Category:Business, Research