Executive pay's faulty market.(Observations)

We probably all know examples of executives earning several millions of euros in salary, bonuses, and options. Almost every day the media reports on what seem like excessively generous pay packages. It is also likely that you entertain an opinion about executive pay, especially if you've compared their pay with your own.

Policy-makers certainly have an opinion. Responding to public furore over executive pay, many nations have introduced new legislation, for example regulating executive pay disclosure, and bringing corporate governance codes into line with best practice. These efforts have not been very successful, however. The debates continue; if anything, in fact, they appear to have intensified over the past few years.

Amid all this turmoil, boards of directors clearly have problems explaining and justifying pay arrangements to investors and others. Why, despite all the recent legislation, are the debates over pay no closer to being settled?

Many theories are put forward to explain executive pay practices. But the dominant argument is that executive pay levels are set by "simple" economics. It is often assumed that market forces set pay packages, compensating executives for the risks they take to provide their services. Since highly qualified executives are scarce, and thus valuable, pay levels at the top are disproportionably higher than for less qualified executives and lower level employees. In addition, to provide executives with the necessary incentives to take on the additional risks to make firm value-increasing decisions, the thinking goes, executives receive different kinds of variable pay schemes in the form of, say, bonuses, shares and option grants. Put simply, executives are paid by performance.

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There are, however, some fundamental problems with such explanations. Literally thousands of empirical studies have investigated whether there is a robust link between corporate financial performance and executive pay. Most of these studies show that it is relatively weak at best. The theoretical argument that incentives boost firm performance hasn't found much support in empirical studies.

Another issue is that pay practices differ greatly across firms. Even when comparing similar executives, who are employed by comparable firms, executive pay differs greatly. Not only do these differences remain over time, they also exist when taking an international point of view. The level and structure of executive pay varies greatly across national contexts. If the "market forces" explanation was really to hold up, comparable executives working for comparable firms should over time receive comparable pay. That is not borne out by the evidence.