Q&A Friday #95: CEO Pay & Golden Parachutes.

10 Oct, 2008 by John Hawkins

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Question: “I have heard attacks against CEO’s getting “golden parachutes” lately, because the economic downturn and the fact that we are paying for some of these in the numerous bailouts. This policy of awarding money upon firing is becoming standard practice, but can’t be good for the future of our corporations. Although I realize that having government interfere in the private sector is generally bad, would it be a good idea to classify this as an illegal business practice for the good of the country. I just don’t see how rewarding CEO’s with millions for doing a bad job is a good thing. What is your opinion on the disparity of pay of CEO’s vs. your average worker, and should something be done about these golden parachutes?” — onethingmine

Answer: First off, let’s talk about CEO pay. Here’s Walter Williams from way back in 2005 on the subject,

Is a CEO worth millions of dollars to a corporation? When Jack Welch became General Electric’s CEO in 1981, the stock market judged the company to be worth about $14 billion. Through hiring and firing, buying and selling, Welch turned the company around before he retired in 2001. Today, GE is worth nearly $500 billion, making it one of the most valuable companies in the world. What’s a CEO worth for providing the brains and leadership to turn a $14 billion corporation into one worth $500 billion?

How about paying just a measly one-half of a percent of the increase in value? If that were the case, Welch’s total compensation would have come to nearly $2.5 billion, instead of the few hundred million that he actually received.

The Gillette Co. was in the early stages of corporate death in

2001 when Jim Kilts took over as CEO. The company’s stock had lost almost half of its value in two years, and sales volume and market shares of its major brands had plummeted. Between the time Kilts took over at Gillette and this year’s Jan. 28 announcement of Procter & Gamble’s purchase of Gillette, Gillette’s market value increased by $11.3 billion, a 34 percent improvement, and since the announcement, Gillette’s value has risen by another $5.7 billion.

Kilts’ salary and bonuses over the past four years, totaling about $17.5 million, haven’t been especially large by CEO standards.

Predictably, however, Kilts’ pay and particularly the size of his compensation package from the merger — $153 million — have been the subject of media carping, particularly in Boston, where Gillette is headquartered. This figure is indeed large, but it, added to what Gillette has paid him since 2001, makes Kilts’ total compensation a mere 1.5 percent of his contribution to Gillette’s value.

Here are a couple of questions to you: If you were the owner of GE, and a CEO could turn your $14 billion corporation into a $500 billion one, how much would you be willing to pay that man in salary and bonuses?

Or, in the case of Jim Kilts, turning Gillette from a corporation in steep decline into one Procter & Gamble was willing to buy for $57 billion, how much would you be willing to pay?

Percentage wise, these CEO’s make a very tiny sliver of a company’s revenues and yet, they have an enormous impact of the bottom line. Since that’s the case, companies are willing to pay top dollar to get the very best person they can for the job.

In other words, I think because people’s eyes get so big looking at how much CEO’s make, they tend to forget the size of the companies these people are managing and how much of an impact they have with their decisions.

As to CEO’s who do a bad job, that’s just the reality with every job: a small percentage of people are great at it, most people are average, and a small percentage do terrible work. Whether you’re talking about a CEO, a hot dog vendor, or the teacher at your local school, that’s the case. However, with CEOs, even the bad ones tend to make great money. That’s just the free market at work. Some professions are worth more than others and if people think they’re overpaid — well, the water’s also warm and anyone who thinks CEO’s are overpaid can start on the long, hard road to becoming a CEO any time they please.

Now, on to golden parachutes.

First off, severance pay is hardly unusual. That happens across a number of occupations and so it’s not unusual that a CEO might get some sort of compensation if he leaves his job — and obviously, a CEO is going to get a much larger severance package than a regular employee would.

Additionally, a golden parachute provides some job security. It helps insure that a CEO isn’t going to be fired for any little thing. That helps make taking a position at a company more attractive.

On the other hand, perversely, it may also ultimately make it easier to get rid of powerful CEO’s who may be tempted to cause problems for the company. Getting rid of a CEO who knows everything about your business, all your customers, and every iota of your business carries a certain risk factor that, say, firing a middle level manager doesn’t. It’s better for a CEO to have an incentive to leave happy and not start any sort of power struggle or create problems on the way out the door.

It’s also worth noting that there is no law that says a golden parachute has to be paid out. Any company, any time they hire a CEO, can choose not to include a golden parachute.

Personally, whether you’re talking about CEO’s, company owners, high powered lawyers like John Edwards, authors, movie stars, or professional athletes, I don’t worry too much about what they’re getting paid. In the long run, it would be considerably more dangerous to our freedom and the economy to have the government regulating salaries than it would be to have these people making a lot of money.