The average annual compensation for a CEO of a public company in the United States was $9.6 million in 2012, according to a study by the Associated Press. The average U.S. worker, in contrast, made a little more than $44,000 in 2012. So, what accounts for this huge difference in pay?
Two recent studies shed some light on why CEOs in the United States are so highly paid and suggest that, despite what some people may think, top-tier executives actually deserve their hefty paychecks.
The studies, conducted by Anup Srivastava and Clare Wang, both assistant professors of accounting information and management at the Kellogg School of Management at Northwestern University, found that a recent rise in executive pay coincides with new trends in how CEO compensation is calculated. Both researchers recently discussed these trends, and the stark contrast between CEO and employee pay, in a podcast for Kellogg's digital magazine.
In the podcast, Srivastava said the ratio of a CEO's total compensation to an average worker's salary has increased dramatically over the past several decades.
"In an American context, the average ratio of a CEO's total compensation to an average worker's salary has increased from approximately 20 to 30 times to approximately 300 to 400 times over the last few decades," Srivastava said. "It seems exorbitant when we compare it to similar economies — for example, in European countries."
The switch to stock options
The reason for such a contrast in pay, Srivastava said, has to do with a shift in how companies compensate their CEOs. In recent years, the composition of CEO compensation has changed from salary and bonus-based to predominately stock-options-based. [How is CEO Compensation Determined? It's Complicated]
Unlike regular stockholders, Srivastava said, CEOs can't sell their stock options on the market; they're stuck with the stock they have. That means that if a company's stock price goes down, so does the value of a CEO's stock options.
"Stock options are turbo-charged," Srivastava said. "By that, I mean that if there is a 10 percent fluctuation in stock prices, it can lead to 80 percent changes in the value of stock options."
By tying CEO compensation to stock options, companies have made it possible for CEOs to earn huge amounts of money, but they've also, presumably, made these executives work harder for every dollar they take home, Srivastava said.
"CEOs can forecast future risks that are not known to the market," Srivastava said."I call this an extraordinary ability. And I find that the turbo-charged portion of CEOs' compensation is highly linked to that ability."
The $1 salary trend
In addition to the switch to stock-option-based compensation, there's another trend in CEO pay that complicates the issue: the $1 salary, Wang said.
The $1 CEO salary was popularized recently by former Apple CEO Steve Jobs. For many years, Jobs earned an annual salary of $1. In lieu of a regular paycheck, Jobs was compensated in stock options and restricted stock, which helped make him a multibillionaire.
Wang said it seems like many CEOs emulated this compensation model.
"The CEOs of anywhere from 15 to about 30 publicly traded firms in the S&P 500 in any given year are taking a dollar salary," Wang said. "Once it is known that a few higher-profile CEOs have a dollar salary, other CEOs and boards of directors consider it."
Why take a $1 salary? There are two main reasons, Wang explained. First, in some situations, the CEO may benefit handsomely because the value of the corporation's stock is on the rise. Second, if a company has been performing poorly, or if the economy is facing an economic downturn, some CEOs see a $1 salary as the best compensation option.
"The CEOs and companies in this category are more likely to lay off workers, and are really under pressure to show some empathy — or to share some of the sacrifice — with employees," Wang said.
"The irony that came out of our research is that alignment CEOs are sometimes described as engaging in a gimmick, while the downturn CEOs who took a dollar salary are sometimes lauded," Wang said. "But the CEO of a successful firm who takes a dollar salary, along with stock and options, maintains the success of the firm, benefiting both the CEO and shareholders in the long run. And when you take a dollar salary as a symbol of sacrifice, it's a good public relations move, but it does not change the economic fundamentals of the struggling firm."
Originally published on Business News Daily.