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In part one of this series (Tales of Cobras, Windows, and Economic Promise), I discussed the “cobra effect.” It is a term that derives from a venomous cobra outbreak in India. I chose this tale to exemplify how solutions to problems, on occasion, have the opposite of the intended effect.
In this article, I present a two-headed cobra effect: Government legislation designed to limit executive compensation runs afoul of economists and academia who chose to base executive compensation on “performance.”
Bush versus Clinton
In the early 1990s, like today, there was a disproportionate gap between corporate executive and employee compensation. Academia held the belief that the level of executive compensation was not warranted based on executive performance, claiming that closing the gap would benefit employees and the economy.
In 1992, there was a presidential election between George Bush, the sitting president, and the two-term governor from Arkansas, Bill Clinton. Part of Clinton’s campaign pledge was to tame what he called, “excessive executive pay.”
Specifically, Clinton intended to reverse a recent veto by President George Bush, limiting corporate tax deductions for executive compensation.
After being elected in November of 1992, Clinton signed into law section 162(m) of the IRS code. The code limits corporate deductibility of executive pay to $1 million for “named executives” at publically traded companies.
Financially penalizing companies with high wage-earning executives may seem like a smart way to limit compensation. Then again, putting a bounty on cobra heads also seems like a reasonable way to get rid of cobras.
Thirty years later
Now, 30 years later, we can clinically evaluate the effectiveness of that legislation. The graph below illustrates one measure comparing executive pay to worker compensation.
Data Courtesy: The Economic Policy Institute
Executives have excellent legal counsel and they employ the best accountants. They quickly found ways to avoid the penalties imposed by Clinton’s legislation. Essentially they would limit their traditional take-home pay and increase other forms of compensation – most notably, stock and stock option awards.
The graph below shows a distinct change in the makeup of compensation packages starting in 1992. While the graph is only through 2008, the trends continued to this day.
Executives not only helped their company’s tax planning, but increased their pay immensely. Changes in pay structure also pleased economists and academia, who thought economic progress was best achieved with performance-based compensation.
But people differ over the definition of performance.
Incentives
Stock-based compensation as a percentage of total executive pay has grown since 1992. Laws written and passed based on what was thought to be sound academic analysis radically modified incentives.
A person paid in stock will be motivated to get the stock to trade for as high a price as possible. Logically, the next issue to analyze is the correlation between stock performance, long-term corporate profitability, and employee welfare.
According to research from the Harvard Law School Forum on Corporate Governance, since 1990, CEO median pay at large U.S. corporations has grown 514% adjusted for inflation. Over the same period and on an after-inflation basis, median household income has increased by 21%, GDP by slightly less than 100%, and S&P 500 earnings by 129%.
Such massive outperformance of executive compensation over corporate and economic performance is telling. As CEO pay became more closely aligned with the stock price, CEOs and executive leadership, in general, targeted corporate decisions that drove share prices higher. Those include cutting expenses, leveraging up the company, neglecting investments, and of course, manipulating the stock price via share buybacks.
With a focus on share prices, not only do corporate profits suffer but so do economic and productivity growth. Executives grew more prosperous at the expense of the economy and a large segment of the population.
Sowing the seeds
It is easy to blame political leadership and their legislation, but they had a lot of support. As noted, at the time, academia lobbied for performance-based executive compensation in the name of enhancing “shareholder value.” They theorized that basing pay on performance would solve the compensation problem. This line of thought was not new. They were parroting what economists were saying over the prior 20 years. In Short Term Gain – Long Term Pain, I wrote the following:
In the early 1970’s, economists began to argue that the motives of agents (executives) were different from those of the principals (shareholders). Thus in their opinion, a principal-agent problem existed. To align the interests of executives and shareholders, economists promoted a theory that executives should be given financial incentives derived from corporate stock performance.
With the “do-gooder” economists, think tanks, and large universities behind him, Clinton enacted legislation that laid the groundwork for economic failure. He put a bounty on cobras without considering that executives would begin breeding them for income.
The simple fix
One would think that shareholders would be aghast at what has occurred. They are not, and for a good reason. The average holding period of stocks has shrunk from eight years in the 1960s to less than one year today. While the graph below is dated, I venture the current holding period indeed has not lengthened. Most are no longer “investing” as part owners in a company. They have become stock renters, flipping electronic pieces of paper with a click or two of a mouse.
Short-term shareholders do not care about long-term corporate performance. Buybacks are cheered and will always trump investments into a company’s future.
The fix is easy. Pay executives on metrics related to future corporate profitability. Force their attention to that which is best in the long run for shareholders, employees, and the communities they operate in. Not only will shareholders prosper, but workers and the economy will as well. It may be wishful thinking given the power structure. Still, corporate, economic, and monetary policies must be re-aligned away from short-termism and expediency to those which will deliver organic growth and long-term prosperity.
Summary
What started in 1992 as a seemingly noble idea to shrink the wealth gap and income disparity has made the problem worse. Poorly thought-out legislation hurt productivity growth, economic trends, and the prosperity of almost every citizen.
The solutions for solving some of our economic woes are neither complex nor difficult. They will, however, require sacrifice to establish proper incentives. Much of that sacrifice falls on the top 1% who benefit the most from an artificially inflated stock market.
As I hope you will notice with this series of articles, the rationale and justification for addressing a problem are often well-founded. Still, the incentives borne out of the “solution” lead to viperous unintended consequences.
Michael Lebowitz is the founding partner of 720 Global and partner with Real Investment Advice. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics. For more information about our upcoming subscription service RIA Pro, please contact us at 301.466.1204 or email [email protected].
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
