CEO Compensation Surged In 2017

BOX B

CEO-to-worker pay ratios: The new SEC rule and the EPI methodology

Beginning in 2018, all publicly traded companies are required to disclose CEO total compensation alongside the median annual total compensation of all employees other than the CEO in annual proxy statements submitted to the Securities and Exchange Commission. In addition, they are to provide the ratio of CEO-to-worker compensation (SEC 2015).

Advocates, investors, and researchers alike have welcomed the disclosure of this information, because these disclosures offer previously unavailable insight into compensation inequality within firms. Historically, constructing a firm-specific CEO-to-worker pay ratio was impossible without the cooperation of the firm, although sector-specific estimates were possible (see Mishel and Schieder 2017). The new CEO-to-worker compensation ratios contained in this year’s proxies shine a ray of sunlight onto the compensation of the typical worker. According to the authors of a report titled Rewarding or Hoarding? An Examination of Pay Ratios Revealed by Dodd-Frank, from the office of Congressman Keith Ellison (D-Minn.), “These new data give us a much clearer picture as to which corporations are sharing the wealth and which are not” (Staff of Congressman Keith Ellison 2018).

Fierce business resistance to the mandate to report the CEO-to-worker compensation ratio watered down their potential use. Many corporations implausibly contended that constructing these ratios was too difficult. The SEC gave these claims far too much credence, providing firms tremendous leeway in how to construct the ratios. This SEC capitulation diminished the utility of these new median worker compensation measures for making comparisons across firms and will affect the utility of comparing them over time when additional years of data are available.

Specifically, the SEC’s rule grants firms significant discretion in reporting median worker pay, which makes the reported ratios incompatible across firms. A company’s reported “median worker” may, for example, work part time or full time, reside in the U.S. or abroad, and have worked for the firm for a limited number of weeks during the previous year. The data on median compensation are not provided on a per hour basis or annualized to that of a full-time, full-year worker. Without such information, or simply the annual hours worked by the median worker, it is not possible to standardize the compensation for comparisons across firms. In addition, firms may not adhere to the same metric each year, limiting the ability to make historical comparisons in the future.

Given these limitations, this year’s annual EPI examination of CEO compensation will once again provide an annual estimate of CEO-to-worker pay. Our methodology (described in Sabadish and Mishel 2013) has a number of advantages over the SEC’s calculated ratio. First, our methodology compares CEO compensation to the median worker in the main industry of the CEO’s company. It thereby eliminates artificial reductions in the CEO-to-worker pay ratio that could arise from the extensive use of subcontracting. Second, our worker compensation series reflects annualized compensation (multiplying an estimate of hourly compensation by 2,080 hours), eliminating the ambiguity that arises when weeks worked and hours per week are not specified or differ across firms. This assumption also makes our ratio a conservative estimate of the true ratio as measured by the figures reported to the SEC. Third, our analysis captures the ratio of CEO compensation to U.S. domestic workers, which provides comparability that the SEC required ratios do not provide. Fourth, our series is able to extend back to 1965, providing an opportunity to analyze trends in executive compensation over time. The consistent basis of the measurement of our ratios permits historical comparisons on a year-to-year basis. These (and other) benefits justify the continued production of our CEO-to-worker pay series—although it is our hope that with time the ambiguities of the SEC ratio will be addressed and adjusted, to produce a reliable time series for investors and the public to use.

In terms of CEO compensation based on realized stock options, CEOs of major U.S. companies earned 20 times more than a typical worker in 1965. This ratio grew to 30-to-1 in 1978 and 58-to-1 by 1989. It surged in the 1990s, hitting 344-to-1 in 2000, at the end of the 1990s recovery. The fall in the stock market after 2000 reduced CEO stock-related pay (e.g., realized stock options) and caused CEO compensation to tumble in 2002, to 177 times typical worker pay, before beginning to rise again in 2003. CEO compensation recovered to a level of 327 times worker pay by 2007, almost back to its 2000 level. The financial crisis of 2008 and accompanying stock market decline reduced CEO compensation between 2007 and 2009, as discussed above, and the CEO-to-worker compensation ratio fell in tandem. By 2014 the stock market had recouped all of the value it had lost following the financial crisis, and the CEO-to-worker compensation ratio in 2014 had recovered to 284-to-1. The fall in CEO compensation between 2014 and 2016 caused the CEO-to-worker pay ratio to fall to 270-to-1; the sharp upward spike in CEO compensation in 2017 lifted the CEO-to-worker compensation ratio to 312-to-1. Although the CEO-to-worker compensation ratio remains below the values achieved earlier in the 2000s at the peak of the stock market bubble, it is far higher than it was in the 1960s, 1970s, 1980s, and 1990s.

The pattern using the CEO compensation measure that values stock options as they are granted is similar. The CEO-to-worker pay ratio peaked in 2000, at 361-to-1 even higher than the ratio with the stock-options-realized measurement. The fall from 2000 to 2007 was steeper than for the other measure, hitting 227-to-1 in 2007. The stock market decline during the financial crisis drove the ratio down to 176-to-1 in 2009. It recovered to 213-to-1 by 2014 and remained flat thereafter, rising to 221-to-1 in 2017. This level is far lower than its peak in 2000 but still far greater than the 1989 ratio of 42-to-1 or the 1978 ratio of 22-to-1.

Does dramatically high CEO pay simply reflect the market for skills?

This section reviews competing explanations for the extraordinary rise in CEO compensation over the past several decades. CEO compensation has grown a great deal since 1965, but so has the pay of other high-wage earners. To some analysts, this suggests that the dramatic rise in CEO compensation was driven largely by the demand for the skills of CEOs and other highly paid professionals. In this interpretation, CEO compensation is being set by the market for “skills” or “talent,” not by managerial power or rent-seeking behavior. This explanation lies in contrast to that offered by Bebchuk and Fried (2004), who claim that the long-term increase in CEO pay is a result of managerial power.

One prominent example of the “it is other professions, too” argument comes from Kaplan (2012a, 2012b). In the prestigious 2012 Martin Feldstein Lecture at the National Bureau of Economic Research, he claimed:

Over the last 20 years, then, public company CEO pay relative to the top 0.1 percent has remained relatively constant or declined. These patterns are consistent with a competitive market for talent. They are less consistent with managerial power. Other top income groups, not subject to managerial power forces, have seen similar growth in pay. (Kaplan 2012a, 4)

In a follow-up paper for the Cato Institute, published as a National Bureau of Economic Research working paper, Kaplan expanded this point:

The point of these comparisons is to confirm that while public company CEOs earn a great deal, they are not unique. Other groups with similar backgrounds—private company executives, corporate lawyers, hedge fund investors, private equity investors and others—have seen significant pay increases where there is a competitive market for talent and managerial power problems are absent. Again, if one uses evidence of higher CEO pay as evidence of managerial power or capture, one must also explain why these professional groups have had a similar or even higher growth in pay. It seems more likely that a meaningful portion of the increase in CEO pay has been driven by market forces as well. (Kaplan 2012b, 21)

The argument that CEO compensation is being set by the market for “skills” does not square with the data. Bivens and Mishel (2013) address the larger issue of the role of CEO compensation in generating income gains at the very top and conclude that substantial rents are embedded in executive pay. According to them, CEO pay gains are not the result of a competitive market for talent but rather reflect the power of CEOs to extract concessions.

We draw on and update their analysis to show that CEO compensation grew far faster than compensation of very highly paid workers over the last few decades, which suggests that the market for skills was not responsible for the rapid growth of CEO compensation. To reach this finding, we use Kaplan’s series on CEO compensation and compare it with the wages of top wage earners rather than the household income of the top 0.1 percent, as Kaplan did.6 The wage benchmark seems the most appropriate one, because it avoids issues of household demographics (e.g., changes in two-earner couples) and limits the income to labor income (i.e., excludes capital income). We update Kaplan’s series beyond 2010 using the growth of CEO compensation in our own series. This analysis finds, contrary to Kaplan, that the compensation of CEOs has far outpaced that of very highly paid workers, the top 0.1 percent of earners.

Table 2 shows the ratio of the average compensation of CEOs of large firms (the series developed by Kaplan, incorporating stock options realized) to the average annual earnings of the top 0.1 percent of wage earners (based on a series developed by Kopczuk, Saez, and Song [2010] and updated by Mishel and Wolfe [2017]). The comparison is presented as a simple ratio and logged (to convert to a “premium,” defined as the relative pay differential between two groups). Both the simple ratios and the log ratios understate the relative pay of CEOs, because CEO pay is a nontrivial share of the denominator, a bias that has probably grown over time as CEO relative pay has grown; removing top CEOs’ pay from the top 0.1 percent category would reduce the average for the broader group.7

For comparison purposes, Table 2 also shows the changes in the gross (not regression-adjusted) college-to-high-school wage premium. This premium, which is simply how much more pay is earned by workers with a college degree relative to workers with just a high school degree is useful because some commentators, such as Mankiw (2013), assert that the wage and income growth of the top 1 percent reflects the general rise in the return to skills, as reflected in higher college wage premiums. (The comparisons end in 2016 because 2017 data for top 0.1 percent wages are not yet available).

In 2016 CEO pay was 5.45 times the pay of the top 0.1 percent of wage earners, up from 2015 (despite the decline in compensation in 2016) and substantially higher than the 4.31 ratio in 2007. Since 2007 CEO compensation has thus grown far more rapidly than did the wages of the top 0.1 percent of earners. CEO compensation relative to the wages of the top 0.1 percent of wage earners in 2016 far exceeded the ratio of 2.60 in 1989, a rise (2.86) equal to the pay of almost three very-high-wage earners (a one-point rise in the ratio is the equivalent of the average CEO earning an additional amount equal to that of the average earnings of someone in the top 0.1 percent). The log ratio of CEO relative pay grew 74 log points with respect to wage earners in the top 0.1 percent.

Is this increase large? Kaplan (2012a, 4) concludes that CEO relative pay “has remained relatively constant or declined.” He finds that the ratio “remains above its historical average and the level in the mid-1980s” (2012b, 14). His historical comparisons are inaccurate, however. Figure D compares the ratios of the compensation of CEOs and top 0.1 percent of wage earner ratios back to 1947. In 2016 this ratio was 5.45, 2.27 points higher than the historical average of 3.18 (a relative gain in wages earned by the equivalent of 2.27 high-wage earners).

The data in Table 2 also provide a benchmark of CEO compensation to that of the college-to-high-school wage premium. Since 1979, and particularly since 1989, the increase in the logged CEO pay premium relative to other high-wage earners far exceeded the rise in the college-to-high-school wage premium, which is widely and appropriately considered to have had substantial growth. Mankiw’s claim that top 1 percent pay or top executive pay simply corresponds to the rise in the college-to-high-school wage premium is unfounded (Mishel 2013a, 2013b). Moreover, the data would show even faster growth of CEO relative pay if Kaplan had built his historical series using the Frydman and Saks (2010) series for the 1980–1994 period rather than the Hall and Liebman (1997) data.8

If CEO pay growing far faster than that of other high earners is a test of the presence of rents, as Kaplan suggests, one would conclude that today’s top executives are collecting substantial rents, meaning that if they were paid less there would be no loss of productivity or output. The large discrepancy between the pay of CEOs and other very-high-wage earners also casts doubt on the claim that CEOs are being paid these extraordinary amounts because of their special skills and the market for those skills. It is unlikely that the skills of CEOs of very large firms are so outsized and disconnected from the skills of others that they propel CEOs past most of their cohorts in the top 1/10th of the top 1 percent. For everyone else, the distribution of skills, as reflected in the overall wage distribution, tends to be much more continuous.

Conclusion

Some observers argue that exorbitant CEO compensation is merely a symbolic issue, with no consequences for the vast majority of workers. However, the escalation of CEO compensation, and of executive compensation more generally, has fueled the growth of top 1 percent incomes. In their study of tax returns from 1979 to 2005, Bakija, Cole, and Heim (2010) establish that the increases in income among the top 1 percent and top 0.1 percent of households were disproportionately driven by households headed by someone who was either a nonfinancial-sector “executive” (including managers and supervisors, hereafter referred to as “nonfinance executives”) or a financial-sector worker (executive or otherwise). Forty-four percent of the growth of the top 0.1 percent’s income share and 36 percent of the top 1 percent’s income share accrued to households headed by a nonfinance executive; another 23 percent for each group accrued to financial-sector households. Together, finance workers and nonfinance executives accounted for 58 percent of the expansion of income for the top 1 percent of households and 67 percent of the income growth of the top 0.1 percent. Relative to others in the top 1 percent, households headed by nonfinance executives had roughly average income growth, those headed by someone in the financial sector had above-average income growth, and the remaining households (nonexecutive, nonfinance) had slower-than-average income growth. These shares may actually understate the role of nonfinance executives and the financial sector, because they do not account for increased spousal income from these sources.9

High CEO pay reflects economic rents—concessions CEOs can draw from the economy not by virtue of their contribution to economic output but by virtue of their position. Clifford (2017) describes the Lake Wobegon world of setting CEO compensation that fuels its growth: Every firm wants to believe its CEO is above average and therefore needs to be correspondingly remunerated. CEO pay could be reduced and the economy would not suffer any loss of output.

Another implication of rising CEO pay is that it reflects income that otherwise would have accrued to others: What the executives earned was not available for broader-based wage growth for other workers. (Bivens and Mishel 2013 explore this issue in depth.)

Average CEO compensation (based on stock options realized) spiked upward by 17.6 percent in 2017. The spurt in CEO compensation reflects the underlying growth in the stock-related components of compensation, both stock awards and stock options realized. Compensation of the bottom 80 percent grew just 0.2 percent in 2017, continuing the trend of sluggish compensation growth for the vast majority. CEO compensation is historically high, although it remains below the levels attained in 2000 and 2007.

Several policy options could reverse the trend of excessive executive pay and broaden wage growth. Some involve taxes. Implementing higher marginal income tax rates at the very top would limit rent-seeking behavior and reduce the incentives for executives to push for such high pay. Another option is to set corporate tax rates higher for firms that have higher ratios of CEO-to-worker compensation. Clifford (2017) recommends setting a cap on compensation and taxing anything over the cap, similar to the way baseball team payrolls are taxed when they exceed a cap. Other policies that could potentially limit executive pay growth are changes in corporate governance, such as greater use of “say on pay,” which allows a firm’s shareholders to vote on top executives’ compensation.

Acknowledgments

The authors thank the Stephen Silberstein Foundation for its generous support of this research. Steven Balsam, an accounting professor at Temple University and author of a book on executive compensation (Balsam 2013), provided useful advice on data construction and interpretation.

About the authors

Lawrence Mishel is a distinguished fellow and former president of the Economic Policy Institute. He is the co-author of all 12 editions of The State of Working America. His articles have appeared in a variety of academic and nonacademic journals. His areas of research include labor economics, wage and income distribution, industrial relations, productivity growth, and the economics of education. He holds a Ph.D. in economics from the University of Wisconsin at Madison.

Jessica Schieder is an economic analyst for the Economic Policy Institute and the Economic Analysis and Research Network. Her areas of research include wage trends, executive compensation, gender and racial wage gaps, and social protection. She holds a master’s degree in international development from Georgetown University.

Endnotes

1. There were 38,824 executives in publicly held firms and 9,692 people in the top 0.1 percent of wage earners in 2007, according to the Capital IQ database (tabulations provided by Temple University professor Steve Balsam).

2. We chose which years to present in the table in part based on data availability. Where possible, we chose cyclical peaks (years of low unemployment).

3. In previous reports, the sample in a year had fewer than 350 firms, because there were no data for large firms that did not have the same CEO for most of or all of the year or the compensation data were not reported. The samples now include the largest firms (by revenue), which report executive compensation. We revised the data back to 1992 accordingly, using ExecuComp data from Compustat. Establishing these criteria for inclusion in the sample prevents potentially volatile shifts in the composition of firms in the sample because of missing data from influencing the level and trends in compensation. By establishing 350 firms in the sample, we are forcing some smaller firms with lower executive compensation into it, thereby lowering the average compensation and the average CEO-to-worker compensation ratio.

4. Most Fortune 500 companies release annual financial data in early spring; the data are included in samples limited to the first half of the year. However, the date we present for previous years includes all of the data that were released during each calendar year. This creates a bias in comparing data for the first half of the year relative to the full year’s data in the prior or earlier years: compensation levels for the full year’s data are higher than compensation in the data limited to the first half. A comparison of data available in June thus shows a smaller increase when compared with the previous year’s full data than a comparison with the data that were available at the same time a year earlier. We analyzed the impact of this bias and found that the vast majority of top firms remain unchanged between the samples for the first half and the full year. However, there is churn among the smaller firms in the sample. Among firms with lower net annual sales, average CEO compensation tends to be higher in the full-year sample. Additionally, in recent years firms reporting later in the year have tended to be firms with lower worker compensation levels and therefore higher CEO-to-worker compensation ratios.

5. There are a limited number of firms, which existed only for certain years between 1992 and 1996, for which a North American Industry Classification System (NAICS) value is unassigned. This makes it not possible to identify the pay of the workers in the firm’s key industry. In these cases these firms are not included in the calculation of the CEO-to-worker compensation ratio.

6. We thank Steve Kaplan for sharing his CEO compensation series with us. The series on the income of the top 0.1 percent of households that Kaplan used is no longer available. Moreover, as we discuss, the appropriate comparison is to other earners, not to households, which could have multiple earners and shifts in the number of earners over time.

7. Temple University professor Steve Balsam provided tabulations from the Capital IQ database of annual wages of executives exceeding the wage thresholds (provided to him) that place them in the top 0.1 percent of wage earners. The 9,692 executives in publicly held firms who were in the top 0.1 percent of wage earners had average annual earnings of $4.4 million. Using Mishel et al.’s (2012) estimates of top 0.1 percent wages, we find that executive wages make up 13.3 percent of total top 0.1 percent wages. One can gauge the bias of including executive wages in the denominator by noting that the ratio of executive wages to all top 0.1 percent wages in 2007 was 2.14 but the ratio of executive wages to nonexecutive wages was 2.32. We do not have data that would permit an assessment of the bias in 1979 or 1989. We also lack information on the number and wages of executives in privately held firms; to the extent that their CEO compensation exceeds that of publicly traded firms, their inclusion would indicate an even larger bias. The Internal Revenue Service reports that there were nearly 15,000 corporate tax returns in 2007 of firms with assets exceeding $250 million, indicating that there are many more executives of large firms than just those in publicly held firms.

8. Kaplan (2012b, 14) notes that the Frydman and Saks series grew 289 percent whereas the Hall and Liebman series grew 209 percent. He also notes that the Frydman and Saks series grows faster than the series reported by Murphy (2012).

9. The discussion in this paragraph is taken from Bivens and Mishel 2013.

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