Mike Jensen on CEO pay

Abstract

When I joined the University of Rochester's Graduate School of Management (now the Simon School) as a newly minted assistant professor in January 1984, my thesis advisors from the Chicago Economics Department warned me to be wary of Michael Jensen, the most prominent and influential faculty member at the school. Their well-intended warnings proved unnecessary: in short order, Mike became my mentor, co-author, colleague, and life-long (if not always uncomplicated) friend.

By the early 1980s, Mike and Bill Meckling's 1976 paper “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” was already generally recognized as establishing the leading paradigm for empirical corporate finance. Largely missing from the Jensen-Meckling treatise, however, was the role that executive incentive contracts play, or could play, in limiting the cost of agency conflicts between managers and shareholders. Mike became highly intrigued by executive compensation and, along with colleague Jerry Zimmerman (co-founding editor of the Journal of Accounting and Economics), organized the “Conference on Management Compensation and the Managerial Labor Market” in April 1984, whose proceedings were published as a special issue of the JAE in 1985. The conference—and the Jensen-Meckling paradigm—helped launch executive compensation as a legitimate topic of academic research in accounting, finance, and economics.

My personal contribution to the April 1984 conference was using time-series data with executive fixed effects to uncover a statistically positive pay-performance elasticity—which I measured as the percentage change in compensation associated with a percentage change in the value of the firm. While acknowledging the statistical significance, Mike kept pushing on the question of the economic significance of my finding: was the estimated elasticity really large enough to provide meaningful incentives? We developed a construct we called the pay-performance sensitivity that measured the “effective ownership share” akin to the manager's ownership share in Jensen-Meckling, but included all the sources of incentives we could find useful data about (including stock and option holdings, bonuses, and year-to-year salary adjustments, as well as the probability of performance-related terminations). In our 1990 Journal of Political Economy article, we concluded that the wealth of a typical CEO changes by only $3.25 for every $1000 change in shareholder wealth, hardly enough to get CEOs to take projects that increase shareholder wealth and avoid projects that decrease shareholder wealth.1

Mike and I considered as many explanations as we could find or think of for what we believed were unexpectedly low observed pay-performance sensitivities, including risk aversion, limits to credible contracting, imperfect performance measurement, and CEO production functions. We concluded that the most plausible explanation reflected the role of third parties in the contracting process, notably Congress, labor unions, and media pundits who influence pay (by, say, truncating the upper tail of the earnings distribution for CEOs) but have no real ownership stake in the company. Indeed, the role of “uninvited guests to the bargaining table” has been a primary theme of our work on executive compensation since a New York Times op-ed article we wrote together in 1984, a few months after I joined Rochester, and continuing through Mike's last published journal article in 2018.2

The low pay-performance sensitivity was not our only compensation-related observation where it was difficult to reconcile theory and evidence. Our 1998 study with George Baker identified and analyzed several (to us) puzzling compensation practices we found in for-profit as well as non-profit organizations—practices that included the following: the absence of meaningful incentive systems throughout the organization (not just in the executive suite); problems with promotion-based incentive systems (including tenure and up-or-out promotion systems); the absence of relative-performance measures; profit-sharing plans for low-level workers; subjective performance measurement; and biased or inaccurate performance evaluations.3 While we tackled some of these puzzles in our future research, we left the rest to others (and, with nearly 3400 Google cites and climbing, there have been quite a few others).

Throughout most of his career, Mike prided himself on taking a “positive” rather than a “normative” approach to research (those that try to explain the world rather than to fix it). Mike and Bill, for example, considered the emerging (and highly mathematical) optimal contracting literature as normative: structuring the principal-agent relationship to provide incentives to maximize the value of the firm. In contrast, Mike and Bill viewed their own work as positive: understanding and explaining existing practices as the equilibrium outcome of a nexus of contracts primarily between managers, shareholders, and debtholders, but also (in Mike's later work) including employees, customers, suppliers, and other stakeholders (including those “uninvited guests to the bargaining table” discussed earlier).

From time to time, though, Mike would happily make forays into the normative world, such as our Harvard Business Review article “CEO Incentives: It's Not How Much You Pay, But How,” which many have identified as launching the explosion in executive stock-option grants in the 1990s.4 Our own view is more nuanced, since we maintain that the option explosion largely reflected the unintended consequences of Congressional acts designed to reduce levels of CEO pay.5

In late 2003, Mike and I were commissioned by the Compensation Committee of a major international corporation to write a high-level “think piece” on executive compensation, addressing such issues as the appropriate objective function, history and trends in CEO pay, and strengths and weaknesses of current practices. More broadly, the Committee asked us to consider whether there was scope for a new intellectual framework for compensation in the current economic, political, and governance climate. We asked our friend and colleague Eric Wruck to assist us in this project. We presented our report to the Committee in January 2004, and later (with their permission) submitted the report as an ECGI working paper.6

The project made us focus on how much had changed in aspects related to CEO pay from 1990 to the early 2000s. First, the use of stock options exploded in the 1990s, tripling the inflation-adjusted level of CEO pay in the S&P 500 in less than a decade. While Mike and I had indeed advocated for an increased reliance on stock options and other forms of equity-based pay, our naïve expectation was that such increases would be accomplished through reductions in other forms of pay (such as salaries and accounting-based bonuses). What actually happened was that companies added increasingly generous grants of stock options on top of already competitive pay packages, without any reduction in other forms of pay and showing little concern about the resulting inflation in pay levels.7

Second, we had long known that public companies, on average, experienced consistent excess returns following public earnings announcements. In particular, studies (starting with Doug Skinner's and Richard Sloan's in 20028) have shown that stock prices react strongly and positively to small positive earnings surprises, but there is not much additional stock-price reaction to larger surprises. Similarly, stock prices react strongly and negatively to small negative earnings surprises, but there is not much additional stock-price decline following larger surprises.

The standard interpretation of such findings is that executives holding stock or options have strong incentives to beat analyst expectations by a little, but not by a lot. And although executives have strong incentives to avoid missing analyst expectations, if they are going to miss them, they might as well miss them by a lot (since the stock-price penalty for missing by a lot is not much worse than missing by just a little). Also worth noting here is that the incentives motivating such behavior are suspiciously similar to those held out by typical accounting-based bonus plans, in which no bonuses are paid before some performance threshold is met, and then bonuses are capped at a higher performance threshold. But, while Compensation Committees can tweak bonus plans to mitigate bad incentives, Committees have no control over the incentives provided by the market's reaction to earnings announcements.

Third, by the early 2000s it became apparent that the shares of many companies (especially new-economy firms) were grossly overvalued, and in some cases propped up by questionable or fraudulent accounting, legal, brokerage, investment banking and other financial practices. Share prices plummeted, and a strikingly large number of US companies—including Enron, WorldCom, Qwest, Global Crossing, HealthSouth, Cendant, Rite-Aid, Lucent, Xerox, Tyco International, Adelphia, Fannie Mae, Freddie Mac, and Arthur Andersen—became embroiled in accounting scandals. Without asserting causality, a common feature of most of the scandal-ridden firms was an extraordinary reliance on stock options in executive compensation packages. Overvaluation is a challenge for Compensation Committees: it is difficult to provide incentives for executives to hasten price corrections in their own company's stock, especially when much of their existing wealth is held in equity or stock options.

These observations (and others) led Mike and me to reassess many of our underlying assumptions about CEO pay. (My personal reassessment was informed by spending a year on leave at a major compensation consulting firm, learning first-hand how the sausage is produced.) For example, we implicitly assumed that executives and directors fully understood the opportunity cost of stock options and would grant them only if the potential benefits (including effort and retention) outweighed the cost. We came to what we thought were two important recognitions about employee stock options: (1) that risk-averse and undiversified executives will rationally value unvested stock options well below their opportunity cost, and (2) that directors too often presume that the cost of granting options was near zero since they could be granted without an accounting charge and without a cash outlay. As a result, we came to the conclusion that too many options were granted to too many people.9

Similarly, our 1990 work advocating the increased use of equity-based pay was implicitly based on the efficient market hypothesis, a fundamental component of Mike's work since his dissertation. In the extreme, when markets are strong-form efficient, shareholder return (or perhaps shareholder return relative to peers) is a compelling performance measure for CEOs, since stock returns capture the long-run present value of actions and decisions CEOs take and make today. And for most applications, the distinction between semi-strong efficiency (where the stock price incorporates all publicly available information) and strong-form efficiency (where the stock price incorporates all knowable information, including information held by insiders) is not particularly important, since even inside information comes out eventually (and is likely, in any case, to be incorporated into stock prices long before showing up in accounting earnings).

But as Mike and I thought more about this, distinguishing between semi-strong and strong-form efficiency could become much more important in the context of executive pay, since the information making market pricing less reliable than strong-form is precisely the information held by insiders who are compensated based on the stock price. Top executives, for example, generally have better information than shareholders (or directors) on whether the company beat earnings expectations through remarkable performance, or through earnings management.10

Mike and I used our commissioned 2004 report as the basis for an invited (and accepted) book proposal from the Harvard Business School Press, which we eventually decided to title, CEO Pay and What to Do about It: Restoring Integrity to Both Executive Compensation and Capital-Market Relations. The manuscript was “mostly written” by 2011, with 10 (out of 14) completed (or “mostly competed”) chapters and 300 pages of text. While many of the chapters have been published as standalone papers,11 the biggest regret in my professional career is not bringing this book to publication. I have three (collectively non-compelling) excuses.

The first was the untimely death from cancer of our third co-author, Eric Wruck, in 2011. Eric was a wonderful, intelligent, and good-natured soul with a heart of gold. His passing took the wind out of our sails.

The second was Mike's contemporaneous research agenda with Werner Erhard, starting with a focus on leadership (including short courses taught at several Universities) and evolving into a positive theory of integrity. The “excuse” is not about the allocation of Mike's time: Mike was the ultimate multi-tasker and was passionate about both projects. The larger issue was Mike's intuition and insistence that “integrity” (as he and Erhard usefully distinguished from morality and ethics) should be featured prominently in every chapter we had written on executive compensation (including several we thought were completed). The problem was not with Mike's definition of integrity as a factor of production—value would clearly be increased if managers had incentives to announce that their overvalued company's stock price was too high, or that they couldn't meet analysts’ forecasts without cheating—but we struggled to find a solution that could be implemented through the compensation system.

Third, the journey was always more fun than reaching the finishing line. Mike and I would schedule multiple talks each week and would spend a week together (either at my home in California or his homes in Vermont and Florida) every couple of months. Our discussions were consistently rigorous and intellectually challenging and working with and learning from Mike has been the highlight of my professional career.