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October 3, 2007

Do High CEO Salaries Pay Off?

New research suggests that high-priced talent at the top may be justified in a globalized world.


With so much talk about soaring pay for CEOs — who may earn multiples more than their midlevel peers — people are asking, “Are they worth it?” Perhaps they are, because globalization rewards talent at the top, argues Professor Maria Guadalupe, based on her recent research. Her study, with Vicente Cuñat of the Universitat Pompeu Fabra, examined causality between globalization and performance-based pay.

Their key findings? As global competition grew over the 1990s, so did the link between executive pay and performance, with a higher proportion of all compensation coming from incentive-based pay than in the past.

In fact, a whopping 35 percent of the rise in performance-linked contracts from 1992 to 1999 can be attributed to greater competition from globalization, the researchers say, with total compensation rising faster and higher for CEOs than the four highest-ranking executives below them.

“Compensation contracts are changing because markets are changing,” says Guadalupe. “As foreign competition increases, firms are willing to pay more for the most talented CEOs and will proportionately reward them for performance.”

Here’s how the study worked: Guadalupe first crunched salary numbers gleaned from the S&P Execucomp database for executive pay among major U.S. manufacturers between 1992 and 1999. Those are key global trade years because barriers to entry fell sharply over that time as a result of the passage of the North American Free Trade Agreement, which enabled easier entry of Mexican- and Canadian-made goods, and the end of the Uruguay Round of General Agreements on Tariffs and Trade talks, which slashed tariffs on many foreign-made goods.

The researchers calculated shifts in incentive pay based on the change in total pay earned (including discretionary bonuses, stock options and restricted stock) linked explicitly in contracts or in implicit agreements to every extra dollar earned by the firm on a CEO’s watch. Globalization was measured by import penetration, or a rise in the share of foreign-made products in U.S. markets, many of which were previously protected.

Guadalupe and Cuñat singled out import penetration as the best measure of globalization because tariffs and exchange-rate shifts are normally outside a firm’s sphere of influence and are therefore “exogenous.” Imports can therefore be isolated and, as a measure of globalization, projected out and compared to wage fluctuations at firms, and over time.

And to quantify talent, the researchers estimated the market value of each executive at each firm in the sample. To arrive at a base value of how much firms would be willing to pay for each executive, they stripped out all contributing factors to executive pay, including company type, industry characteristics and the size of the firm. They then compared that number with changes in import penetration that the firm faced.

Their analysis generated some noteworthy results. The study established a clear link between globalization and the power of incentives for senior positions. The rise in the use and amount of performance-based pay also seemed to correlate with salary spreads between levels, which echoed earlier findings by Thomas Lemieux and others about incentive pay and wage inequality. Furthermore, the researchers’ findings questioned prior conclusions by Lucian Bebchuk and Jesse Fried suggesting that high CEO pay was the result of rent extraction, or excessive compensation because of one’s privileged position. Finally, CEOs seemed to leave firms sooner in their tenure and with more frequency, with many of them moving into radically different industries. This in turn seemed to foreshadow salaries rising to stratospheric levels, as the ranks of truly talented managers thinned from bidding wars and poaching.

Moreover, rising senior executive wage inequality suggested that the market might be motivating senior executives to exert a huge effort to reach the top, since great wealth might await them in the CEO suite. So what do these finding indicate? As competition intensifies and as communication, technology and information costs fall further, compensation structures may continue to shift along with market dynamics — and those changes make economic sense.

“Whether one thinks that the level of CEO compensation is too high is a value judgment,” says Guadalupe. “But markets respond to change. And economic analysis shows that the market is demanding and rewarding talent at the top.”

Maria Guadalupe is an assistant professor of finance and economics at Columbia Business School. This paper won Spain’s 2007 Jaime Fernández de Araoz Prize for Corporate Finance.


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