December 13, 2005
Excerpts: The Battle For The Soul of Capitalism - Part XVI
Burgeoning Executive Compensation
The recent era, however, defied the long-run reality. When the S&P 500 Index rose from 130 in March 1981 to 1,527 in March of 2000, the return on investor capital, excluding dividends, was 13.8 percent per year. Earnings growth amounted to 6.2 percent annually, less than half of the return, with the remainder the result of a rise in the price-earnings ratio from eight times to thirty-two times. That increase alone accounted for 1,100 points of the 1,400-point gain, or 7.6 percent per year. If one were to attribute even a 5 percent corporate cost of capital as a threshold for a stock option grant—a return a company might have earned merely by placing all of its assets in a bank certificate of deposit—corporate management could claim responsibility for an extra return of only 1.2 percent per year. Yet when the Index reached 1,527, a stock option for ten thousand shares at $130 at the outset would have placed a cool $14 million on the executive’s plate at its conclusion. Nice work if you can get it!
With huge option grants to corporate managers and overstated earnings, all the while disregarding the cost of these options as an expense, total executive compensation went through the roof. In 1980, the compensation of the average chief executive officer was forty-two times that of the average worker; by the year 2004, the ratio had soared to 280 times that of the average worker (down from an astonishing 531 times at the peak in 2000). Over the past quarter-century,[...], CEO compensation measured in current dollars rose nearly sixteen times over, while the compensation of the average worker slightly more than doubled. Measured in real (1980) dollars, however, the compensation ofthe average worker rose just 0.3 percent per year, barely enough to maintain his or her standard of living. Yet CEO compensation rose at a rate of 8.5 percent annually, increasing by more than seven times in real terms during the period.
The rationale was that these executives had “created wealth” for their shareholders. But were CEOs actually creating value commensurate with this huge increase in compensation? Certainly the average CEO was not. During that twenty-four-year period, corporations had projected their earnings growth at an average annual rate of 11-1⁄2 percent. But they actually delivered growth of 6 percent per year—only half of their goal, and even less than the 6.2 percent nominal growth rate of the economy. In real terms, profits grew at an annual rate of just 2.9 percent, compared to 3.1 percent for our nation’s economy, as represented by the Gross Domestic Product. How that somewhat dispiriting lag can drive average CEO compensation to a cool $9.8million in 2004is one of the great anomalies of the age. If CEOs have failed to create value, there must be another explanation for such compensation. One can only wonder what it might be.
What is more, the staggering sums paid to CEOs are understated. The figures include only what is publicly disclosed as CEO compensation, and since our CEOs receive a host of perquisites to augment their lavish lifestyles, the reality is considerably higher. These “perks” are often undisclosed and excluded from the “total compensation” reported for officers in the proxy statement. Even the list in Box 1.2 does not exhaust the undisclosed special benefits extended to executives, such as bargain interest rates on their loans and high interest rates on their deferred compensation.
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