When more is never enough

Executive compensation is soaring to unheard-of heights. What on earth do they want it for?

"Tis the season to be jolly..." Yet some have more reason for being jolly than others. Take E. Stanley O’Neal, who recently brought home more than US$161.5 million after leaving the financial management firm Merrill Lynch. Or his successor as chief executive, John A. Thain, who’s expected to rake in around $120 million for the next couple of years, if everything goes by the playbook. It’s easy to continue the rant, but the challenge lies in determining whether there is a basis for it or not. Nowadays, are corporate executives overpaid, underpaid or, as the fairytale goes, are they paid “just right”?

That is a question, I’m afraid, this article won’t be able to answer for any concrete case. To do so, we’ll have to be second-guessing the judgment of corporate boards and their pay committees, duly advised by consultants, not to mention the views of hundreds of thousands of shareholders or even that of the market at large. But what we could do is to provide some ethical perspective, however modest, that could help shed light on the issue.

The first thing to consider is what exactly are executives paid for and how. The standard response consists in saying that they are paid for their performance in delivering investor returns, which usually translates into an increase in share price. Consequently, an ever greater proportion of executive compensation comes in the form of stock options. On that count, O’Neal’s package would indeed be hard to justify, given his legacy of a $2.2 billion loss and an additional $8.4 billion mortgage-caused write-down at Merrill Lynch in the third quarter of this year. Unfortunately, such an anomaly happens to be more of the rule than the exception, with the practice of “golden parachutes” —the farewell equivalent of the “golden handcuffs”, as those offered Thain at his welcome— becoming firmly entrenched. No prize for discovering who foots the bill for all this corporate largesse.

Perhaps we should be trying to rid ourselves of our obsession with share price as the sole indicator of corporate, and transitively, of executive performance. After all, an increase in share price per se does not necessarily mean that a company is doing well. It could be triggered simply by the announcement of some massive layoff. And this certainly is odd, were we to believe what we are often told: that a company’s most important asset is its people. In that case, the price spike would be something like a dead-cat bounce. Neither does a rise in share price automatically further the interests of all shareholder groups: some may prefer dividends or greater investments in new products, businesses or markets. All of these may momentarily depress profits or market value.

As we have already seen, the use of stock options as the predominant form of executive compensation does not guarantee an alignment of their interests with those of shareowners, employees and other stakeholders, much less with those of the company as a whole. They tend to exaggerate the executive’s role in value-creation, bucking the trend in managerial theory according to which corporate success is, above all, the result of a team effort. Moreover, they tend to encourage short-termism among executives, eager to cash in at the company’s own expense. This seems to be the only foolproof effect of stock options-based incentives.

Another point to bear in mind is the social relevance of executive pay, in the sense that it is never really just a matter of private agreement. The fact that individuals sign a contract stating the terms and conditions in which one renders services to the other is not enough to make the contract just. The pay should also be sufficient to cover the worker’s needs, as well as those of his dependents, in what has usually been called a “living wage”. Furthermore, justice requires a certain degree of equity or proportionality between one’s contribution to the corporate product and his compensation. This is always relative to the contribution and compensation of the others in the company. In this respect, the fact that a typical Fortune 500 CEO now earns 364 times the earnings of an average employee may very well be unconscionable.

A frequently overlooked matter in evaluating executive compensation is its impact on what people, in the end, are after: happiness or a flourishing life, something which, apparently, could never be achieved as an isolated individual, apart from others. Work provides us with income, but will an increase in income buy us greater happiness? After all, as human beings that is what we ultimately seek.

A host of recent studies* uncover the fallacy behind the widespread notion that income and happiness go together, inasmuch as higher income expands an individual’s opportunity set, that is, the goods and services he can consume. Defenders of this position argue that as soon as an individual is no longer interested in the commodities, he could then always dispose of the surplus, since an expanded opportunity set does not entail an obligation to consume anyway. However, empirical economic research enriched with inputs from psychology reveals that the case is not as straighforward as it seems.

At low levels of development, income indeed provides subjective well-being. But beyond a certain threshold —an average income of US$10,000 per head— income ceases to have any significant effect on country-wide levels of happiness. Therefore, happiness is not merely a matter of having disposable income and knowing where to shop. Neither is subjective well-being primarily an issue of rising incomes over fairly short periods of time. In many industrialized countries, although income per head has risen sharply in recent decades, the proportion of people who consider themselves “very happy” has nevertheless fallen steeply. That is mainly because people’s aspiration levels surge even more than their incomes, coupled with the experience that they quickly get accustomed to advancements in comfort levels. For instance, at first, getting a TV set, albeit in black and white, was the big thing. But then came colored TVs, VCRs, cable TV, satellite TV, HDTV and so forth. The extra pleasure that additional material goods initially provided rapidly vanishes as soon as the process of hedonic adaptation kicked in. Our achievements always fall short of our aspirations and expectations.

Even when comparing people who live in the same affluent society such as Switzerland, for example, one finds that those with higher incomes are not happier than those with lower incomes. This seems to be due to the fact that people cannot help but compare themselves to others, so much so that it is not the absolute level of income that matters, but one’s position relative to a reference group. Simply raising everyone else’s income would not do the trick. Rather, it lies in choosing the right reference group with which to compare oneself. The lower the income of the group chosen, the happier one is, apparently. And there would be no greater cause for disappointment —at least for the ultracompetitive— than when your spouse or another household member or a close relative (your sister’s husband, for example)— earns a lot more than you. Leave it to the green-eyed devil to let all that extra money go to waste.

In the end, perhaps it’s not so much a matter of getting the Goldilocks income as knowing what to do with it. Happiness cannot be reached by just earning and spending. That’s why it’s priceless. What people are really after are non-material goods. It should come as no surprise that they get disappointed when material things fail. I wonder if O’Neal and Thain have ever given this any thought.

Dr Alejo Sison holds the Rafael Escolá Chair of Professional Ethics at the University of Navarra in Spain.

 * Richard A. Easterlin, “Happiness in Economics”, Cheltenham,UK/ Northampton, MA, USA: Edward Elgar, 2002; Bruno S. Frey and Alois Stutzer, “Happiness and Economics”, Princeton, NJ: Princeton University Press, 2002; Richard Layard, “Happiness. Lessons from a New Science”, London: Penguin/ Allen Lane, 2005; Anthony Kenny and Charles Kenny, “Life, Liberty and the Pursuit of Utility. Happiness in Political and Economic Thought”, Exeter: Imprint Academic, 2007 among others.