Sunday, April 11, 2004

Every year about this time, the nation’s leading newspapers and business magazines begin competing to see who can appear most outraged about how much the top corporate chief executive officers (CEOs) were paid during the previous year. Thus on June 25, 2001, Fortune featured “The Great Pay Heist,” complaining about the “highway robbery” of the year before. We are sure to be deluged by similar stories in the next few weeks. This is an annual sport.

These annual reports on CEO pay need to be read more carefully than they are written. It helps to begin with a few tips for the unwary learned from previous years:

Lesson One: Nearly every major newspaper and business magazine has its own uniquely dubious way of handling the way stock options are valued as executive pay.

On March 25, 2002, Gary Strauss of USA Today reported top executives “rarely felt shareholders’ financial pain last year.” On April 15, by contrast, Business Week reported CEO pay fell by “nearly 31 percent, to… a level not seen since 1997.”

These two completely contradictory conclusions illustrate just two contradictory ways of measuring CEO pay. There are more. Business Week included the value of older options that had been cashed-in (exercised) that year. Fortune instead chose to crudely estimate the value of new options at one-third their face value. Not to be outdone, USA Today added both. They counted both the cost of options exercised in 2001 and the estimated value of options granted in 2001. That meant an executive’s pay in 2001 could include compensation for work done in any or all years between 1991 and 2005.

Lesson Two: Although estimates of the “fair value” of new stock options are commonly lumped together with cash salaries and bonuses, such estimates tell us next to nothing about how much cash executives will receive. To estimate the value of options when granted, Fortune has simply assumed the options were worth a third of their face value. Even with sophisticated estimates, however, risky options cannot sensibly be treated as if they were no different from an equivalent salary or bonus. An article in The Washington Post fussed over AOL stock options granted to Steve Case in 2001, said to be worth $76 million. But that estimate depended on AOL stock being worth $49 to $73 a share by now. The estimate (the same sort that FASB wants firms to “expense”) was pure smoke.

Lesson Three: Selling off assets is no different than selling a home — it does not make an executive wealthier, and it should not be counted as income.

Writing about “highflying executive pay” at Southwest Airlines, The Washington Post’s Keith Alexander wrote on April 12, 2003, that the CEO’s pay “excludes the $344,000 he gained from the sale of more than 31,000 shares of Southwest stock.” There is a reason for excluding stock sales from pay. It isn’t pay. Another report described another executive’s loan repaid with interest as “stealth pay.” Loans aren’t pay, either.

Stock options are contingent pay, but the year of the payoff (if any) is not the only year in which they are earned. Consider what happened in 2001 to Larry Ellison, CEO and founder of Oracle. The 2002, Business Week account said Mr. Ellison “earned a special place in the history of U.S. compensation last year with the $706 million he pocketed from exercising long-held options.” But “long-held options” cannot really be considered compensation for a single year, nor could their exercise be considered an increase in Mr. Ellison’s wealth. In fact, the value of Mr. Ellison’s options fell $2 billion in 2001.

Lesson Four: “Pay for performance” does not mean tying future pay to last year’s stock performance.

Because USA Today defined CEO pay to include both past and future rewards from stock options, little wonder they could find no link between that measure and what happened to stocks that year. But the whole idea there should be such a link is false.

If shareholders wanted CEOs to be paid on the basis of what happened to their stock last year, CEOs could be paid entirely with a January bonus. But that would offer executives zero incentive to do better in the future. Grants of options, and to a lesser degree restricted stock, are contingent on future stock performance and employee retention. Such forward-looking incentives should never be linked to past moves in share prices. Yet business journalists continued to make this fundamental mistake, year after year.

In any event, CEO pay actually fell quite dramatically as stock prices did, even though some pretended not to notice. On October 20, 2002, Paul Krugman wrote in the New York Times Magazine that (estimated) CEO salaries from Fortune’s top 100 had risen from a dismal low during the recession of 1975 to $37.5 million in 1999. Yet Fortune’s 1999 figures, with their rosy estimates of the future value of new stock options, were inexcusably antique by October 2002.

The New York Times on April 6, 2002, had reported a 20 percent decline in CEO pay for 2001 alone. Doesn’t Mr. Krugman read that paper? By October 2002, when Mr. Krugman’s article appeared, it should have been painfully obvious the paper wealth of CEO’s in 1999 had been hugely reduced by the market’s horrific decline.

For 2002, Fortune’s estimate of average top 1,000 CEO salaries and benefits was $15.7 million — down 58 percent from the obsolete $37.5 million estimate Mr. Krugman treated as a current fact — a drop of nearly 20 percent per year for three years, including Fortune’s estimate of a 23 percent drop in 2002 alone. The magnitude and duration of that decline needs to be kept in mind today, as similar stories for 2003 begin to emerge, some possibly as deceitful as Mr. Krugman’s was in October 2002.

Journalists who heretofore preached that CEO pay (including future incentive pay) should have fallen because stock prices fell ought now to find themselves trapped by their own reasoning. If they stick to past logic, they will have to write that most increases in CEO pay are fully justified by the spectacular rise in stock prices. But saying that, of course, would get them fired. So they will have to change the subject, perhaps by copying the New York Times’ comical new ploy of suggesting CEO pay should never rise if employment falls.

It will be amusing to watch how those who specialize in griping about CEO pay every year now manage to bravely revise their stories to say CEO pay should fall whether stocks rise or not. If this year’s festival of journalistic indignation about CEO pay turns out to be even half as deceptive as previous years, I might even hand out (with appropriate ceremony) the coveted Krugman Award for Economic Trickery.

Correction: Last week’s column incorrectly referred to the Strategic Petroleum Reserve in billions of barrels rather than millions (specifically, 652 million on April 7). This does not affect my analysis or conclusion.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.

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