My high school physics teacher was named Mr. Foote. He was a great teacher, and I think truly cared about public high schoolers learning physics. So, he was probably secretly miserable. But if he was, he never showed it, and was instead endlessly patient and enthusiastic. I remember learning in his class that the definition of inertia was: “a tendency of matter to continue in its current state of rest or motion.” Which, believe it or not, has something to do with the astronomical growth in executive pay that has happened over the last several decades.
To understand the connection, I want to walk you through some data on the last three decades of executive pay. (And if that doesn’t sound exciting to you, you might be at the wrong blog.) Then, I want to explain how one key aspect of executive pay — pay through equity — has grown tremendously over this time. And, this explanation will lead us into a discussion of what the heck inertia and executive pay have in common.
Thirty Years of Executive Pay
To look at executive pay, I will use the CompuStat Executive Compensation Dataset. This dataset contains information on the pay of executives at companies in the S&P 1,500, some of the biggest publicly-traded firms in the U.S. The database allows the user to identify how much executives are paid in total, and also how that pay is determined (e.g., base salary, stock options, etc.).
The figure below shows total compensation for the executives in this dataset since 1992. Notice that the height of each bar is divided in two components — cash pay and pay through equity. The second component is necessary because executives are often paid directly in company stock or through being given a certain number of “stock options.” A stock option gives an executive the right to a certain number of shares of a company’s stock at the current price. So, if the stock’s price increases, the executive can buy the stock at the lower price and sell it at a profit.
Figure 1. Mean Non-Equity and Equity-based Executive Compensation, 1992-2021 (2021 Dollars)
The figure makes two things clear. First, executive pay more than doubled over a timespan when the typical worker’s pay barely budged. Second, much of that growth has come through equity. In the figure above, non-equity pay grew by 45 percent from 1992-2021. But, equity pay grew by over 300 percent! So, equity pay has been the real driver of rising executive compensation.
Why Equity Pay at All?
So, equity pay is clearly driving rising executive compensation. But, why is this sort of compensation so prevalent? The reason comes down to the incentives associated with running a large company. At small mom-and-pop businesses, the owners are often also the managers. They hire employees and plan strategy. At large companies, the owners of companies are shareholders, who have little to do with day-to-day operations.
For example, somewhere buried in my 401(k) is probably some amount of stock in Coca-Cola. This stock means that I own a piece of the Coca-Cola Company. Probably a small piece. I like to pretend that I paid for 3 seconds of one of those Polar Bear ads. Despite my ownership, does Coca-Cola call me up and ask me what their next flavor should be? They do not (it should be Orange Julius).
Instead, the shareholders elect a Board of Directors to act on their behalf in running Coca-Cola. And that Board of Directors hires executives to manage the company. And what better way to get these executives to care about shareholders than to, you know, give them some shares themselves?
Equity compensation is therefore designed to solve a classic problem in Economics — how do you get executives to care about shareholders who they likely have never met? You make the executive’s pay contingent on the shareholder’s success. However, this type of equity-based pay wasn’t always so common. Instead, the shift to equity pay has picked up only gradually, and really started growing in the 1980s and early 1990s. And that gets us to the role of inertia in rising executive pay.
Inertia in Stock Options
With equity pay becoming more common, it is fair to ask if it is being determined in a sensible way. After all, if you own stock in a company, executive pay comes out of your pocket. So, what would sensible pay look like? I don’t know about you, but when my salary is determined it is determined in dollars. Boston College tells me at the beginning of each year, “Geoff, we will pay you [insert giant figure here], which is [insert large percent here] higher than last year because of your [insert positive adjective here] performance.”
At the executive level, one expects it to work the same way. And if executive pay worked this way, then it would be very rare for a CEO to get paid the same number of options each year. After all, stock options change in value from year to year, so any given dollar raise is unlikely to correlate exactly to the same number of options. Yet, executives often do get paid the same number of options each year, suggesting boards are likely to fall pray to inertia. The figure below shows the share of executives based on the percent change in options they got relative to the previous year. That giant spike is at a zero percent change — inertia.
Figure 2. Share of Executives by Percent Change in Number of Options Awarded, 1992-2021
This observation of “inertial” pay isn’t mine, and is based a paper by Kelly Shue and Richard Townsend in the Journal of Financial Economics. Those authors point out that this sort of inertial pay explains a few facts. First, it explains why U.S. executives have seen faster growth than in other countries, where pay through stock options is less common. Second, inertial pay also explains why executive pay has become so correlated with stock returns (which you can see if you look back at Figure 1). Since stock returns drive option value, if the same number of options are given then someone’s raise is entirely driven by growth in their stock’s value. So, inertial pay is an important feature of our current economy.
Inertia and Inequality
You may be asking, so what? If a company’s stock goes up, don’t the executives deserve the raise? Probably not, and certainly not always. A company’s stock may respond to good performance by executives. But, a stock might also increase just because the macroeconomy is going well. And, there’s substantial evidence that executives are often paid for just this sort of luck. Indeed, the authors of the study on rigid stock options suggest that giving the same number of stock options is far from an optimal payment strategy, and is likely due to naiveté on the part of boards.
In any case, inertial executive pay certainly matters for inequality. Over the last thirty years, major stock indices have grown much faster than workers’ wages. For example, over the last decade, average wages grew by about 3 percent each year. The S&P 500 grew by 13 percent. So, if you just got paid a fixed number of options, you’d see growth four times as fast as the typical worker.
Furthermore, even though only some executives get paid this fixed number of options, this sort of pay has a huge impact. After all, executive pay at one firm is often based on the pay at competing firms. If some executives are getting huge raises through these options, then it can spread even to people who aren’t paid this way.
Fortunately, the fix might be fairly easy. Studies suggest that when the company’s Board of Director’s (which determines executive pay) has on it large shareholders (people who own more Coke stock than me), pay through luck is much less common. After all, those shareholders are the ones losing out when executives get paid too much. So, ensuring that firms are governed by people with a stake in the pay of executives can make this form of inequality a bit less extreme.