Executive Compensation

In the aftermath of huge corporate scandals at Enron, Global Crossing, WorldCom, Adelphia, and others, there is new pressure for corporate accountability and calls for review of executive compensation. Many are concerned about how a CEO can make tens of millions of dollars per year and yet also take a company into bankruptcy. Larry Ellison of Oracle Corporation took home $706 million in 2001 when he exercised stock options as Oracle's stock price began to fall. It appears to the average stockholder that CEO pay is not based on company performance but rises continuously at a rate greater than inflation. In 2001, CEOs experienced their first double-digit decline in pay in seven years (16%). Even in these past three years of economic downturn, many CEOs experienced substantial increases in total compensation. These events have led Business Week to call for a change in how executive pay is calculated. To understand this situation better, let's explore three theories of executive compensation.

The first theory is social comparison, which basically argues that executive compensation should be set in relationship to other salaries. In this approach to executive compensation, arriving at a relevant comparison group is a major challenge. Some argue that the appropriate peer group is other CEOs of similar organizations. These comparisons are market driven, and in the case of hospitals comparisons to CEO salaries in other hospitals would control for size and location of the hospital. Another approach is to compare the CEO salary with that of the lowest-paid employee. Ben and Jerry's Ice Cream became the most famous example of this methodology by setting the CEO salary at seven times the salary of the lowest-paid employee. This comparison demonstrates how the CEO salary has risen much faster than ordinary wages. In 1980 the average CEO was paid a salary that was 42 times the wages of ordinary workers. By 1990 that factor more than doubled, rising to 85 (Milkovich & Newman, 1996). However, because employee salaries vary widely among industries, it is not advisable to establish a uniform rate for all CEOs. Review of this type of data is relevant for compensation committees that set the salaries of CEOs. Organizations that have a pay structure where the CEO makes 85 to 100 times that of the lowest-paid employee run the risk of disgruntled, unproductive employees. Within the health care field, the social comparison theory has added the dimension of comparing salaries to potential services rendered. In California, the State Nurses Association has called on Tenent Healthcare to reallocate profits and executive wealth to help resolve the public health care crises in Los Angeles.

A second theoretical perspective on executive salary is economic. Here the basic question is, How well is the company performing? The idea is to tie CEO compensation to [Page 198]corporate success. This is easier said than done: Even in the for-profit sector of health care, the economic model does not appear to be a major factor in an economic downturn. In 1999, the compensation of CEOs of 17 publicly traded HMOs rose by 14% while the company's stock declined by an average of 15%. Traditionally, corporate success has been measured by stock market prices, but this perspective emphasizes short-term gains. Although defining a well-run (successful) organization is increasingly complicated, it is not impossible. Including indicators of customer satisfaction and loyalty, employee retention rates, and market share into a CEO's performance scorecard would help develop a more balanced assessment of the organization. The pay then would depend on whether or not the organization met pre-established goals. One problem in this methodology is that the CEO may be able to manipulate the data to demonstrate success in the short run, at the expense of long-term success. This model of executive pay has been used most frequently in establishing the bonus portion of executive compensation.

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