3 Problems With How Executives Get Paid

Source: Thinkstock

Source: Thinkstock

In what amounts to a rare instance these days, shareholders of burrito behemoth Chipotle (NYSE:CMG) voted against giving the company’s two standing CEOs — Steve Ells and Montgomery Moran — huge compensation packages. In 2013, both executives took home monster pay days over more than $24 million. However, as Upstart Business Journals explores, perhaps the message sent from Chipotle’s shareholder base to its CEOs is that their pay level should be more on par with that of a manager.

This is a message that hasn’t gone mainstream, at least not yet. One of the primary factors behind the growing income gap is the tremendous gains in income secured by members of the nation’s wealthiest classes. Many members of the top classes happen to be high-level and powerful executives at many of the world’s largest multi-national corporations, a healthy portion of which are based in the United States. The Wall Street Journal even points out that even though the economy has technically recovered and there have been large economic gains since 2009, the lion’s share, 95 percent, has gone to the nation’s top one percent.

Over the past two decades, executive pay has shot through the roof. There have been many reasons behind the growth spurt, but one of the primary factors has been a trend of restructuring executive compensation. A study from the Economic Policy Institute shows that CEO pay has risen 725 percent since 1978, 127 times faster than employee pay over the same period, according to Think Progress.

What exactly has changed? As base salary has more or less stayed the same, the biggest difference has been huge increases in stock, bonuses, and options. These changes have led to executives have insanely-inflated total compensation packages and have primarily fueled increasing wealth gaps. How do these differences cause problems?

Read on on to see the three main problems with the new trends in CEO compensation.

Source: Thinkstock

Source: Thinkstock

1. Stock-heavy plans have downfalls

Equity-based compensation structures have taken the business community over, and now represent a growing segment of executive pay plans. The basics of the structure is that through the establishment of certain business metrics, shareholders and analysts can track a company’s performance and growth over time. From that growth, executives are awarded accordingly through percentages, bonuses, or stock. This was done in an attempt to make please shareholders and motivate the heads of companies to get results.

However, the New York Times explains that using these metric-based systems may have led to the unintended consequence of rationalizing huge paychecks for executives. Cornell Law Professor Lynn Stout even mentions that through these type of pay structures, it’s possible to create bad incentives.

While it makes sense to align a CEO’s interests with the shareholders through a stock-heavy plan, it may not always play out in the best way. Stever Robbins of the Harvard Business School explains that stock can stop motivating when companies come up against hard times, and even lead to jealousy amongst the ranks. He also goes on to mention that it’s difficult to motivate an individual to have hard-hitting effects, as they are usually incapable of doing so.

“There’s rarely a link between someone’s work and share price. Stock makes a nice bonus for people, but it doesn’t affect their performance because no one can figure out how to have an impact. So stock is a nice reward while the share price rises. When the price falls, though, the company has to resort to motivating with good old-fashioned salary,” he said.

Source: Thinkstock

Source: Thinkstock

2. The role in widening the wealth gap

As previously mentioned, the adoption of equity-based compensation has been a major driving force in the increasing disparity of wealth. But how exactly does that happen? For one, it has to do with the stock market’s resurgence following the 2008 financial crisis. Since many executives are seeing big chunks of their compensation come in the form of stock and options, the wealth generated by that portion of income has seen huge gains.

Compare that to the common employee, who does not receive stock as a part of their compensation, and probably can’t afford any. They are not sharing in on the growing wealth, and most likely have seen their value diminish as wages stagnate or go down even as production has gone up to fuel stock price increases.

CNN reports that it is expected that the global economy should grow by 3.2 percent this year, an increase over 2013′s 2.4 percent. Yet, even with all the economic growth, things keep getting worse for a majority of the world’s citizens. Those gains are going almost entirely to the top percentiles of society, keeping the lower and middle classes ever more shut out. Even traditional methods of breaking through to the upper-echelons of earners have become less and less an option. Education costs have become so high that for many that attaining a degree may no longer be worth the cost.

With the equity-based compensation model driving big-time growth on stock price, the rewards of those gains are primarily celebrated by those at the top. As an emphasis on increasing share value and growth year over year becomes ever more important, thanks to these compensation models, the wealth and income gaps can be expected to widen even further.

Source: Thinkstock

Source: Thinkstock

3. Emphasis on short-term earnings

The most apparent backlash of executive pay models is an emphasis on short-term earnings, in order to keep their shareholders happy. This can be expressed in risky behavior, cutting corners in production and a lower concern for employee welfare. Since executives are making decisions with the end goal of seeing metrics rise, many other concerns can be cast aside in favor of reporting growth for annual reports.

A report from The National Bureau of Economic Research explains the potentially disastrous process as a result of executives favoring the bottom line in lieu of building their organization’s long-term health.

“Equity-based pay is often criticized as encouraging executives to manage short-term earnings to appease Wall Street instead of managing for long-run value creation. And given the market’s occasional bouts of excessive optimism, executives may be tempted to fool the market by figuring out ways to temporarily prop up their stock prices and then cash out their equity holdings. Under pressure to boost the stock price, for example, managers may cut R&D or take other actions that increase short-term earnings at the expense of (appropriately discounted) long-run cash flow. Such “short termism” is likely to be especially tempting for managers nearing retirement or whose jobs are on the line because of weak performance,” the report says.

As shown, there are some clear disadvantages to the new iteration of executive compensation models. It’s true that equity-based models can return some governing power to shareholders and hold CEOs accountable for company performance, there are ways to work the system from the top. While it’s a stretch to say that equity-based models are a terrible idea, there is evidence they may not be the ideal structure going forward.

Add that to the fact that these models are a big catalyst behind the growing wealth gap, and it may be time for shareholders to investigate the next evolution in executive pay. If the board at Chipotle can put its collective foot down on the issue, so can many others.

More From Wall St. Cheat Sheet: