Excessive CEO Pay? Common Shareholders May Be to Blame
Antón, Miguel; Ederer, Florian; Giné, Mireia; Schmalz, Martin C.
Publisher: Ross School of Business
Original document: Common Ownership, Competition, and Top Management Incentives
Just how much are CEOs making?
An annual study by the Associated Press and research firm Equilar found that the median pay among CEOs of S&P 500 companies -- i.e., large, U.S., publicly traded companies -- was $10.8 million in 2015. That was up 4.5 percent -- or $468,449 -- from the $10.3 million received the year before. Meanwhile, the average American is making less than $50,000 in total income. Did CEOs really need another half-million-dollar raise last year?
No wonder outrage over CEO compensation levels seems to keep growing. Especially when outsized raises seem to have little or nothing to do with how well business is faring.
For instance, a 2016 poll by Reuters/Ipsos of 1,024 individual investors found that a majority wanted to see more pressure on public companies to rein in executive pay. And yet that pressure is lacking. Why?
New research offers a disturbing explanation. In a much-discussed working paper titled "Common Ownership, Competition, and Top Management Incentives," Miguel Antón of IESE, Florian Ederer of Yale, Mireia Giné of IESE and Martin Schmalz of the University of Michigan connect the dots between an increasing amount of common ownership in public companies and top management incentives that discourage aggressive competition.
So, why might the presence of common shareholders be linked to anticompetitive practices? Simply put, it's about these shareholders' votes and incentives.
Consider the fact that public companies' largest shareholders are the most influential on matters that go to shareholder votes, such as executive compensation. Compensation packages may or may not be linked to company performance. And now consider the identity of these largest shareholders: They tend to be mutual funds and other asset managers, such as BlackRock, Vanguard and Fidelity in the United States. Thinking in purely economic terms, what do these asset managers want? "To maximize the value of their entire stock portfolio, rather than the performance of individual firms within that portfolio," explain Antón, Ederer, Giné and Schmalz. The problem here is that maximizing the value of the entire portfolio may also mean undermining tough competition between companies, where one company's gain is another's loss.
In other words, CEOs who must beat the competition in order to earn big may bring down competitors' market values. But CEOs who are paid well no matter what they do can have their lunch and leave their competitors plenty to eat, too.
Shying Away From Fierce Competition?
BlackRock, Vanguard and Fidelity -- which hold considerable sway as major shareholders in thousands of public companies -- vote to approve executive compensation packages about 96 percent of the time. (That is according to 2016 data from Proxy Insight, as reported in the New York Times.) BlackRock, Vanguard, Fidelity and similar companies make their money by charging customers (investors) a fixed percentage of their assets under management. As such, if there is fierce competition in the financial industry, for example, with a price war in a key market, profit margins for the industry as a whole may fall. That is bad news for mutual funds with financial holdings. Of course, while harming the industry's less competitive players, a price war tends to benefit banking customers looking for lower fees.
So, are common shareholders undermining competition in banking? This research is not the first to suggest that the answer seems to be "yes." José Azar, who joined IESE's faculty in September 2016, wrote a recent, widely cited paper linking common ownership to higher prices for consumers in the airline and banking industries. Azar suggests that new tools to counter the industries' monopolistic practices may be required.
A Scandal to Learn From
In their own buzzed-about research, Antón et al. cite Azar's work and provide "a first answer to the question of how anticompetitive shareholder incentives resulting from common ownership are translated into the anticompetitive behavior of firms." They do so, in part, by returning to a scandal in the mutual fund industry, which has helped inform Antón's research in the past.
In 2003, allegations of illegal trading severely damaged the reputations of several mutual fund families. Those funds tainted by the scandal lost an estimated 14 percent of their capital within one year and more than 21 percent the second year. The common ownership of stocks was impacted significantly by the scandal -- as an external shock affecting a quarter of all mutual fund assets in the U.S. It thus presented a natural experiment to test the strength of the link between public companies' common ownership and their compensation levels -- and how much compensation is linked to performance metrics.
(See also, "Connect the Stocks.")
Comparing common ownership before and after the scandal to their compensation variables, Antón et al. corroborate their model's findings: "executives are given weaker incentives to compete aggressively when their industry is more commonly owned." In fact, CEOs receive higher unconditional pay where common ownership concentrations are higher.
Where Common Ownership Can Be Found
Analyzing public data over the past two decades, the research shows the highest common-ownership concentrations in finance, construction, manufacturing and services. This may be dangerous because "high levels of common ownership rationalize performance-insensitive pay" and, potentially, other anticompetitive practices.
What's more, common ownership is increasing over time. If this trend continues, the problem of powerful shareholders voting to undermine aggressive competition is likely to increase as well. And so will public outrage.
Methodology, Very Briefly
The co-authors' $10-million-dollar (per year) question: "High and performance-insensitive pay packages defy both common sense and established economic theory on optimal incentive provision. Why, then, do the largest and most powerful shareholders of most firms approve them?" This working paper applies theoretical analyses, based on modeling, and empirical tests in an attempt to get at an answer.
Data on common ownership of publicly traded U.S. firms spans from 1993 to 2014. Looking industry by industry and over time at common-ownership concentrations, the co-authors find strong empirical evidence to support their predictions.