CEO Pay Rates U.S. vs.

Foreign Nations

Management 510 Dr. Mark Kroll November 17, 2005

Presented By: Adam Choate Dana Rowzee Jerrod Tinsley

Executive Summary Are American Chief Executive Officers (CEOs) paid more in relation to the rest of the world? In this paper, our research will show that Americas corporate executives get paid huge sums of money for the work that they do. Be it in salary, bonuses, or options, American CEO pay dwarfs the pay of CEOs around the world. The fact that American CEOs have been extremely overcompensated for their work has received a great deal of attention in management and economics journals and in the popular press. We will discuss the duties and responsibilities of American and foreign CEOs, the CEO compensation compared to other countries, and also the minimum wage disparity that CEO overpay can create. Along the lines of pay gap disparity, three theories found in research will be addressed. These theories include the marginal revenue product theory, tournament theory, and opportunity theory. Each theory takes a different approach on why American CEOs seem to be overcompensated compared to their foreign counterparts.

Introduction The American dream is one of upward mobility. US citizens believe that if one works hard, and plays by the rules they can ensure themselves the quality of life that they desire. Recently, the dream toward upward mobility has been limited to a select class of corporate executives that have received record levels of compensation in recent years. Today American Chief Executive Officers (CEOs) are paid outrageously large amounts of money compared to foreign CEOs who essentially perform similar jobs as their American counterparts. AFL-CIO Secretary Treasurer Richard Trumka said "what looks excessive in the context of US workers is truly outrageous when viewed globally. The global economy is not working for working families when boards of directors hand US CEOs tens of millions of dollars while paying the people who actually do the work less than ten dollars a day (Burton 2005). CEOs total pay packages have continued to spiral upward over the years, even though thousands of average employees lose their jobs, corporate profits fall, and shareholders lose money. An executive compensation package is typically comprised of total base salary, yearly bonuses and benefits, stock-options, and anticipated value of long-term projects. Base salary is generally a fixed component that is the value an organization attributes to the position, and is usually relevant to the labor market, but may vary based on performance. Chief Executive Officers are continually reaping larger and larger benefits each year. Over the past two years the average compensation among the top 200 companies has increases thirty-seven percent. At the end of 2003 the average CEO compensation was almost ten million dollars, excluding profits made on stock

options. As of 2004 the median compensation for a CEO in one of the top public corporations in the United States has increased 25% to $13.7 million. In 2004, the average American CEO was paid $10 million, as reported in The Wall Street Journals annual analysis of the 350 largest public companies (WSJ 2005). This is a huge 14.5 percent increase over the annual CEO compensation in 2003. American CEO pay currently dwarfs foreign CEO pay. German CEOs make 13 times more than the average German manufacturing employee an in Japan, the CEO-to-worker pay ratio is just 11-to-1 (Greenfield 1999). Characteristics of CEOs Two questions can come about when dealing with CEO pay. What actual job tasks do foreign and American CEOs perform, and how much do CEOs deserve to be paid for these tasks? It is when you look at the actual work that a CEO actually does, compared to the pay they receive, when the irrelevance between work and pay is most prominent. To address the first issue, compared to many other average American jobs, being a CEO requires little or no physical work. It is not strenuous or physical, but it can cause a great deal of stress (Kudo 1988). Some writers say that CEOs are prone to more stress related illness that many other average American jobs (Seymour 2002). According to one study, the average American CEO works 13 hours a day, which includes time spent traveling to meetings (Kudo 1988). The CEOs job is difficult in the sense that their job requires them to complete many complex tasks such as negotiating deals, processing information, and meeting with subordinates and clients (Keiser 2004).

What does it take to perform the job of CEO? 97% of American CEOs hold college degrees; 50% of those holding advance degrees. Of the 50% of American CEO with advance degrees, 68% of those are MBAs. The average American CEO is 53 years old, and worked an average of 13 years before become CEO (Keiser 2004). When comparing the average requirements to be a CEO between American firms and foreign firms as far as experience goes, American CEO seem to be promoted at younger ages than that of their foreign counterparts. Today, over 60% of foreign CEOs had 15 or more years of tenure before being appointed as the CEO of their company. The Average Japanese CEO joined the company at the age of 29, spent 27 years in the company, and was promoted to CEO at the age of 56 (Kato 2005). As far as education credentials go, 95% of Japanese CEOs hold college degrees, close to 30% of those being earned at the University of Tokyo. CEO Job Responsibilities The second question of how much CEOs should be paid is connected to the first. Once the job and responsibilities of the CEO have been determined, the amount of pay that the CEO deserves for those tasks can be fairly dispersed. Or in actuality, is it really fairly dispersed? To pay a CEO accordingly, one much see how deserving he or she actually is. Say a CEO works 4000 hours in a year, should that person make $400,000 or $4 million dollars? If the firm sees a 20% increase in the years profits, the CEO rightfully deserves a 20% pay increase for their contribution to the firms success. But what should the starting salary be in the first place? It is required to match the CEOs responsibilities and jobs to the rate of pay, to come up with a fair base salary.

Comparing the job to the rate of pay can be extremely difficult, it is this difficulty of comparison that leaves the business open for criticism about CEO overpay. Consider the topic of this paper, the complaint that American CEOs are paid more than foreign CEOs. Skeptics could say that American CEOs are not overpaid, but foreign CEOs are underpaid. American CEOs are paid roughly twenty-two times more than Japanese CEOs, and six times more than British CEOs (Conyon 2000). But twenty-two times more is a far jump from being just slightly over paid. Executive officers of foreign corporation make between 4% and 27% of the amount earned by the average American executive. As far as what they deserve for their current responsibilities, American CEOs are paid too much, no matter how stressful their job may be. In response to the proposed question of how much CEOs should be paid, no matter how much they feel that might be, they do not deserve to make 301 times more than their employees. If the average American employee makes $27,000 a year, CEOs do not deserve to make $8 million a year. Who is to say that a CEO is 301 times more deserving than their employees that actually do the work? Examples of CEO Compensation This following chart is a list of the most well compensated American CEOs, and their salary as a percent of their direct compensation.

Name (company)

Salary (mill. $)

George David 1.2 (United Technologies) Ray R. Irani (Occidental) Richard Fairbank (Capital One) 1.3 0.0

Total Direct Compensation 88.3

Salary as % of total direct compensation 1.4%

66.4 56.5 51.4 50.0

2.0% 0.0% 1.9% 2.0%

Richard Kovacevich 1.0 (Wells Fargo) Bruce Karatz (KB Home) Jeffrey Bleustein (Harley-Davidson) Lawrence Ellison (Oracle) William Greehey (Valero Energy) Irwin Jacobs (Qualcomm) 1.0

0.9 0.7 1.4

46.7 45.8 44.8

1.9% 1.5% 3.1%

1.1

44.1

2.5%

Robert Toll 1.3 44.0 3.0% (Toll Brothers) Source: Wall Street Journal, CEO Compensation Survey, April 11, 2005. The CEO pay rate among American public companies is outrageous. They are receiving astronomical amounts of money compared to the average American worker. Meanwhile, the average full-time worker over the age of 25 struggles to get by on a mere $683 a week, an increase of less that one percent over the last year (Chattman 2005).

Compared to the pay rate of an average CEO, the average full-time worker would have to work in the upwards of 385 years to make what a CEO receives in one year. During the 1980s the pay gap between CEO and ordinary factory workers grew from 42 times to almost 85 times (Byrne 1991). In 2004 CEOs in the United States made over 475 times as much as the average worker. Compared to the pay ratio between US CEOs and US average workers, other countries ratios between the two are significantly lower, as indicated in the chart below. Country Japan Germany France Italy Canada South Africa Britain Hong Kong Mexico Venezuela United States Ratio of CEO pay to average worker pay 11:1 12:1 15:1 20:1 20:1 21:1 22:1 41:1 47:1 50:1 475:1

Compared with other countries in the world the gap between CEO pay rates and the minimum wage in the U.S. is obviously the largest. We have allowed more wealth inequity than any other nation. A question that has remain unanswered or unseen is, will the U.S. pay trends among CEOs versus production workers soon be the global trend? CEO Minimum Wage Disparity If the issue of minimum wage disparity is addressed, many startling points can be made in opposition of the huge pay gap between the minimum wage and CEO pay. If the

average pay of workers had risen as fast as the pay of CEOs since 1990, the minimum wage rate would not be $5.15, it would now be $23.03 per hour. As of January 2001, the real value of minimum wage due to inflation is $4.77 per hour. The following chart compares the minimum wages around the world and what percent of gross domestic product it currently accounts for. Country Australia Belgium France Greece Ireland Netherlands New Zealand Spain UK USA Min. Wage ($US) $362/week $1,500/month $9.18 $34/day $8/hour $1,507/month $6.45/hour $592/month $8.53/hour $5.15/hour % of GDP 54% 48% 51% 42% 32% 47% 49% 26% 45% 25%

If the minimum wage was raised to $23.03 as projected by the CEO inefficiencies in pay, the average production worker would now make $110,126 per year, instead of the average $32,594. Dr. Brian Fitzpatrick, professor of finance at Rockhurst University,

stated that CEOs should not receive a raise unless his or her workers receive a raise (Hepp 2005). This would significantly decrease the pay gap between CEOs and the average worker. The full-time worker average is 11% less than 1973s average worker pay of $36,629, adjusting for inflation, even though productivity rose 78% between 1973 and 2004 (Sklar 2005). Plato contended that in a community the earnings of the highest paid person should not exceed those of the lowest paid by more than five times (Walters 1995). It is amazing to see that the pay gap has increased that much over such a short period of time. Do these numbers seem fair to America when total national poverty and debt has increased over that past few years? American vs. Foreign Compensation Shifting attention from just over compensation of American CEOs, we can now further compare them to that of foreign CEOs. There is some difficulty in comparing the United States compensation packages with those of other countries because of the way the packages are compiled. An international comparison of CEO pay---rather than total compensation---necessarily understates the full size of American compensation packages by excluding bonuses and other non-cash forms of compensation (Burton 2005). Compared to the plethora of information on American CEO pay, some foreign firms are not required to disclose information about their companys CEO. This holds true mainly in the Asian based firms. Though they are not required to report salary and bonuses of CEOs, Japanese corporations are required to report total salary and bonuses earned by all directors (Kato 2003).

This table is an international comparison of CEO pay: International Comparison of CEO Pay Country Average CEO Pay

Foreign CEO pay relative to U.S. (U.S.=100) ________________________________________________________________________ 1988 2003 Japan $437,655 $456,937 -4% 20% Belgium $361,591 $697,030 93 31 France $381,015 $735,363 93 33 Sweden $221,138 $700,290 217 31 Netherlands $373,545 $675,062 81 30 New Zealand $449,414 20 Switzerland $481,125 $1,190,567 147 53 Germany $388,486 $954,726 146 42 Spain $331,708 $620,080 87 28 Australia $170,336 $694,638 308 31 Italy $322,743 $841,520 161 37 Canada $398,946 $889,898 123 40 UK $427,335 $830,223 94 37 United States Non-U.S. avg. $759,043 $360,969 $2,249,080 $748,904 196 129 100 33

% change 1988 to 2003

Source: Economic Policy Institute, State of Working America 2004/2005, Ithaca, NY: Cornell University Press. Despite being ranked third in percentage growth of pay, the CEOs in the United States are paid extremely well compared to their equivalents in other industrialized countries. Usually CEO pay in industrialized companies is one-third of U.S. CEOs. So far our hypothesis about CEO over pay among U.S. companies is true compared to other countries. One aspect to consider is that the average work load between American CEOs and other countries work loads; the U.S. work load is perceived to be much greater.

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Another inefficiency between American CEO pay and that of foreign CEOs is the pay based on firm performance. When looking at the average pay of the Japanese directors, one can see that the CEOs cash compensation is sensitive to firm performance. However, the opposite seems to be true when referring to some of the average American CEOs pay. According to Michael Brush, the worst offenders of the insensitivity between the performances of the firm and the CEO compensation include Gary Smith at Ciena, and Scott McNealy at Sun Microsystems. Gary Smiths compensation over the past four years has been $41.2 million, even thought his shareholders have been virtually wiped out, losing 93% over that period. Although Sun Microsystems shareholders lost 76% of their money over the past four years, McNealy raked in $13.1 million a year over that span (Burton 2005). It is this difference between many foreign and American firms that has caused common criticism about the American CEO pay increase in years when firms have performed badly. Many argue that a CEO should get the wages they deserve, that the wage a CEO deserves is determined by his or her contribution to the firm. If the firm performs worse in year two than in year one, one can argue the CEO deserves to make less, and rightfully should make less, in year two than in year one. Company Comparison When comparing Foreign CEO pay rates to that of American CEO pay rates, taking similar companies and comparing their compensation and responsibilities can give outside viewers a more accurate look at the inequities between them. For instance, the Vietnam Online News recently reported that the Viet Nam Shipbuilding Industry Corporation, Vinashin, has announced it would become the first State-owned company in

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the country to hire a foreign chief executive officer. The company currently has three candidates in mind from Poland, Japan, and South Korea. All three are qualified in the field, and have extensive training in the area of shipbuilding. Compensation for the job will include a three year contract for $3,500 a month or $42,000 a year, and a share of the companys profits. Under oversight of the management board, the new CEO will be expected to develop plans on organization and operations of the corporation, as well as ways to reach its business targets (VNS 2005). A similar American comparison to the Vietnam Company, Vinashin, is Tidewater Inc. Tidewater is an American company based in Houston, TX, whose fleet of more than 560 vessels provides services such as transporting crews and supplies to offshore platforms, towing oil rigs, aiding in offshore construction, and anchoring rigs and equipment. Tidewater owns Quality Shipyards, which builds, repairs, and modifies vessels for its parent company and for third parties. The CEO for Tidewater, Dean E. Taylor, makes a $490,000 salary a year and $600,000 in bonuses. In comparing the two ship building companies, it is obvious to see that the American CEO is far more overcompensated for his job than the foreign CEO of Vinashin. The American CEO is bringing in $490,000 a year compared to the measly $42,000 the future CEO of the Vietnam Company will earn. Both perform the similar jobs in that they are in charge of the oversight of the management board and responsible for the organization and operation of the corporation. If the American CEO performs similar functions as the foreign CEO, one would think that they would be similarly

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compensated. CEO Overcompensation Theories Based on facts and statistics it is apparent that American CEOs are rewarded more monetarily than their foreign counterparts. The question now is why this pay gap exists. In our research, we discovered several theories that address the issue, which include marginal revenue product theory, tournament theory, and opportunity theory. Marginal Revenue Product Theory The basis behind marginal revenue product theory stems from the neo-classical economic analysis that well-functioning labor markets have informed, active buyers and sellers. In this analysis the belief is that negotiations between an informed buyer, the board of directors, and an informed seller, the CEO, lead to a competitive price prevailing in the market. The firm hires additional labor until the cost of an additional worker equals the additional revenue that the worker brings to the firm, that workers marginal revenue product (Bok 1993). This theory predicts that in a competitive labor market the firms CEO should be paid his/her marginal revenue product. If an executive contributes more to the firm, then the executive should be more highly compensated. According to Khurana, 10-20% of firm performance can be attributed to economic climate, 30-45% of performance depends on the state of the firms industry. The amount left over, 35-60% of the firm value, can be attributed to management. For example, managers approach in determining policy, acquisition and diversification strategy, cost-cutting policies, and others, will affect firm performance (Betrand 2002). From this we would expect that if top managements

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contribution to firm value is lower in foreign countries than in the United States, then foreign top executives will be paid less that American CEOs. If this holds true, there are several predictions that can be made about executive compensation. Greater Growth Opportunities in the US First, we would expect that firms with more growth opportunities will compensate managers more highly. The United States economy is the leader in the area of intangible, or intellectual property, and this is the main engine of future economic growth (Colecchia 2001). Intangible assets fall into the categories of discovery, organizational structure, and human resources (Lev 2001). In each of the three categories, the U.S. is at or near the top when compared globally. The nation ranks high in Gross Domestic Expenditure on R&D, seems to be the most productive nation in terms of patents, and possesses an advanced venture capital infrastructure, turning invention into business success (Colecchia 2001). Giving support is one of the top educated and trained work forces in the world. If these intangibles are the biggest engine of future economic growth, then it would seem that the United States firms have the greatest opportunities for economic growth. In the marginal revenue product theory, if it is the case that firms with greater growth opportunities should pay their managers more because of creation of wealth, then American CEOs may be entitled to higher pay than foreign CEOs. Greater Role for U.S. CEOs Also, larger firms have greater resources to be used by their managers. The resources of these larger firms are obviously affected by managerial decisions, giving

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managers the ability to create greater value for the firm. In the U.S., where the shareholder base of corporations is widely dispersed, the CEO plays a pivotal leadership role and has tremendous discretion in decision-making. Large firms executives have a greater scale of operations, handling a more complex organization, and these large firms should employ the better-qualified, more talented executives to make these decisions (Rosen 1999). The fundamental difference is that the U.S. CEO is usually the true leader in their company, therefore having the ability to create high marginal revenue product. In many foreign countries, where the norm is concentrated shareholder ownership, the role of the CEO is smaller. In these countries, most large corporations have a control shareholder, or controlling shareholder group (Prahalad 2000). For example, in Japan, the CEO is thought of as more a first among equals who carries out a set of tasks that could be performed capably enough by various others, as the controlling shareholders help make critical decisions about the future of the firm (Meyer 1992). Assuming that the U.S. CEO has more power and decision making ability than its foreign counterparts, and supply of talented managers is relatively fixed in the short run, the demand for good executives that can create a high marginal revenue product will drive industry-wide compensation levels upwards. Under marginal revenue product theory, if firms in the U.S. economy have greater growth opportunity and resources to be used, and the CEO has greater decision making authority, contributing more to the firm, then in theory they should be paid more than foreign CEOs.

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Tournament Theory A second opinion that offers an explanation of international pay gap is the theory that U.S. CEOs are paid more because they are participants in the biggest tournaments. This theory, aptly called tournament theory, of executive pay claims that internal firm labor markets are like single elimination tournaments, meaning that as the winners advance, the prize of moving on to the next round of the competition gets disproportionately larger. The winner of the tournament is the CEO, getting the most power within the firm, and receiving the largest paycheck. According to the theory, the greater the power that the CEO exercises, the more fierce the competition to win becomes. If American firms give their CEOs more power than foreign firms do, then we would expect that obtaining the CEO position at one of these corporations would offer the biggest prizes, or compensation packages. In short, United States executive pay should be greater than in foreign firms if internal tournaments are bigger events at American firms. A basic premise is used that analyzes promotions within an internal labor market to tournaments: the best performers in the workplace are promoted to the next level of jobs. At each level of the organizational job ladder, workers are competing with other workers for a fixed number of spots in elimination tournaments (Wilkins 1999). The winner not only receives the immediate prize of a higher paying job and benefits, but also the chance to compete for a job at the next level. The value of this ability to compete later for higher positions gives additional incentives to the players in the lower rounds of competition (Wilkins 1999).

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As the winners progress up the job ladder, there are fewer higher levels to attain. For each winner, this reduces the value of their option to compete for future jobs. In order to maintain the incentives to compete, an employer must therefore increase the direct financial gains from obtaining a promotion as individuals rise in the hierarchy. In other words, the amount of the increase in pay associated with a promotion must increase as an individual reaches the higher managerial levels (OReilly 1996). This is especially true for the pay gap between the CEO and the level of executives directly below that position, because there are no further competitions for the CEO to win. Internationally, CEOs have less power in the control shareholder dominated companies most prevalent abroad. Less power equates with smaller prizes for winning the tournament. Foreign CEO pay should therefore be lower than in the United States. Equally important, foreign firms control shareholders are likely to want to retain their power within their family. This is especially true in Asian countries. Children and relatives of the controlling shareholder therefore have an excellent chance of being promoted to the top job. As outsiders are not destined to arise from the middle level management ranks, the internal tournaments for jobs at these firms will offer much lower prizes to outsiders. Opportunity Cost Theory Another theory is the opportunity cost theory. It claims that the returns to skilled labor, such as top corporate management, have increased in the United States in recent years. This has occurred as increased access to financial markets has driven down the barriers to entry in many industries, which, accompanied by increased international

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competition, has forced many large vertically integrated firms to break up and allowed the development of many smaller niche firms. The human capital required by these smaller firms is much less firm specific than before, allowing skilled managers to change jobs more easily, or to create their own firms (Rajan 2001). These options have led to a shift in the balance of power within firms, shifting it towards skilled labor and away from capital, in turn increasing the returns to skilled labor. There are implications of this shift in power for executive compensation. Established firms will need to offer their most skilled employees, the ones that have the most alternative options for employment, a larger amount of the firms surplus in order to retain quality employees. The flip side to the fact that American managers have been able to gain more power as compared to capital is that until very recently this phenomenon has not spread to other countries. Continental Europe and the market-oriented economies of Asia have not witnessed the expansion of financial markets with nearly the speed, or measure, that this has happened in the United States. Further, many foreign countries have smaller internal labor markets for managers, more capital intensive industries, and more restrictive legal regulations on executive pay arrangements, all of which will tend to depress executive compensation (Cheffins 2002). The opportunity cost theory believes simply that executive pay in those nations will not reach the levels seen the United States. American CEOs Opportunity Costs are Higher For years, larger, vertically integrated firms controlled most of the United States economy. These firms employed professional salaried managers, and dominated most

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sectors of the economy. They were heavily capital intensive, with oligopolistic positions in their industry, and protected by barriers to entry (Rajan 2001). Managers of these types of firms were unable to break away and start their own businesses because larger amounts of capital were needed to start a competing firm and existing financial markets were underdeveloped. Further, managers skills were highly firm specific, with limited transferability to other industries. These vertically integrated firms continued to grow until the 1970s. Beginning around that time, several factors combined to force their break up. These factors include increased openness in trade and markets, financial innovations, and new technologies (Rajan 2001). The opportunities for American executives expanded tremendously from this. For example, the internet boom in the 1990s created great opportunities for managers to start up new businesses. Almost anyone with a good idea, and a modest amount of managerial experience could start a new business. These changes increased the employment options for managers. Although lasting only a short while, it had a dramatic effect on executive pay levels as the executives greater potential to move from current jobs raises their opportunity cost. If executive pay levels accurately reflect the returns to skilled labor, then the opportunity cost theorys prediction should be that the returns to managerial inputs are lower at foreign companies than at American firms. The question is why foreign CEOs, in the past, have had lower opportunity costs which resulted in receiving lower pay than American CEOs. Two factors that may explain why are foreign executives more limited access to financial capital, and the more limited job options of foreign executives. The

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fact is that now these forces may be changing. International labor markets are growing, and financial capital is becoming more available to foreign executives. If this continues, the opportunity cost theory would lead to a prediction that executive pay levels will converge. Limited Access to Financial Capital For European executives, the fractionalized nature of continental European capital markets and securities regulation has made it more difficult and expensive for executives to raise capital to start new firms. Venture capital funding, a prime source of financing for start-ups in the United States, is much less available in Europe EU market capitalization is only about half that of the U.S., even though the EU economy is about three-quarters the size of American economic output (Hofheinz 2002). This suggests that funding start-ups will be more difficult in Europe, and therefore reduce the potential opportunities for executives to create their own firms. Fewer Job Options One important implication of the opportunity cost theory is that the size of the relevant labor market for executives will have an important impact on their opportunity costs and therefore compensation. In a small labor market, firms should have more power over their executives since those managers will have fewer job options, other things being equal, if they leave an established firm (West 2000). For example, in the past, the continental European countries offered relatively small job markets compared to the U.S. because of the comparatively small size of their national economies. However, with the growth of multinational business, the number of potential jobs available to top

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executives may be expanding. Cross border hiring, which is simply hiring foreign talent, may have an impact on this. The argument is that if senior management departs to the United States from elsewhere, this will cause significant increases in executive pay. This could, in effect, cause foreign firms to fear that their most talented executives will migrate to the U.S. to grab the more generous American compensation packages. In order to keep their best managers in place, these companies would need to reconstruct managerial compensation along American lines to compete. Moreover, if foreign owned companies seek to hire an American CEO, they will need to offer that person a compensation package comparable to those American companies provide. Therefore, in theory, the emergence of a global market for executive talent may foster changes in managerial compensation. Conclusion Americas corporate executives get paid huge sums of money for the work that they do, whether in salary, bonuses, or options. From research findings of statistics and the opinions of others it seems apparent that American chief executive officers are paid more in relation to the rest of the world. The exact reason for this difference in compensation between the U.S. and foreign CEOs can not be totally explained. Examining the marginal revenue product theory, tournament theory, and opportunity cost theory only scratch the surface of the underlying causes. The fact that American CEOs have been overcompensated for their work does receive a great deal of attention in management and economics journals and in the popular press. This argument is probably only just beginning with the growth of

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multinational businesses exploding over recent years, and the gap only seems to continue to get bigger.

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