February 2004

Pay without Performance, The Unfulfilled Promise of Executive
Compensation, Part II: Power and Pay∗

Lucian Arye Bebchuk and Jesse M. Fried∗∗This paper contains a draft of Part II of our forthcoming book, Pay
without Performance: The Unfulfilled Promise of Executive Compensation(Harvard University Press, 2004). The book provides a detailed account of
how structural flaws in corporate governance have enabled managers to
influence their own pay and produced widespread distortions in pay
arrangements. The book also examines how these flaws and distortions canbest be addressed.
Part II of the book shows how an understanding of the role ofmanagerial power can help explain executive compensation practices. We
provide a framework for assessing whether pay arrangements are a productof managerial influence. We discuss managers’ interest in camouflaging theamount and the performance-insensitivity of their pay. Applying ourframework, we discuss how managerial influence can help explain, among
other things, the evidence on the relationship between managerial pay andmanagerial power; the use of retirement benefits and other compensation
arrangements to provide stealth compensation; and the ability of departing
managers to obtain more than their contractual entitlement.
Keywords: Corporate governance, managers, shareholders, boards,
directors, executive compensation, stock options, principal-agent problem,
pay for performance, agency costs, rent extraction, stealth compensation,
camouflage.
JEL classification: D23, G32, G34, G38, J33, J44, K22, M14.
∗

William J. Friedman Professor of Law, Economics, and Finance, Harvard Law School,
and Research Associate, National Bureau of Economic Research.
∗∗

Professor of Law, Boalt Hall School of Law, University of California at Berkeley.
In the course of writing our book manuscript we have incurred debts to many
individuals whom we will thank in the published version of the book. For financial
support, we are grateful to the John M. Olin Center for Law, Economics, and Business(Bebchuk) and the Boalt Hall Fund and U.C. Berkeley Committee on Research (Fried).
Comments are most welcome and could be directed to bebchuk@law.havard.edu orfriedj@law.berkeley.edu.
© 2004 Lucian Bebchuk and Jesse Fried. All rights reserved.

Pay without Performance:
The Unfulfilled Promise of Executive Compensation
Lucian Bebchuk and Jesse FriedTABLE OF CONTENTS

Introduction
Part I: The Official View and its Shortcomings
Chapter 1:
Chapter 2:
Chapter 3:
Chapter 4:

The Official Story
Have Boards Been Bargaining at Arm’s Length ?
Shareholders’ Limited Power to Intervene
The Limits of Market Forces
Part II: Power and Pay

Chapter 5:
Chapter 6:
Chapter 7:
Chapter 8:
Chapter 9:

The Managerial Power Perspective
The Relationship Between Power and Pay
Managerial Influence on the Way Out
Retirement Benefits
Executive Loans
Part III: The Decoupling of Pay from Performance

Chapter 10: Non-Equity Compensation
Chapter 11: Windfalls in Conventional Options
Chapter 12: Excuses for Conventional Options
Chapter 13: More on Windfalls in Equity-Based Compensation
Chapter 14: Freedom to Unwind Equity Incentives
Part V: Going Forward
Chapter 15: Improving Executive Compensation
Chapter 16: Improving Corporate Governance―Included inthis paper

TABLE OF CONTENTS OF PART II (THIS PAPER)
CHAPTER 5:

THE MANAGERIAL POWER PERSPECTIVE ......................................... 1

Power and Rents........................................................................................... 1
The CEO and Other Top Executives.......................................................... 4“Outrage” Costs and Constraints .............................................................. 5
Camouflage ................................................................................................... 7
Outrage and Camouflage at Work............................................................. 8
The Role of Compensation Consultants.................................................. 11
Ratcheting .................................................................................................... 12
Managerial Power and the Past Decade ................................................. 13
Alternative Explanations for Inefficient Contracts................................ 16
CHAPTER 6:

THE RELATIONSHIP BETWEEN POWER AND PAY ........................... 21

Strength and Independence of Boards .................................................... 21
Presence of Large Outside Shareholders ................................................ 24
Antitakeover Protection ............................................................................ 27
The New CEOs Objection.......................................................................... 28
The Pattern .................................................................................................. 30
CHAPTER 7:

MANAGERIAL INFLUENCE ON THE WAY OUT ............................... 31

When CEOs are Fired ................................................................................ 32
When Companies are Acquired ............................................................... 34
Acquirer-Paid Sweeteners......................................................................... 35
When CEOs Retire...................................................................................... 36
It’s Now or Never....................................................................................... 38
CHAPTER 8:

RETIREMENT BENEFITS .................................................................... 40

Retirement Pensions................................................................................... 41
Deferred Compensation ............................................................................ 50
Perks in Retirement .................................................................................... 58
Consulting Contracts ................................................................................. 60
De-coupling Pay from Performance ........................................................ 62

CHAPTER 9: EXECUTIVE LOANS ........................................................................... 64
The Use of Loans ........................................................................................ 64
Arm’s Length Contracting ........................................................................ 66
Camouflaging Subsidized Rates .............................................................. 68
Loan Forgiveness........................................................................................ 70
Camouflaging the Sale of Shares.............................................................. 71

CHAPTER 5: THE MANAGERIAL POWER PERSPECTIVE“What it amounts to is that there’s no one representing shareholders. It’s likehaving labor negotiations where one side doesn’t care.”
Anonymous Fortune 500 CEO, interviewed by Fortune, 2002
The arm’s length contracting model, then, does not provide anadequate account of executive compensation. An understanding of the roleof managerial power is necessary to improve our understanding of thissubject. We introduce in this chapter some conceptual building blocks of the
managerial power perspective, concepts that we will useful for examining
the executive compensation landscape.
We start by explaining the relationship between managerial power
and rents. Managers use their power to secure rents – i.e., extra value
beyond what they would obtain under arm’s length bargaining. Outrage
costs and constraints do place some limits on deviations from arm’s length
contracting. To avoid outrage, compensation designers attempt to hide,obscure, and justify—to ”camouflage”—the amount and form of executive
pay, and our discussion of camouflage will highlight the role played bythese compensation consultants. We conclude by addressing alternative
explanations for why executive compensation arrangements may deviate
from efficient contracting.
Power and Rents
Like the arm’s length contracting approach, the managerial power
analysis begins by recognizing the agency problem inherent in the managershareholder relationship. The managerial power approach, however, does
not view executive compensation as a remedy for this agency problem. On
the contrary, the pay-setting process is itself seen as a major part of the
problem. And where the arm’s length contracting approach takes as a giventhat the board faithfully represents shareholders’ interests when negotiating
executive pay arrangements, the managerial power approach views theboard as incapable of bargaining at arm’s length with the CEO for the same
reasons that make us skeptical about the arm’s length contracting approach.
1Managerial Power Perspective

Our analysis in the preceding three chapters showed that substantial
departures from arm’s length bargaining are likely to be widespread among
publicly traded companies where there is separation of ownership andcontrol. CEOs and their management teams have considerable influence
over boards. Directors have both financial and nonfinancial incentives tofavor executives. Social and psychological factors tend to reinforce theseincentives. The cost to directors of pay arrangements that hurt shareholders
is low, and directors therefore have little economic incentive to resist a
CEO’s compensation demands. Directors also devote too little time to theirboard positions to perform effectively the role of informed arm’s length
bargainers.
For all of these reasons, managers have power to influence their own
pay arrangements. We can expect them to use this power to obtaincompensation more favorable than they would get under arm’s length
bargaining. Their power enables them to extract “rents.”
Economists use the term “rents” to refer to excess returns that firms orindividuals obtain due to their positional advantages. We will use the term
to refer to the extra value managers obtain beyond what would be granted
by a board that had both the inclination to maximize shareholder value andthe necessary time and information to perform that task properly.
Managers, like most people, generally prefer to have more money,
rather than less, so we can expect executives to use their power to obtainhigher pay than they would receive under arm’s length contracting. It is
important to recognize, however, that compensation arrangements may alsofavor managers in nonfinancial ways. For a given amount of compensation,
managers prefer to bear less risk and feel less pressure to generateshareholder value. Managers, that is, wish to enjoy as much slack as
possible. A primary objective of efficient compensation arrangements is to
reduce slack, i.e., to discourage managers from pursuing strategies, such as
corporate empire-building, that serve their interests but not shareholders’.
When they can get away with it, managers prefer to have their cake and eat
it, too; they prefer to receive a given amount of monetary compensation
without cutting managerial slack.
Given a certain amount of compensation, managers might prefer tohave that compensation decoupled from their performance. The more theircompensation depends upon their performance, the more risk managers

2Managerial Power Perspective

must bear, the more effort they must exert, and the more they must forgo
self-serving strategies such as empire-building.
Consider the following two pay arrangements. In the first, a CEO isguaranteed to receive $5 million regardless of firm performance. In thesecond, a performance-dependent arrangement, the manager receives $5
million only if the firm meets certain performance targets. Suppose theperformance-dependent arrangement will induce the manager to meet theperformance target (and thus earn $5 million) by taking steps that are
personally costly, such as trimming the size of the corporate empire,
abandoning a pet project, firing an unproductive crony, and so forth.
Though the CEO should expect to earn $5 million under both packages, thefirst package is more favorable because it does not require acting against hisor her private interests.
Note that if the CEO uses influence to acquire the first arrangement,
the personal benefit of the resulting managerial slack may well be smaller
than the slack’s cost to shareholders. Suppose that in the above example, thebenefit of the slack to the manager is $2 million and its cost to shareholders
is $20 million. If the manager secures the performance-independent
arrangement, the resulting $2 million rent comes at a tenfold cost to
shareholders. The important point here is that managers may use theirinfluence not only to obtain more pay, but also to structure thatcompensation in forms that are less performance-sensitive. And to the extent
that deviations from arm’s length contracting lead to compensation
arrangements that create efficiency costs by, for example, giving managers
too much slack, shareholder losses will be larger than managerial gains.
Because of the association between managerial influence and rents,
the managerial power approach predicts a correlation between power andrents. All executives have some power and therefore all can secure somerents, but the amount of managerial power varies across firms depending oneach firm’s ownership and governance structures. The greater the CEO’s
power, the managerial power approach predicts, the larger his or her rents
will tend to be.1 As we will show in chapter six, empirical evidence confirms
this prediction.
1 The managerial power approach is in the spirit of the economics literature that
focuses on certain agents’ power within organizations and the ability of these agents to
extract rents. See, for example, Jack Hirshleifer, “Competition, Cooperation, andConflict in Economics and Biology,” American Economic Review 68 (1978): 238-243;3

Managerial Power Perspective

The CEO and Other Top Executives
Who receives rents under the managerial power model? The CEO, ofcourse. But sometimes other top executives receive rents as well. Although
we focus on the CEO in our discussion of power and rent-taking, influence
is often concentrated in the hands of a small number of top executives in a
firm, with each executive having some influence on board decision-making.2
When executives other than the CEO serve on the board, for example, someof the factors that provide the CEO with influence on other directors also
benefit the other executives. All the executives on the board, for example,
gain from the forces of collegiality, team spirit, and respect for those leading
the firm. And, as members of the board, they may also have some influenceon future nominations and director compensation.
Even when the CEO alone has power, rents are likely to spill over tothe other high-ranking executives.3 When other officers are friends or
protégés, the CEO may use influence to obtain favorable pay arrangements
for them. These spillover rents will come largely at the expense ofshareholders. Increasing the pay of other top executives can also benefit theCEO, whose own rent extraction becomes less noticeable to outsiders. This
lowers “outrage costs,” which we will discuss shortly.
Finally, by favoring other top executives, CEOs may reduce
resentment of their own high pay, thereby improving working relationships
with their subordinates. Indeed, if the effects of resentment prove costlier
than the spillover rents, shareholders may be better off with this spillover
effect, taking as given the CEO’s influence over her own package. The
important point is that even when spillover rents benefit shareholders, theRaghuram G. Rajan and Luigi Zingales, “Power in a Theory of the Firm,” Quarterly
Journal of Economics 113 (1998): 387-432; Raghuram G. Rajan and Luigi Zingales, “TheFirm as a Dedicated Hierarchy: A Theory of the Origin and Growth of Firms,”
Quarterly Journal of Economics 116 (2001): 805-851. However, most financial economists
working in the particular context of executive compensation have largely assumed
arm’s length contracting and have paid little attention to the role of managerial power.
2 For evidence that power is often distributed among two or more managers, see
Sydney Finkelstein, “Power in Top Management Teams: Dimensions, Measurement,
and Validation,” Academy of Management Journal 35 (1992): 505-538.
3 Ibid.

4

Managerial Power Perspective

officers’ pay arrangements differ from those that would exist if the CEO
could not manipulate his own compensation.
In sum, the CEO’s own compensation will almost always reflect
managerial power, and in many companies, the same will be true for othertop executives. Thus, our analysis applies to compensation of senior
management in general and not only to compensation of the CEO.
“Outrage” Costs and Constraints
Managers’ potential rents are not unlimited. Though market forces
and the need for board approval do not altogether prevent deviations fromarm’s length contracting, they do place some constraints on how far plan
designers can go. There is a limit to what managers will seek and directors
will approve.
In the face of these constraints, how far firms will go in favoring
managers will depend not only how favorable considered arrangements willin fact be but also on how they will be perceived by outsiders. Whether
directors and managers will be deterred from adopting a given
compensation arrangement depends on the extent to which it will be
reviewed by relevant outsiders as unjustified or even abusive or egregious.
We will refer to negative reactions by outsiders as “outrage,” and to thecosts that such reactions imposes on managers and directors as “outrage
costs.” The more widespread and strong negative reactions are – that is, thegreater the outrage -- the larger costs to directors and managers. When thepotential outrage costs are large enough, they will deter the adoption ofsome arrangements that managers would otherwise favor. We shall referarrangements that are deterred in this way as ones that violate the “outrage
constraint.”
Why should perceptions – and in particular, outrage – matter? To
begin with, market forces penalize and thus discourage some arrangements,
and the extent to which markets will penalize managers and directors for the
adoption of some arrangements will depend on how these arrangements areperceived. Consider the market for corporate control. The market forcorporate control will penalize the adoption of some arrangements if the
adoption will increase the vulnerability of managers and directors to acontrol contest. Such penalty is likely to be significant only if the firm adopts
compensation arrangements that appear sufficiently outrageous.

5Managerial Power Perspective

Institutional investors may view such arrangements as a strong signal thatthe executives or directors are especially insensitive to shareholder interests.
These investors may become less likely to support the incumbents should ahostile takeover or a proxy fight occur. In this manner, outrage overcompensation can erode support for incumbent and make a control
challenge viable despite the barriers that ordinarily protect incumbents fromouster.
Consider also the market reputation of managers and directors. A
reputational damage might have an adverse effect on the future careerprospects of managers and directors, and it might also affect their current
business dealing with others outside the firm. Indeed, some outside
directors join boards partly for the prestige and connections that the posts
provide, and gaining a bad reputation would take away these benefits andimpose costs instead. Reputational losses to managers and directors will
likely be significant, however, only if their firms adopts compensation
arrangements as sufficiently outrageous. A suboptimal arrangement would
be unlikely to impose such costs as long as it falls within the range of what isjustifiable and legitimate.
Indeed, we believe that outrage costs deter more arrangements thanan analysis based solely on the above market incentives suggests. That is, we
believe that constraints on rent extraction are somewhat tighter thansuggested by an analysis of the (limited) market penalties that outrageouscompensation arrangements involve. In Chapter two, we have taken into
account that directors are affected not only by “narrow” interests of anhomo economics but also by various social and psychological factors (ofcollegiality, loyalty, and so forth) that pull them in the direction of favoring
executives. Similarly, the analysis of the constraints on rent extraction will
not be complete if we do not recognize that some social and psychologicalfactors increase the costs that managers and directors will suffer fromadopting arrangements that are viewed as sufficiently outrageous.
Managers and directors are likely to care about the extent to which
they are viewed with approval and esteem by some relevant social andprofessional groups. Directors are likely to prefer to avoid criticism or
ridicule from the social or professional groups whose opinions they value –even if and to the extent to which such criticism or ridicule does not involve

6

Managerial Power Perspective

any monetary losses for them.4 Likewise, fear of embarrassment or criticism
may discourage managers, wholly aside from costs arising from markets forcontrol or managerial labor, from seeking outrageous compensation
packages in the first place. When Jack Welch gave up some retirements
benefits to which he was contractually entitled, he was probably seeking toprotect the approval and esteem he had earlier enjoyed and not somenarrowly economic interests.
Clearly, for outrage to impose significant costs, it must be sufficiently
widespread among a relevant group of observers. It is not enough for asmall group of researchers or arbitrageurs to identify a compensation
scheme as egregiously bad for shareholders. For executives or directors to be
adversely affected in a material way, outrage must spread among thoseoutsiders whose views matter most to them: the institutional investor
community, the business media, and social and professional groups towhich directors and managers belong.
Camouflage
The main costs to directors and managers of adopting compensation
arrangements that favor managers, then, depend mainly not on how costly
the arrangements actually are to shareholders, but on how costly thearrangements are perceived to be by important outsiders. Perceptions matter.
Recognizing this brings us to another concept that is critical forunderstanding the compensation landscape: “camouflage.”
Because perceptions are so important, the designers of compensationplans can limit outside criticism and outrage by dressing, packaging, or
hiding — in short, camouflaging -- rent extraction. The more reasonable anddefensible a package appears, the more rent managers will be able to enjoy
without facing significant outrage. Accordingly, under the managerial
power approach, managers will prefer compensation practices that obscure
the total amount of compensation, that appear to be more performancebased than they actually are, and that package pay in ways that make iteasier to justify and defend.
One might reasonably ask how, if rent extraction is camouflaged, any
observer (including this book’s authors) can determine that executives are
4 See Jay W. Lorsch and Elizabeth M. MacIver, “Pawns or Potentates?: The Reality ofAmerica’s Corporate Boards” (Boston: Harvard Business School Press, 1989), pp. 23-31.

7

Managerial Power Perspective

enjoying rents. In theory, rent extraction could be camouflaged so well as tomake it absolutely undetectable. In fact, however, camouflage is successful
as long as the rent extraction does not upset those outside observers whose
outrage would be particularly costly for directors and managers, even if
other observers are aware the executives are enjoying large rents.
Thus, the idea of camouflage is consistent with the possibility that an
outsider might identify the hidden, camouflaged rents of a compensation
arrangement. Such a conclusion would simply reflect the observer’s
judgment, not yet widely shared, that the compensation program isdistorted in favor of managers. In time, of course, such conclusions might
become widely accepted, in which case the rent extraction will no longer becamouflaged.
Outrage and Camouflage at Work
Some critics of our earlier work accused us that the idea of outrage
costs, and the related idea of camouflage, are not empirically testable.5 But
this is not the case. These is evidence that directors and executives areindeed influenced -- in compensation and other types of decisions -- bystrong outside criticism and outrage. And there is evidence that they engage
in camouflage.
To begin, there is empirical evidence that negative media coverage
affects compensation decisions. One study found that firms whose executive
compensation policies received negative coverage in Business Week, Forbes,
Fortune, and Institutional Investor during the years 1992–1994 experienced
smaller increases in total compensation than did other firms.6 These firms
also increased the sensitivity of cash compensation to firm performance.
Studies have also examined the effect on executive pay of shareholder
resolutions that criticize managers’ high compensation and propose that it
be limited. As discussed above, such resolutions are non-binding and
5 See, e.g., Kevin J. Murphy, “Explaining Executive Compensation: Managerial Power
vs. the Perceived Cost of Stock Options.” University of Chicago Law Review 69 (2002):
847-869; Holman W. Jenkins Jr., “Business World: Outrageous CEO Pay Revisited,”
Wall Street Journal, 2 October 2002, p. A17.
6 Marilyn F. Johnson, Susan Porter, and Margaret B. Shackell, “Stakeholder Pressure
and the Structure of Executive Compensation,” working paper, University of Michigan
State University, University of Massachusetts at Amherst, and Notre Dame (1997): 4.

8

Managerial Power Perspective

generally fail to pass anyway. However, their appearance might shine a
critical light on problematic aspects of the firm’s executive compensation
policies and to make them more salient. Indeed, a study examining such
resolutions in the mid-1990s found that they had a moderating effect on
subsequent compensation decisions. The study found that during the twoyear period following the passage of shareholder resolutions criticizing
executive pay in particular firms, total compensation (adjusted for industry)in those firms declined by a statistically significant average of $2.7 million.7
In a subsequent study, the researchers also found that higher negative votes
in management-sponsored stock option proposals during the late 1990s
slowed the increase in CEO compensation in subsequent years.8
Another study, by Alexander Dyck and Luigi Zingales, documents
the effects of media scrutiny on corporate decisions. They find that suchattention leads firms to adopt more environmentally friendly policies, forexample. As for issues of corporate governance, they also find that media
attention reduces the amount of value that controlling shareholders siphon
off.9
A well-known example of how outside criticism affects governancedecisions involves the campaign of shareholder activist Robert Monks
against Sears’ directors. During the late 1980s and early 1990s, Monks urged
the Sears board to adopt various proposals to improve the firm’s dismal
performance. In April 1992, having been ignored by the board, Monks tookout an advertisement in the Wall Street Journal entitled “The non-performing
assets of Sears” and identified the directors by name. The presumably
embarrassed directors then adopted many of Monks’ proposals, generatinga market-adjusted price reaction of almost 10 percent when the changes
were announced.10
7 Randall S. Thomas and Kenneth J. Martin, “The Effect of Shareholder Proposals on
Executive Compensation,” University of Cincinnati Law Review 67 (1999): 1021-1065.
8 Kenneth J. Martin and Randall S. Thomas, “When is enough, enough? Market
reaction to highly dilutive stock option plans and the subsequent impact on CEO
compensation,” Journal of Corporate Finance 202 (2003).
9 Alexander Dyck and Luigi Zingales, “The Corporate Governance Role of theMedia,” working paper, Harvard Business School and the University of Chicago, 2002;
Alexander Dyck and Luigi Zingales, “Private Benefits of Control: An International
Comparison,” forthcoming Journal of Finance (2004).
10 Robert Monks and Nell Minow, Corporate Governance, Cambridge, M.A.:Blackwell9Managerial Power Perspective

Another example is the California State Pension Fund for Public
Employees’ (CalPERS) practice of identifying poorly run companies. For
some years CalPERS put poorly performing firms on what it called its “focus
list” and suggested various ways to improve their corporate governancepractices, such as making compensation and nominating committees fully
independent. In many cases, firms placed on the list implemented some of
the requested changes. Then, in 1991, CalPERS decided to adopt a “kinder,
gentler” approach that did not involve public shaming after several CEOs
told CalPERS that being less antagonistic would be even more effective.
Absent the threat of adverse publicity, however, firms approached by
CalPERS were actually much less cooperative. The then-CEO of CalPERS,
Dale Hanson, said at the time, “ ‘Kinder, gentler’ is not working…It has
shown us that a number of companies won’t move unless they have to deal
with the problem because it’s in the public eye.” In 1992 CalPERS reinstatedits policy of publicly shaming uncooperative firms.11
In fact, CalPERS’ policy of shaming has had a measurable effect ontargeted corporations. YiLin Wu finds that firms put on CalPERS’ poor
governance focus list were subsequently more likely to reduce the numberof inside directors on their boards. These firms were also more likely toexperience CEO turnover.12 Shaming also appears to have adversely affected
the careers of inside directors that left the targeted firms’ boards. They weremuch less likely than inside directors departing non-targeted firms to land
other board positions. As this study makes clear, negative publicity – oroutrage -- does impose costs.
Finally, there is substantial evidence of camouflage activities. A
testable implication of the camouflage idea is that, when compensation
arrangements deviate from arm’s length bargains, they should do so in a
way that reduces the visibility of rent extraction to outsiders. This prediction
is borne out by actual compensation practices. As we shall describe in thecourse of subsequent the following chapters of this book, many common
compensation practices, such as retirement pay, deferred compensation
Publishing, 2001.
11 Judith Dobrzynski, “CalPERS is Ready to Roar, but Will CEO’s Listen?” Business
Week, 30 March 1992, p. 44.
12 YiLin Wu, The impact of public opinion on board structure changes, director career
progression, and CEO turnover: evidence from CalPERS’ corporate governanceprogram, Journal of Corporate Finance 10 (2004): 199.

10

Managerial Power Perspective

arrangements, company loans, non-indexing of options, and the at-themoney strike prices, serve a camouflage purpose.
The Role of Compensation Consultants
U.S. public companies typically employ outside consultants toprovide input on the executive compensation process.13 From the arm’s
length contracting perspective, consultants’ use can be justified on the
grounds that they provide expert assistance in the design of pay packages:
they are privy to pay data that are not shared directly among companies.
Firms participate in consultants’ compensation surveys with theunderstanding that individual firm data will be kept confidential. The
consultants then use the data to improve the design of their clients’compensation arrangements.
Although we agree that compensation consultants can and sometimes
do play a useful role, it is important to understand how they are also used to
camouflage rents. The fact that directors adopt a pay package recommended
by a compensation consultant – rather than developing their own -provides legitimacy. When challenged, the directors can justify theircompensation decision by pointing to the outside expert’s recommendation.
Courts in fact have generally given greater deference to board
decisions that relied on advice by outside experts. Compensation
consultants can provide similarly useful cover for board compensation
decisions. In fact, James Wade, Joseph Porac, and Timothy Pollock provide
evidence that pay consultants are used strategically to justify executive
compensation to outsiders. Their study finds that firms that have moreconcentrated and more active outside shareholders, who are more likely tomonitor and scrutinize pay arrangements, are more likely to rely on
consultants.14
Unfortunately, the mere fact that a CEO pay’s package isrecommended by a compensation consultant does not mean that it is good
13 It has been reported that at least 65 percent of U.S. firms use compensation
consultants. See John M. Bizjack, Michael L. Lemmon, and Lalitha Naveen, “Has theUse of Peer Groups Contribute to Higher Levels of Executive Compensation?”working paper, Portland State University, 2000, p. 10, 44.
14 James B. Wade, Joseph F. Porac, and Timothy G. Pollock, “Worth, Words, and theJustification of Executive Pay,” Journal of Organizational Behavior 18 (1997): 657, 658.

11

Managerial Power Perspective

for shareholders. Indeed, in their study, Porac, Wade, and Pollock examinedthe choice of peer firms against whose performance the given firm wasbenchmarked. They found that, when the firm performed poorly relative tothe industry or the CEO was highly paid compared with the industry, thedefinition of “peer firms” was expanded beyond industry boundaries.15
Kevin Murphy found that “two-thirds of the largest 1000 corporations
reported beating the performance of their industry peers over the last fivefiscal years.”16 Such inconsistent assessments were facilitated by thecooperation of pay consultants.
Ratcheting
The combined efforts of consultants, who have incentives to help theCEO, and boards, which are similarly inclined, have led to an escalation of
pay levels over the years. John Bizjack, Michael Lemmon, and Lalitha
Naveen reviewed the 1997 compensation committee reports of one hundred
firms in the S&P 500 index. They reported that the “vast majority” of firmsthat use peer groups set compensation at or above the fiftieth percentile ofthe peer group.17 Such generous benchmarking is likely to boost executive
compensation over time even if managerial performance does not improve.
To investigate ratcheting, Bizjack and his co-authors examined theactual compensation decisions of approximately 1,500 publicly traded firms
during the period 1992–1998. They found that CEOs who were initially paid
below the median amount received much larger than average pay increases,
in both percentage and absolute terms, even when their firms had worse
accounting and stock price performance. Such practices lead inevitably toever-increasing compensation and benefit even poorly performing
executives.18
15 Joseph F. Porac, James B. Wade, Timothy G. Pollock, “Industry Categories and thePolitics of the Comparable Firm in CEO Compensation,” Administrative Quarterly 44(1999): 112-144.
16 Kevin J. Murphy, “Politics, Economics, and Executive Compensation,” University ofCincinnati Law Review 63 (1995): 736.
17 John M. Bizjak, Michael L. Lemmon, and Lalitha Naveen, “Has the Use of Peer
Groups Contribute to Higher Levels of Executive Compensation?” working paper,
Portland State University, 2000, pp 2-3.
18 Kevin J. Murphy, “Executive Compensation,” in Handbook of Labor Economics, ed.
Orley Ashenfelter and David Card (New York: Elsevier, 1999), 2485, 2517-2518; Graef

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Managerial Power Perspective

Kim Clark, the dean of Harvard Business School, recently described
the process of ratcheting as follows: “[T]he use of consultants….creates what
I call the ‘the Lake Wobegon effect.’ You recall that in Lake Wobegon
everybody is above average. And in a lot of companies the way the system
works is most CEOs want to be at the 75th percentile of the distribution ofcompensation….You get a ratcheting-up effect as that information pervades
the market, and we get serious distortions in CEO compensation.”19Managerial Power and the Past Decade
Kevin Murphy and Brian Hall have criticized our earlier work on theconnection between power and pay, suggesting that our approach cannot
explain the large increases in executive compensation during the 1990s.20
Wall Street Journal columnist Holman Jenkins attacked our work on similar
grounds.21 These critics assert that CEO power declined during the 1990s as
boards added more independent directors. They argue that if the managerial
power approach is correct, pay ought also to have declined, rather thanincreased, during this period.
However, it is not at all clear that CEO influence on pay declined
during the 1990s. Although the composition of boards might have
improved, takeover defenses were also strengthened. Thus boards andexecutives were much less concerned about the threat of a hostile takeover
during the 1990s than they had been during the preceding decade. In any
event, executive pay increases during the 1990s resulted not from changes in
the amount of managerial power. Rather, they resulted from developmentsin the compensation environment – such as shareholders’ increased interestin linking pay to performance and the broader stock market boom -- which
managers were able to use to their advantage.
S. Crystal, In Search of Excess: The Overcompensation of American Executives (New York:
Norton, 1991): 219; Shawn Tully, “Raising the Bar,” Fortune, 8 June 1998, p. 272.
19 Harvard Business School dean Kim B. Clark, prepared remarks, National Press
Club, 26 February 2003.
20 Kevin J. Murphy, “Explaining Executive Compensation: Managerial Power vs. thePerceived Cost of Stock Options.” University of Chicago Law Review 69 (2002): 847-869;
Brian J. Hall and Kevin J. Murphy, “The Trouble with Stock Options,” Journal of
Economic Perspectives 17 (2003): 64-65.
21 Holman W. Jenkins Jr., “Business World: Outrageous CEO Pay Revisited,” WallStreet Journal, 2 October 2002, p. A17.

13

Managerial Power Perspective

In the early 1990s, institutional investors and federal regulators, withthe support of financial economists, pressed for greater use of performancebased compensation. The enactment in 1992 of Section 162(m) of the Internal
Revenue Code, which denies firms a deduction for compensation paid to an
executive in excess of $1 million per year unless the excess compensation is“performance-based,” was intended to encourage the use of suchcompensation.
Executives took advantage of this surge of enthusiasm. They usedtheir influence over directors to obtain substantial option pay without
sacrificing corresponding amounts of cash compensation. In an arm’s length
world, an employer is often able to trade an increase in one part of acompensation package for an offsetting reduction in another part of the
package. But in the real world of manager-influenced compensation, boards
and executives responded to the calls for equity-based compensation byadding more such compensation to existing arrangements, rather thansubstituting it for performance-insensitive compensation.
Furthermore, and more importantly, executives used their influence
to make the design of option plans advantageous to them. As will be
explained in part III, conventional option plans do not link pay tightly to the
managers’ own performance. Rather, they enable managers to reap
windfalls from stock price increases that are due solely to market and sector
forces beyond managerial control. As a result, managers capture muchlarger gains than more cost-effective and efficient plans would haveprovided.
In view of the huge increase in pay during the past decade, critics of
our approach might ask why risk-averse managers would not use theirinfluence to get higher cash salaries rather than more options. Holding thevalue of compensation constant, one would indeed expect this to happen.
But managers seeking to increase their pay during the 1990s were notoffered a choice between additional cash compensation and additional
option compensation with the same expected value. Instead, outsiders’enthusiasm for equity-based compensation created an opportunity for
managers to obtain additional option compensation without offsetting
reductions in their cash compensation.
Furthermore, because option compensation offers the possibility of
improved incentives, the use of options made compensation levels thatwould have triggered prohibitive outrage had they been in cash more

14

Managerial Power Perspective

defensible. In 2001, Steve Jobs was able to obtain an option package worth
more than half a billion dollars, albeit with some outcry.22 Cashcompensation of this magnitude is still quite inconceivable. As we discuss indetail in chapter eleven, firms could have used better-designed option plansthat would have provided the same incentives for significantly less cost. But
the large windfall elements of the option plans that firms did use were notsufficiently clear and salient to make these plans blatantly unjustifiable.
Managers’ influence has enabled them to take advantage of shareholders’
understandable desire for more performance-based compensation. As aresult, during the 1990s executives captured much larger benefits than theywould have received under arm’s length arrangements that provided thesame incentives.
The stock market boom is a second important factor that worked to
managers’ advantage in the 1990s. Executive compensation has historically
been and is still correlated with a firm’s market capitalization. Executives offirms with larger market capitalization tend to receive higher
compensation.23 Thus, the rising stock market of the 1990s, which buoyed up
many poorly performing companies, provided most firms with a convenientjustification for substantial pay increases.
Furthermore, investors and other outsiders are generally lessbothered by excessive and distorted pay arrangements when markets arerising rapidly. The bull market of the 1990s -- the biggest bull market since
the Great Depression – weakened the outrage constraint, giving managers
and boards more latitude to boost executive pay. The stock market boom
thus played a role in the run up of executive compensation during thisperiod. Conversely, shareholders who have seen the value of theirinvestments decline precipitously are more prone to scrutinize managerial
behavior and less likely to be forgiving of what they perceive (correctly or
incorrectly) to be managerial overreaching. It is no coincidence that manylarge stock market declines are followed by new laws that seek to curb what
is viewed as insider overreaching.24 Thus, that pay has not continued to

22 Geoffrey Colvin, “The Great CEO Pay Heist,” Fortune, 25 June 2001, p.64.
23 See Kevin J. Murphy, “Executive Compensation,” in Handbook of Labor Economics,
vol. 3, bk. 2, ed. Orley Ashenfelter and David Card (New York: Elsevier, 1999), p. 2493.
24 The 1929 crash led to the enactment in 1933 and 1934 of the country’s first securities
laws. The recent crash has already led to the passing of the Sarbanes-Oxley Act of 2002.

15

Managerial Power Perspective

escalate rapidly since 2000 is in part due to some tightening of the outrage
constraint.
Alternative Explanations for Inefficient Contracts
In the coming chapters we will describe various compensation
practices that appear to be inefficient and thus inconsistent with arm’s
length contracting. They are, however, completely consistent with thepredictions of the managerial power approach. Before proceeding, however,
we wish to discuss briefly two alternative explanations for inefficientcompensation practices, and how their predictions differ from those of the
managerial power approach.
Norms and Conventions
The desire to conform to prevailing norms and conventions influencesindividuals’ behavior in many contexts. In recent years, a number of legal
scholars have studied the role of norms in the context of corporate law andcorporate governance.25 It is natural to ask whether norms play a role inexecutive compensation. Inefficient arrangements might arise and persist,one could argue, simply because boards have a tendency to conform to thepractices of other firms, whether or not those practices serve shareholderinterests.
The tendency to conform likely plays a significant role in board
decisions about executive compensation. Directors will be more willing toapprove pay arrangements that are similar to those of other firms.
Following the herd requires less explanation, less justification, and lessconfidence in one’s own judgment than does carving out a new path. Thus,
compensation committees and boards have a natural desire to conform to“the norm,” or at least to be perceived as conforming to the norm.
The desire to conform makes any change in the status quo –- any
move from one “equilibrium” to another -- slower than it would otherwise
be. The evolution of compensation arrangements is slowed down or made“sticky” by compensation committees’ preference for adhering to
25 See, for example, Melvin A. Eisenberg, “Corporate Law and Social Norms,”
Columbia Law Review 99 (1999): 1253-1292, and the articles appearing in University ofPennsylvania Law Review, Symposium on Norms and Corporate Law, 2001.

16

Managerial Power Perspective

conventions and their reluctance to deviate substantially from established
pay practices.
However, the desire to conform cannot explain the ways in which
compensation arrangements have evolved in the past –- and thus the current
landscape of executive compensation. Nor can it predict the direction inwhich compensation arrangements will evolve in the future. The stickinessarising from the tendency to conform implies only that movement from one
equilibrium to another will be gradual and slow. It can neither explain why
we should arrive at any particular equilibrium rather than another, nor what
the next equilibrium is likely to be.
Patterns of executive compensation do change substantially over time.
Some of the practices to be discussed in coming chapters either haveemerged or have become dramatically more important in just the past
decade. The stickiness arising from the desire to conform cannot tell us
much about why arrangements evolved in one direction rather than another.
To provide a full account of executive compensation, norms andconventions must be combined with another theory, such as arm’s length
contracting or managerial power. A theory combining norms with the arm’s
length contracting approach would predict that the evolution of executive
compensation arrangement, although slowed by the tendency to follow
established practices, is shaped by market forces. In this model, as changing
circumstances make an existing equilibrium inefficient, market pressures
induce boards to adopt arrangements that are efficient in the newcircumstances. Although the desire to conform prevents instantaneous
adjustment, market forces reshape arrangements so they become more
efficient. Ultimately, the efficiency gap created by the new circumstances
may be eliminated.
In contrast, the managerial power approach predicts that theevolution of executive compensation over time is shaped, at least in part, byexecutives’ desire to secure rents. When changing circumstances create an
opportunity to enjoy more rents or to better camouflage their rents,
managers will try to take advantage of the opportunity. The stickiness dueto the desire to conform will slow the pace of these changes, but the changes
will tend to be in directions favorable to managers and to reflect their ability
to influence their own pay.
In the following chapters, we will discuss a variety of potentiallyinefficient but executive-friendly compensation practices that have17

Managerial Power Perspective

developed during the last decade or two. We will also discuss somepotentially efficient compensation practices that failed to emerge during thesame period. Why did one set of arrangements arise and not the other? The
stickiness caused by the desire to conform combined with arm’s length
contracting should not systematically yield outcomes that are favorable tomanagers. However, the tendency of changes to favor executives more than
the interest of shareholders is consistent with such stickiness combined withthe operation of managerial influence.
Mistakes and Misperceptions
There is another natural explanation for inefficient compensation
contracts: human error. Even in an economic context where arm’s length
bargainers have incentives to reach efficient outcomes, they can makemistakes. They misperceive, miscalculate, misestimate, and suffer from avariety of cognitive biases. These human imperfections may lead to theadoption of inefficient compensation contracts. One observer has referred tothis explanation for inefficient compensation packages as “honest
stupidity.”26
To assess this mistakes-based explanation, it is first necessary to
specify the identities of those making the errors. Under one version of this
explanation, all those involved in the pay-setting process – including
executives, their advisers, and compensation consultants – make mistakes.
But this is a highly implausible explanation for the persistence of theinefficient practices we will be discussing in subsequent chapters.
The problems we will discuss are hardly complex. It is highly unlikelythat they have so long escaped the attention of managers and their
sophisticated, well-paid advisers. Furthermore, this version of the
explanation cannot account for the fact that apparent departures from arm’s
length contracting systematically favor managers. “Honest stupidity”
should occasion departures that are both favorable and unfavorable tomanagers.
A more plausible version of the honest mistakes explanation focuseson independent directors, who have little at stake in compensation decisions
and devote little time to them. One might argue that they are honestly likely
26 Andrew Balls, “Ill-judged incentives: Share options are a poor way to makeexecutives act in shareholders’ interests,” Financial Times, 12 November 2002, p.13.

18

Managerial Power Perspective

to fail to grasp the problems we will be discussing. In a response by Kevin
Murphy to our earlier study, and in a subsequent paper by Brian Hall andMurphy, these authors have advanced such an explanation – which theylabel “the perceived cost view” -- for the prevalence of seemingly inefficient
option plans.27
As we will discuss in chapter eleven, it is puzzling from an arm’s
length contracting perspective that conventional option plans make little
effort to filter out stock price increases that are not due to managerial efforts.
Hall and Murphy argue that boards use conventional option plans because
they fail to perceive the true economic cost to shareholders of such options.
They argue that conventional options are perceived as inexpensive because
they can be granted without any cash outlay and without an accounting
charge, and thus boards are overly willing to grant them. In truth, options
that filter out windfalls cost less, but boards erroneously view them as more
expensive because reduced-windfall options do require an accounting
charge.
We are skeptical that directors fail to recognize that conventional
options involve substantial costs for shareholders, whose holdings are
diluted by the option grants. We likewise doubt that directors are unawarethat the cost of conventional options exceeds the cost of options that filterout stock price increases not due to the executives’ own efforts.
But for the sake of argument, let us suppose that—when appointed toboards—directors, many of whom are executives or prominent figures in thebusiness world, are oblivious to the true cost of conventional options. Let us
suppose further that—once these ignorant directors are on the board—compensation consultants fail to educate them about these costs. If so, thepossibility of misperceptions by these directors is best seen not as analternative to the managerial power explanation but rather as additional
evidence that supports it.
As we discussed in chapter two, there are several reasons why boards
are unlikely to negotiate compensation arrangements that best serve
shareholders. Directors tend to have financial and nonfinancial incentives toplease or at least not to displease the CEO; even absent such incentives, a
27 Kevin J. Murphy, “Explaining Executive Compensation: Managerial Power vs. thePerceived Cost of Stock Options,” University of Chicago Law Review 69 (2002): 847; BrianHall and Kevin J. Murphy, “The Trouble with Stock Options,” Journal of Economic
Perspectives 17 (2003): 49-70

19

Managerial Power Perspective

host of social and psychological factors are likely to lead directors to favormanagers. In addition, directors lack adequate time and information for theinvestigation of alternative, efficient compensation arrangements withexecutives, and thus their misperception of the cost of options is but one
example among many of the general problem.
For many purposes, it does not matter whether managers’ influence
over their own compensation comes from the pliability of the board or fromdirectors’ naiveté. Whether the problem is conscious favoritism, honest
stupidity, or a combination of both, the important fact is that directors are atleast to some extent willing to approve option arrangements that favormanagers at the expense of shareholders.
In other instances, however – such as the effort to improve
compensation arrangements – it might well matter whether inefficient
contracts arise from conscious favoritism or honest stupidity. If
misperceptions were the only source of past departures from arm’s length
contracting, for example, outsider observers could simply correct themisperceptions— by educating directors or providing them with moreaccurate information —to achieve arrangements much closer to the efficient,arm’s length ideal.
Thus it is worth noting briefly that evidence indicates that managers’
influence on their pay is due not only to directors’ “honest stupidity” butalso at least partially to directors’ willingness to favor managers. For one
thing, even if the failure of firms to filter out windfalls results from directors’
misapprehension of the costs of conventional options, managers are alsofavored in other ways that cannot be so easily explained away.
Misapprehensions cannot explain why, as we discuss in chapters eight andnine , firms have designed retirement plans and executive loans in ways thatseem calculated to make compensation less noticeable.
Furthermore, if managers could not influence their own pay and were
simply benefiting form directors’ misperceptions, one would not expect
executive pay to correlate with executives’ power. As we explain in thefollowing chapter, however, considerable evidence indicates the existence ofsuch a correlation. This pattern indicates that directors’ conscious
willingness to favor the CEO, not merely directors’ misperceptions, plays asignificant role in shaping compensation arrangements.

20

CHAPTER 6: THE RELATIONSHIP BETWEEN POWER AND PAY“I think that in the future, historians will look back on this period oftime and they will say this was a time when there was great corporate
power, maybe too much corporate power, and the smoking gun was CEO
pay.”
Shareholder Activist Robert A.G. Monks, CEO Pay- The Smoking
Gun, 2004“[W]e find that CEO compensation is higher when …. the outside
directors are appointed by the CEO…”John Core, Robert Holthausen, and David Larcker, “Corporate
Governance, Chief Executive Compensation, and Firm Performance,” 1999.
In companies with dispersed ownership and no controllingshareholder, executives will generally have enough power to enjoy morecompensation and managerial slack than they would under an arm’s lengtharrangement. The extent of managerial power, however, is not uniform
across all such companies. Managers will have more or less power
depending on the company’s ownership structure, on the antitakeoverarrangements in place, and on various features of the board. The managerial
power approach predicts that compensation packages will be morefavorable to managers – i.e., that pay will be higher and/or less sensitive toperformance -- in firms in which managers have relatively more power.
Other things being equal, managers will tend to have more power when (i)the board is relatively weak or ineffectual; (ii) there is no large outside
shareholder; (iii) there are fewer institutional shareholders; and (iv)managers are protected by antitakeover arrangements. The empiricalevidence indeed indicates that each of these factors does indeed affectexecutive compensation in the way predicted by the managerial power
approach.
Strength and Independence of Boards
Although CEOs generally influence the board, the degree of influence
differs from company to company depending on whether the board isrelatively weak or relatively strong. The evidence indicates that CEOs obtain21

Relationship Between Power and Pay

more favorable pay arrangements the more powerful they are vis-à-vis theboard.
A CEO is likely to be relatively more powerful as the size of the board
increases. Larger boards are likely to be less cohesive because each director
may feel less “responsible” and therefore may focus less on the firm’s affairs
in general and on management pay in particular. Individual members oflarge boards are less likely to be constrained in their decisions by the threatof public outrage; the larger the board, the harder it is for outside observers
to direct their outrage at any one member in particular. Additionally, any
directors interested in challenging the CEO will find it more difficult toconvince a majority of the board to join them, there being more directors toconvince. For all these reasons, the managerial power approach predicts thata larger board will allow managers to obtain more favorable pay
arrangements. Indeed, John Core, Robert Holthausen, and David Larcker
find that CEO compensation is higher when the board is larger.28 Similarly, a
study conducted by David Yermack finds that pay-performance sensitivity
decreases as the size of the board increases.29
The presence of directors who serve on multiple boards, and are
therefore less focused on the affairs of any one company, is also likely toincrease the relative power of the CEO.30 The managerial power approach
predicts, then, that pay arrangements will be more favorable to the CEO
when outside directors sit on multiple boards. In fact, the Core, Holthausen,
and Larcker study indicates that CEO compensation increases, all else equal,with the number of outside directors serving on three or more otherboards.31

28 John E. Core, Robert W. Holthausen, and David F. Larcker, “Corporate Governance,
Chief Executive Compensation, and Firm Performance,” Journal of Financial Economics
51 (1999): 372-373.
29 David Yermack, “Higher Market Valuation of Companies with a Small Board of
Directors,” Journal of Financial Economics 40 (1996): 205.
30 John E. Core, Robert W. Holthausen, and David F. Larcker, “Corporate Governance,
Chief Executive Compensation, and Firm Performance,” Journal of Financial Economics
51 (1999): 372-373.
31 John E. Core, Robert W. Holthausen, and David F. Larcker, “Corporate Governance,
Chief Executive Compensation, and Firm Performance,” Journal of Financial Economics
51 (1999): 372-373.

22

Relationship Between Power and Pay

A CEO who also serves as chair of the board is likely to be more
powerful. The board chair runs board meetings and sets their agendas. It is
hardly surprising, then, that CEOs occupying that position are less likely to
be fired by the board for poor performance.32 The managerial power
approach to executive compensation further predicts that a CEO who is alsochairman of the board will obtain more favorable pay arrangements. Indeed,numerous studies conclude that compensation tends to be higher when the
CEO serves in these two roles.33
The presence of directors who have ties to or feel an obligation to the
CEO is also likely to increase the latter’s power. In fact, studies indicate that
pay is higher, and the CEO is more likely to get a golden parachute, whenmore of the outside directors have been appointed under — and thus may
feel a greater sense of gratitude or obligation to — the current CEO.34
As we noted in chapter two, interlocking directorships increase theCEO’s ability to influence the board. CEO-interlocking directorships -where the CEO of company A sits on company B’s board and the CEO of
company B sits on company A’s board –- are likely to afford both CEOs aparticularly significant amount of power vis-à-vis their boards. As the
managerial power approach predicts, CEO pay increases when a board
contains interlocking directors.35
32

Vidhan K. Goyal and Chul W. Park, “Board Leadership Structure and CEO
Turnover,” Journal of Corporate Finance 8 (2002): 49-66.
33 Richard Cyert, Sok-Hyon Kang, and Praveen Kumar, “Corporate Governance,
Takeovers, and Top-Management Compensation: Theory and Evidence.” Management
Science 48 (2002):: 453-469; James Wade, Charles A. O’Reilly, III, and Ike Chandratat,“Golden Parachutes, CEO’s, and the Exercise of Social Influence,” Administrative
Science Quarterly 35 (1990): 592-593; Martin Conyon and Kevin Murphy, “The Prince
and the Pauper? CEO Pay in the U.S. and the U.K.,” Economic Journal 110 (2000): F640671; John E. Core, Robert W. Holthausen, and David F. Larcker, “Corporate
Governance, Chief Executive Officer Compensation, and Firm Performance,” Journal of
Financial Economics 51 (1999): 371-406.
34 John E. Core, Robert W. Holthausen, and David F. Larcker, “Corporate Governance,
Chief Executive Compensation, and Firm Performance,” Journal of Financial Economics
51 (1999): 372-373; Richard Cyert, Sok-Hyon Kang, and Praveen Kumar, “Corporate
Governance, Takeovers, and Top-Management Compensation: Theory and Evidence.”
Management Science 48 (2002):: 453-469.
35 Kevin Hallock, “Reciprocally Interlocking Boards of Directors and Executive
Compensation,” Journal of Financial and Quantitative Analysis 32 (1997): 332.

23

Relationship Between Power and Pay

Turning from the board to its compensation committee, the makeupof that committee itself also affects the structure of CEO pay in the way
suggested by the managerial power perspective. First, evidence indicatesthat a CEO’s pay is higher if the chair of the compensation committee has
been appointed during the term of that CEO (an appointment that mightreflect a good relationship between the two).36 Second, when at least one
member of the compensation committee is an insider and therefore
subordinate to the CEO, the sensitivity of pay to performance is lower.37
Finally, the managerial power approach predicts that compensationcommittee members who own significant amounts of stock will tend to be
more involved in firm affairs and more attentive to shareholder value.
Indeed, a study confirms that CEO pay is negatively related to the shareownership of the board’s compensation committee.38
Presence of Large Outside Shareholders
The presence of large outside shareholders will also affect managerial
power. A large outside shareholder has more incentive than dispersed
shareholders have to monitor management and invest effort in reducing
managerial opportunism.39 Thus, the managerial power approach predicts
that the presence of a large shareholder, even one who does not have acontrolling or dominant stake, will lead to executive compensation
arrangements that are better for shareholders and worse for managers.
This prediction is borne out by a study that finds a negative
relationship between the equity ownership of a firm’s largest shareholder
and the amount of CEO compensation. Firms that have a shareholder with astake larger than the CEO’s ownership interest pay their CEOs 5 percent less
36 Brian G. Main, Charles A. O’Reilly III, and James Wade, “The CEO, the Board of
Directors, and Executive Compensation: Economic and Psychological Perspectives,”
Industrial and Corporate Change 11 (1995): 293-332.
37 Harry A. Newman and Haim A. Mozes, “Does the Composition of theCompensation Committee Influence CEO Compensation Practices?” Financial
Management 28 (1999): 41-53.
38 Richard Cyert, Sok-Hyon Kang, and Praveen Kumar, “Corporate Governance,
Ownership Structure, and CEO Compensation: Theory and Evidence,” Management
Science 48 (2002): 453-469.
39 Andrei Shleifer and Robert W. Vishny, “Large Shareholders and Corporate
Control,” Journal of Political Economy 94, no. 3 (1986): 461-688.

24

Relationship Between Power and Pay

in total compensation than firms without such a shareholder.40 Two otherstudies have looked at the effect of a 5 percent or larger blockholder (otherthan the CEO) on CEO compensation. They find that the existence of such a
5 percent blockholder also reduces CEO compensation.41
As might be expected, these studies also find that pay is less sensitive
to performance in companies that do not have a 5 percent external
shareholder.42 The arm’s length contracting view would not predict such a
relationship. Agency problems are likely to be more severe absent a large
external shareholder. The arm’s length contracting model would therefore
predict that, if anything, boards would make pay-performance sensitivity
higher in such cases, in order to counteract these more pronounced agency
problems.
A creative empirical study by economists Marianne Bertrand andSendhil Mullainathan provides additional evidence that managers’ pay isless performance-sensitive in the absence of large external shareholders.43
The study examines whether the presence of a 5 percent (or larger)
shareholder affects how managers are compensated for “luck” – that is, forchanges in company performance beyond their control. The study finds that
CEOs in firms lacking large external shareholders tend to receive more“luck-based” pay. Another study by the same authors finds that CEOs in

40

Richard Cyert, Sok-Hyon Kang, and Praveen Kumar, “Corporate Governance,
Ownership Structure, and CEO Compensation: Theory and Evidence.” Management
Science 48 (2002): 453-469.
41 John E. Core, Robert W. Holthausen, and David F. Larcker, “Corporate Governance,
Chief Executive Compensation, and Firm Performance,” Journal of Financial Economics
51 (1999): 372-373; Richard A Lambert, David F. Larcker, and Keith Weigelt, “The
Structure of Organizational Incentives,” Administrative Science Quarterly 38 (1993): 438461.
42 Donald C. Hambrick and Sydney Finkelstein, “The Effects of Ownership Structure
on Conditions at the Top: The Case of CEO Pay Raises,” Strategic Management Journal
16 (1995): 175-193; Henry L. Tosi Jr. and Luis R. Gomez-Mejia, “The Decoupling of
CEO Pay and Performance: An Agency Theory Perspective,” Administrative Science
Quarterly 34 (1989): 181.
43 Marianne Bertrand and Sendhil Mullainathan, “Are CEO’s Rewarded for Luck?:
The Ones without Principals Are,” Quarterly Journal of Economics 116 (2001): 929.

25

Relationship Between Power and Pay

firms without large shareholders experience smaller reductions in cash
compensation per increase in options-based compensation.44
The significance of outside shareholders as a check on managerial
power may depend not only on the presence of a large shareholder but also
on the percentage of shares held by institutional investors. Althoughinstitutional investors are often reluctant to fight management about pay
issues, they are generally more vigilant than are individual investors, whohave little at stake in any given firm.
In a study of S&P firms during the 1990s, financial economists Jay
Hartzell and Laura Starks have found that a higher concentration of
institutional ownership leads not only to lower executive compensation,45
but also to more performance-sensitive compensation. This evidence
indicates that the presence of institutions serves to reduce both excess pay
and managerial slack.
Another study by Parthiban David, Rahul Kochar, and Edward
Levitas divides institutional shareholders into two categories. One category
includes those that have no other business relationship with the firm and arethus concerned only with its share value (“pressure-resistant” institutions).
The second category includes those institutions that have other business
relationships with the firm (e.g., managing a pension fund) and are thus
vulnerable to management pressure (“pressure-sensitive” institutions). As
the managerial power approach predicts, CEO pay is negatively correlatedwith the presence of pressure-resistant institutional investors and positively
correlated with the presence of pressure-sensitive ones. 46

44 Marianne Bertrand and Sendhil Mullainathan, “Are CEO’s Rewarded for Luck?:
The Ones without Principals Are,” Quarterly Journal of Economics 116 (2001).
45 Jay C. Hartzell and Laura T. Starks, “Institutional Investors and Executive
Compensation,” Journal of Finance 58 (2003): 2351-2374. See also Parthiban David, Rahul
Kochar, and Edward Levitas, “The Effect of Institutional Investors on the Level andMix of CEO Compensation,” Academy of Management Journal 41 (1998): 200-208.
46 Parthiban David, Rahul Kochar, and Edward Levitas, “The Effect of Institutional
Investors on the Level and Mix of CEO Compensation,” Academy of Management Journal
41 (1998): 200-208.

26

Relationship Between Power and Pay

Antitakeover Protection
The market for corporate control – the threat of a hostile takeover –does not exert sufficient force to prevent substantial departures from arm’s
length contracting. It does, however, provide some constraint on managers’
desire and ability to obtain favorable pay arrangements. Thus, themanagerial power approach predicts that the more protected incumbents
are from a takeover, the higher and less performance-sensitive theircompensation will be.
One study by Kenneth Borokhovich, Kelly Brunarski, and RobertParrino reports that CEO compensation increases significantly after
antitakeover provisions are adopted — that is, after CEOs have become lessvulnerable to a hostile takeover.47 This is not readily explainable by arm’slength contracting; if managers’ jobs are more secure, shareholders shouldbe able to pay managers less because managers’ risk-bearing costs arelower.48
Another study finds that CEOs of firms that become protected byanti-takeover legislation reduce their holdings of shares, apparently because
the shares are less necessary for maintaining control.49 This finding, again, is
not readily explained by arm’s length contracting. Arm’s length contracting
might in fact predict the opposite -- that a CEO protected by takeover
legislation would, if anything, be required by a shareholder-oriented board
to increase equity holdings to maintain adequate incentives to maximize
shareholder value.
It is worth noting that managers who are less vulnerable to a hostile
takeover take advantage of their power in other ways as well. Several
studies report that, when protected by strong antitakeover laws or bycorporate charter provisions, managers generate less value forshareholders.50 One study indicates that when managers have fewer reasons
47 Kenneth A. Borokhovich, Kelly R. Brunarski, and Robert Parrino, “CEO Contracting
and Anti-Takeover Amendments,” Journal of Finance 52 (1997): 1503-1513.
48 Anup Agrawal and Charles R. Knoeber, “Managerial Compensation and the Threatof Takeover,” Journal of Financial Economics 47 (1998): 219.
49 Shijun Cheng, Venky Nagar, and Madhar V. Rajan, “Control versus Risk in StockBased Incentives: Evidence from Antitakeover Regulation,” Review of Financial Studies.
Forthcoming.
50 Marianne Bertrand and Sendhil Mullianathan, “Is There Discretion in Wage

27

Relationship Between Power and Pay

to fear a hostile takeover, they tend to operate their firms less efficiently,
producing narrower profit margins and slower sales growth.51 This study
further reports that insulation from takeover threats results in greater
consumption of private benefits by managers and a greater tendency toengage in empire building.
The New CEOs Objection
In a critique of our earlier work, Kevin Murphy, one of the country’s
leading academic experts on executive compensation, presented a finding
that, he argues, is inconsistent with the predictions of the managerial power
approach.52 Murphy found that CEOs hired from the outside receive in theirfirst year almost twice the total compensation received by CEOs promoted
from within. Outsider CEOs do not yet have power to influence their pay,
Murphy argues. Their higher compensation therefore must be inconsistent
with the managerial power hypothesis.
As we explained in chapter two, however, boards cannot be expected
to bargain at arm’s length even with outside CEO candidates. Among otherthings, directors negotiating with a new CEO expect that, once hired, theCEO will influence the re-nomination of directors. It is therefore not in the
directors’ financial interest to engage in hard bargaining. In addition,
directors recognize that the person whose compensation they are structuring
will soon become the firm’s leader and one of their colleagues—that he is, inshort, a person with whom they would like to have collegial relations. Thisfurther reduces directors’ incentive to engage in true arm’s length
bargaining with the would-be CEO.
Furthermore, once a candidate has been identified as the top choicefor the CEO position, it is embarrassing for directors if he or she walks away.

Setting? A Test Using Takeover Legislation,” Rand Journal of Economics 30 (1999): 535;
Gerald T. Garvey and Gordon Hanka, “Capital Structure and Corporate Control: The
Effect of Antitakeover Statutes on Firm Leverage,” Journal of Finance 54 (1999): 519,
520; Paul A. Gompers, Joy L. Ishii, and Andrew Metrick, “Corporate Governance andEquity Prices,” Quarterly Journal of Economics 118 (2003): 107-155.
51 Paul A. Gompers, Joy L. Ishii, and Andrew Metrick, “Corporate Governance andEquity Prices,” Quarterly Journal of Economics 118 (2003): 107-155.
52 Kevin J. Murphy, “Explaining Executive Compensation: Managerial Power versus
the Perceived Cost of Stock Options,” University of Chicago Law Review 69 (2002): 853.

28

Relationship Between Power and Pay

Indeed, failure to close the deal is personally costly to the directors by
forcing them to return to the CEO selection stage. In comparison, thepersonal cost to directors of overpaying the incoming CEO is quite small,given their negligible equity interest in the firm. Finally, and importantly,
time limitations force directors to rely on information shaped and presented
by the company’s staff and compensation consultants, all of whom have
incentives to please the incoming CEO.
We agree with the central point of Murphy’s argument: althoughbargaining with outside CEO candidates still differs from true arm’s length
bargaining, such persons should have less power and influence over theirprospective pay than inside candidates. The managerial approach suggests
that, all else equal, managers with less power should obtain less favorable
arrangements.
However, in Murphy’s comparison between outside and inside CEO
candidates, all else is not equal. The managerial power approach does notsuggest that managerial power is the sole determinant of managerial pay.
Other characteristics, such as managers’ abilities and their bargaining
positions, will also affect executive compensation. Outside candidates, as agroup, are likely to differ from internal candidates.
Companies generally have an incentive to hire inside the firm if they
can find a suitable candidate. Insiders are preferred because of theirfamiliarity with the firm and perhaps also because of their existing ties to theboard. As a result, 75 percent to 80 percent of CEOs are hired from theinside.53 Because of boards’ reluctance to extend their search beyond a firm’s
ranks, the outside hires who are chosen are likely to be, on average, astronger group.
Finally, and importantly, outside hires are often already CEOs ofother firms, while inside candidates, by definition, are not. Those outside
candidates who are already CEOs are likely using their current positions to
extract rents, which the hiring firm will need to match in its compensation
offer. No such additional compensation is needed for an in-housepromotion. The managerial power approach thus predicts that attracting
outside hires will require offering higher pay.

53

Robert Parrino, “CEO Turnover and Outside Succession: A Cross-Sectional
Analysis,” Journal of Financial Economics 46 (1997): 168.

29

Relationship Between Power and Pay

The Pattern
A clear pattern emerges from the many empirical studies described inthis chapter. As predicted by the managerial power approach, there is a link
between managerial power and pay arrangements. The more power
managers have, the more favorable their compensation arrangements are.
Unlike most financial economists studying executive compensation,some of the researchers conducting these studies concluded that rent
extraction might occur where managers are especially powerful. Bertrand
and Mullainathan, for example, concluded that some “skimming” occurs incompanies without a 5 percent shareholder.54 These researchers appear tobelieve, however, that rent extraction does not occur in companies that dohave a such a shareholder.
In our view, once the connection between power and rents is
recognized, there is reason to believe that significant rent extraction will be
discernible even in companies with a 5 percent shareholder. To be sure,managers in such companies may have somewhat less power, and thus lessability to extract rents than managers in companies without a large external
shareholder. However, these managers still have considerable influence.
Consider cases in which a 5 percent or even a 10 percent external
shareholder is present. Such a shareholder may well have some influence,but not likely enough to oust management, given the power that managers
have to issue poison pills and control the proxy machinery. Executives insuch cases are likely to wield a substantial amount of power – and to extract
considerable rents.
Indeed, the compensation practices we discuss in the coming chaptersof this book – practices that, we show, reflect both power and camouflage –are not limited to companies without a 5 percent shareholder. These
practices occur even at companies with a significant blockholder or
substantial institutional investment. This evidence indicates that rent
extraction may well take place, even if to a reduced extent, in companies
where managers are relatively less powerful.

54

Marianne Bertrand, and Sendhil Mullianathan, “Agents With and Without
Principals,” American Economics Review 90 (2000): 205.

30

CHAPTER 7: MANAGERIAL INFLUENCE ON THE WAY OUT“It’s quite normal for a board to want the departing CEO to be afriend, not an adversary.”
Corporate lawyer interviewed by Fortune magazine, 2000
CEOs leaving a firm commonly receive substantial payments. Some ofthese departure-related payments are mandated by the CEO’s employment
contract. It is questionable whether promises of such payments, which
reduce the sensitivity of pay to performance, provide the CEO with good exante incentives. Our focus in this chapter, however, is not on contractually
determined severance payments but on gratuitous departure payments.
We call a departure payment or benefit “gratuitous” when it is notmandated under the CEO’s contract at the time he or she decides (or is
asked) to leave. These payments are made at the board’s discretion, over andabove anything required by the executive’s contract. As we discuss below,
such gratuitous payments have often been made (1) when CEOs are fired,(2) when they agree to have their companies acquired, and (3) when they
retire.
Gratuitous payments and benefits have taken a number of different
forms. These include forgiveness of loans, accelerated vesting of options andrestricted stock, increases in pension benefits (e.g., by “crediting” CEOs withadditional years of service), awards of lump sum cash payments, andpromises of consulting contracts that will provide the departing CEO with agenerous annual compensation for little or no work.
Most employees who are fired, pushed out, or retire receive whatever
benefits or payments they are contractually entitled to, and little else otherthan symbolic gifts. An employer in an arm’s length relationship with these
employees is very unlikely to give them large, uncontracted-for payments
upon termination of employment. The gratuitous departure payments
received by CEOs thus provide strong evidence that directors do not deal atarm’s length with CEOs, even in those rare cases where they push the CEO
out the door.

31

Influence on the Way Out

When CEOs Are Fired
As we noted earlier, boards rarely compel CEOs to resign. Because
many directors –- even nominally independent directors -- are likely to be
influenced by or loyal to the head of the firm, boards have been generally
reluctant to fire the CEO, especially one whose performance is at leastpassable. If the CEO’s performance is extremely poor, however, the need fora replacement becomes obvious to almost every observer. At that point,
directors may succumb to the pressure for change at the top.
In many cases, when a board replaces a CEO, it grants various
benefits to ease the executive’s exit. For example, when Mattel CEO Jill
Barad was forced out by her board, she had a $4.2 million loan forgiven andreceived an additional $3.3 million in cash to cover the tax liability arisingfrom the forgiveness of another loan. In addition, her unvested options wereallowed to vest automatically and to remain exercisable until the end of their
original terms. These gratuitous benefits accompanied the severance benefits
already guaranteed under her contract, which included a termination
payment of $26.4 million, annual retirement benefits of more than $700,000,
and other benefits. 55
Another example is the departure arrangement for Webvan CEO
George Shaheen. He resigned shortly before Webvan declared bankruptcy,
saying that he felt there was a need for “a different kind of an executive tolead the company.” He had a $6.7 million loan forgiven in exchange for$150,000 of Webvan stock, a benefit to which he had not been contractuallyentitled.56
Likewise, when Bank One CEO John McCoy was eased out of his job
in 1999 for poor performance, he met with his friends on the board tohammer out a separation agreement. The package included a $10.3 million
cash payment (in addition to $7.5 million in “special recognition” awards for1997 and 1998), plus a pension of $3 million annually beginning in 2001.57

55 Mattel proxy statement filed with SEC, April 28, 2000, pp. 24-25.
56 Joann S. Lublin, “As Their Companies Crumbled, Some CEO’s Got Big-Money
Payouts,” Wall St. Journal, 26 February 2002, p. B1.
57 Rakesh Khurana, Searching for a Corporate Savior: The Irrational Quest for CharismaticCEOs, Princeton, N.J.: Princeton University Press (2002), pp. 3-4.

32

Influence on the Way Out

Presumably, this arrangement made it easier for his friends on the board togo along with other board members’ desire to end his service.
It is difficult to reconcile such gratuitous payments with arm’s length
contracting. A board has authority to fire a CEO, paying only the severance
benefits required by contract. There appears to be no need to “bribe” apoorly performing CEO to step down. In addition, the “signal” sent by agratuitous departure payment will, if anything, only weaken the next CEO’s
incentive to perform.
On the other hand, such payments can readily be explained by theexistence of managerial power over the board. First, at least some directors
may be reluctant to fire a CEO, even for poor performance. To coax them toacquiesce, it may be necessary to induce the CEO to resign voluntarily or atleast to offer very generous terms. When such directors constitute a majorityof the board, the CEO cannot be replaced without a gratuitous departure
payment. Even as a minority, CEO-captured directors can make thereplacement process contentious and unpleasant for their colleagues. The
other directors may wish to avoid this by being generous to the departing
CEO. In either case, the gratuitous payment acts as a “bribe” to secure thecooperation, or reduce the resistance, of the CEO and his or her friends on
the board.
Second, even directors who are willing to replace their CEO may
prefer to sweeten their action with a gift. They may wish to alleviate thegeneral discomfort caused by the firing, to please or to console the CEO, toexpress their gratitude or friendship, or to make themselves more attractive,
or at least less threatening, to the CEOs of other companies who might
consider appointing them to their boards.
Underlying all of these explanations, the directors’ preference fortreating the CEO generously reflects a relationship that differs substantiallyfrom what is assumed to exist in the arm’s length model. The fact that thegratuitous goodbye payment is paid with shareholders’ money, at very little
cost to the directors themselves, makes the latter even more likely to act on
this preference.
It is important to note that, taking managerial power as given,gratuitous payments to fired CEOs may sometimes benefit shareholders.
Given the loyalty of many directors to the CEO, providing such a sweetener
may be necessary to obtain a board majority in favor of replacing a poor
performer. If so, the gratuitous departure payments benefit shareholders as

33

Influence on the Way Outlong as the CEO’s departure increases shareholder value by more than thecost of the payment. For our purposes, however, what is important is thatthe practice of gratuitous goodbye payments demonstrates the existence ofmanagerial power over the board.
When Companies Are AcquiredManagers of firms that are being acquired often receive acquisitionrelated benefits beyond those required by their employment contracts. These
gratuitous acquisition payments can take a variety of forms, such as special
cash payments or increases in the value of a previously negotiated golden
parachute. For example, the U.S. West board voted to boost CEO Sol
Trujillo’s golden parachute by an estimated $46 million shortly before thefirm was acquired by Qwest Communications.58 A study by Jay Hartzell, Eli
Ofek, and David Yermack reports that in 27 percent of acquisitions, thetarget board gives the CEO a special cash payment at the time it approves
the merger. In 12 percent of the cases where the target CEO has a golden
parachute, the target board increases the golden parachute payout at thetime it approves the merger.59
The two types of possible explanations for gratuitous acquisitionrelated payments parallel the explanations for gratuitous departure
payments. First, some directors may vote in favor of an acquisition that isgood for shareholders only if the CEO supports the deal or is at least treatedgenerously in the transition. When such directors constitute a majority,
sweetening the acquisition for the CEO may be necessary for the deal’s
success. And even when such directors are in the minority, the desire to
avoid a confrontation with them may be sufficient to induce the majority tosweeten the CEO’s acquisition-related departure.
Second, even if the entire board is willing to approve the acquisition
without special treatment for the CEO, the directors may still prefer anacquisition with a golden goodbye. They may wish to favor a CEO who isabout to be displaced in a takeover for the same reasons they may confer
benefits on a CEO who is being forced out by the board. They may be
58 Dan Sabbagh, “Orange Chief Received $70m in Two Severance Payments”, The
Times (London), 12 March 2003, p. 25.
59 Jay Hartzell, Eli Ofek, and David Yermack, “What’s In It for Me? CEOs WhoseFirms are Acquired.” Review of Financial Studies 17 (2004): 37-61.

34

Influence on the Way Out

swayed by loyalty, gratitude, or friendship. They may seek to alleviate theirown unease as they take control away from the CEO. And because thedirectors personally bear only a negligible fraction of the cost of such apayment, they see little reason not to make one.
Again, we wish to make clear that, taking managerial power as given,providing the target CEO with a gratuitous payment may well be beneficial
for shareholders. When such sweetening is necessary to obtain board
approval for a beneficial acquisition, shareholders are likely to be better off
with both the gratuitous payment and the acquisition than with neither.
Thus, accepting the reality of managers’ power and influence over theboard, prohibiting such payments is unlikely to be desirable. For our
purposes, however, the critical point is that these payments indicate theexistence of managerial power over directors.
Acquirer-Paid Sweeteners
In addition to benefits received from their own boards, target firmmanagers have often received substantial benefits from acquiring firms. An
acquirer, of course, is not contractually obligated to give anything to the
CEO of the firm being acquired. Nevertheless, such payments have often
been made. The reason is simple: compensating these managers allows theacquirer either to proceed with the acquisition or to complete the deal on
more favorable terms .
For example, when MCI was negotiating to be acquired by British
Telecommunications in 1996, MCI’s president, Timothy F. Price, arranged
for a $170 million “retention pool” for himself and other key employees aspart of his company's deal with BT.60 Interestingly, the retention pool’s
existence did not depend on the deal’s closing on the original agreed terms.
When BT reduced its offer by 20 percent, Price acquiesced, tellingshareholders the lower price was “a win-win arrangement for bothcompanies.” In the end, Worldcom outbid BT and acquired MCI, but only
after it, too, agreed to pay retention bonuses to MCI’s top executives.
A prominent mergers and acquisitions lawyer interviewed in the New
York Times has said about the phenomenon of the acquirer-paid sweetener:“I have had a number of situations where we've gone to management
60 The story told in this paragraph is more fully covered in Andrew Ross Sorkin,“Those Sweet Trips to the Merger Mall,” New York Times, 7 April 2002, sec. 3, p. 1.

35

Influence on the Way Out

looking to do a deal and been stopped at the door until a compensation
arrangement was signed, sealed, and delivered.” Another lawyer described
it this way: “Publicly, we have to call these things retention bonuses.
Privately, sometimes it’s the only way we would have got the deal done. It’sa kickback. And sometimes it’s my job to negotiate the kickback.”61Hartzell, Ofek, and Yermack investigate the phenomenon more
systematically. Examining 311 large-firm mergers completed between 1995
and 1997, they found that target CEOs accept lower acquisition premia when
the acquirer promises them a high-ranking managerial post after theacquisition.62 Another study by Julie Wulf found that, in 40 merger
negotiations between equal-sized companies during the 1990s, CEOs werewilling to trade higher acquisition premia for better managerial positions in
the merged firm.63
The willingness of acquirers to pay off target executives provides
further evidence of managerial power. Because CEOs can exert influence
over their boards, they can prevent the acceptance of offers that are
attractive to shareholders but harmful to the CEOs themselves. Conversely,
they can convince their boards to accept acquisition offers that are in theCEOs’ own interests, even if they are not in the best interests of theshareholders. Given this managerial power, treating CEOs of target firms
generously has often been in acquirers’ interest.
When CEOs Retire
Boards have often conferred large gratuitous benefits on CEOs whochoose, for example, to retire because of age, even when substantial
retirement payments are already specified by contract. For example, in 1999,
when the market was rising but Kodak’s stock price had fallen, Eastman
Kodak gave its retiring CEO a $2.5 million parting gift in recognition of thecompany’s financial performance.64 In 2000, GE’s CEO, Jack Welch, received
61 Ibid.
62 Jay Hartzell, Eli Ofek, and David Yermack, “What’s In It for Me? CEOs WhoseFirms are Acquired.” Review of Financial Studies 17 (2004): 37-61.
63 Julie Wulf, “Do CEO’s in Mergers Trade Power for Premium?: Evidence from
“Mergers of Equals,” Journal of Law, Economics and Organization, forthcoming 2004.
64 “Retired Kodak CEO Received 47% Boost in His Bonus in 1999,” Wall Street Journal,
14 March 2000, p. A8.

36

Influence on the Way Outa retirement gift of three million stock options, worth approximately $20
million.65
Golden retirement goodbyes sometimes have taken subtler forms.
One way to provide substantial additional value to retiring CEOs is to makelast-minute alterations to their retirement plans. For example, when CEO
Terrence Murray retired, FleetBoston Financial Corporation modified hisretirement plan to more than double the annual payouts: from 60 percent of
his average salary and bonus over the last five years to 60 percent of theaverage of the highest three years of taxable compensation between 1996
and 2000. Taxable compensation was defined to include not only salary andbonus, but also option-exercise gains, the proceeds of sales of vested
restricted shares, and the payout before retirement of some of Murray’sdeferred compensation. On the whole, the change boosted Murray’s annual
pension from an estimated $2.7 million to an estimated $5.8 million.66
Reacting to this change, a Prudential Securities banking analyst noted that
FleetBoston’s shares “underperformed the average bank for a decade…” andwondered: “What happened to [just] getting a gold watch?” 67
From the perspectives of the board and the retiring CEO, an
important advantage of boosting post-retirement benefits is that theadditional value given to the CEO is never reported in the firm’s public
filings. As we will discuss in Chapter eight, even though companies must
disclose in their SEC filings the formulae used to calculate post-retirement
benefits, they need not place a dollar value on these benefits. More
importantly, the benefits’ value is omitted from compensation tables, greatly
reducing the salience of the benefits to the media and other outside
observers. In the case of FleetBoston, the bank did not have to disclose (andin fact did not disclose) that the change in Murray’s retirement plan would
cost the company an additional $3.1 million each year. We know this only
because a newspaper took the unusual step of retaining an actuary to
calculate the figure. The camouflaging of retirement benefits in general is asubject to which we will return shortly.

65 Justin Fox, “The Amazing Stock Option Sleight of Hand,” Fortune, 25 June 2001, p.
86-92.
66 Joann S. Lublin, “Executive Pay under the Radar,” Wall St. Journal, 11 April 2002,
p.B7.
67 Ibid.

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Influence on the Way Out

Executives’ contracts generally provide them with substantial
retirement benefits. The practice of gratuitously augmenting these hefty
benefits when a CEO retires does not reflect arm’s length contracting. We
will later question whether companies should even be in the business ofproviding retirement benefits for executives, rather than letting them savefor retirement themselves. For now, however, we are focusing on gifts madeto CEOs on the way out. One could argue that the prospect of a retirement
gift might provide executives with an incentive to perform well during theirtenure. It is hard to see, however, why well-designed option and bonus
plans that reward excellent performance are not a better means of providing
incentives than retirement gifts given at the discretion of the board.
Large retirement gifts are easier to understand in light of the personal
relationships that directors have with departing CEOs. Directors may wish
to take this last opportunity to confer value on the CEO to honor theircollegial ties or express gratitude for what the CEO has done for them.
According to one compensation consultant, the consulting contracts
frequently given to retiring CEOs “often have more to do with favors forpast deeds” than with future services.68 And because the cost of these extra
payments is generally borne by shareholders, there is little real cost to
directors in making such personally satisfying gestures.
It’s Now or NeverIn each of the above contexts –- when CEOs are fired, when the firm isacquired, or when CEOs retire -- there is a common factor enhancing thewillingness of the CEO to request gratuitous payments and increasing thewillingness of the board to provide them. That factor is the end-game natureof the situation. In each case, the CEO leaves the company. And in one
situation – acquisition of the firm – the directors are likely to leave thecompany as well. For this reason, they have little to lose.
As long as companies are expected to continue to exist independently,
their CEOs know they will be able to use their influence to get favorable
future treatment from their boards. At the same time, directors know they
can reward their CEOs in the future. But impending change – whether
resulting from forced resignation, acquisition, or voluntary retirement –68 Gary Strauss, “CEO’s Cash In after Tenure,” USA Today, 25 April 2002, Money
Section, p. B1.

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Influence on the Way Out

presents both CEOs and boards with a “now or never” choice. CEOs haveevery reason to extract rents aggressively, cashing in whatever friendshipand loyalty chips they have accumulated with directors. Likewise, directors
know that this is their last opportunity to confer substantial financial
benefits on their CEO at others’ expense.
In addition, because each of these cases represents the last period ofplay for a CEO, the potential outrage costs of accepting a large package ofadditional benefits are likely to be low. When the firm is being acquired andthe end of the company’s independent existence is near, the directors, too,have little reason to be concerned about shareholder anger. Additionally, theacquirer usually pays a substantial premium over the pre-offer price,
thereby conferring benefits on shareholders. All these factors likely lead toless shareholder outrage than might exist under other circumstances.

39

CHAPTER 8: RETIREMENT BENEFITS
Camouflage is an important element of the managerial power
approach to executive pay. Compensation plan designers have an incentive
to hide or make less salient the total value of an executive’s compensation
package. They also have an incentive to disguise the extent to which theform of compensation deviates from what best serves shareholders’interests. In this chapter and the next, we discuss various practices that haveenabled plan designers to camouflage the amount of executive pay, and we
start by discussing in this chapter the practice of conveying substantial value
to executives after they retire.
As disclosure requirements for executive salaries, bonuses, and longterm compensation have become stricter, firms have increasingly turned topost-retirement payments and benefits as ways to compensate managers.
These methods enable firms to provide a substantial amount of
performance-insensitive value in a less salient form than, say, salary. Below
we discuss four channels through which companies have been providing
post-retirement value to executives: guaranteed retirement pensions,deferred compensation, post-retirement perks, and guaranteed consulting
fees.
Before discussing each channel in detail, it is worth highlighting two
attributes that they all share. First, these arrangements differ substantiallyfrom those that firms elect to provide to other employees. Although firms
often provide pensions and deferred compensation to lower-level
employees, they do so only to the extent that these arrangements receive a
tax subsidy. This pattern suggests that, absent such a subsidy, pensions anddeferred compensation are generally not efficient—and yet thearrangements provided to executives do not enjoy similar tax advantages.
Furthermore, consistent with economists’ belief that in-kind benefits are
inefficient, firms do not generally provide retired employees with coveragefor specified consumption expenses. Such benefits are, however, given tohigh-level executives. And although firms occasionally use retired
employees as consultants when the need arises, they generally do notguarantee lifetime consulting fees to any employees other than executives.
The second shared attribute of these various retirement payments isthat they all provide a way to obscure large amounts of performance-

40Retirement Benefits

decoupled compensation. As we shall see, firms do not have to disclose thevalue transferred to executives through these channels in the same way that
other forms of compensation -- such as salary, bonuses, and stock options –must be disclosed. Hence we use the term “stealth compensation.”69 Indeed,
the dollar figures used by the media in reporting compensation levels, andby financial economists in their studies, usually do not include the large
value provided to executives via these various retirement benefits.
Retirement Pensions
Many employees are covered by pension plans that provide payments
to workers after retirement. At first glance, it seems only natural for firms toprovide such benefits to their executives. A closer look, however, raises
serious questions about whether the extensive use of executive pensions as aform of compensation reflects arm’s length bargaining.
Differences from Regular Pensions
Most of the pension plans used for firm employees are designed to be“qualified” for favorable tax treatment. The firm gets a current deduction forcontributing to a qualified plan for employees: the same deduction it would
have taken had it paid the amount of the contribution to workers in the formof salary. Workers, however, do not pay income taxes on the pension money
until after they retire and begin receiving payouts from the plan. In themeantime, the funds invested by the firm grow tax-free. Neither the firm nor
the employees must pay any taxes while the fund’s investments increase invalue. Thus, the plans provide a tax benefit to employees at no cost to thefirm.70

69

We borrow the term “stealth compensation” from Robert Monks, who used it torefer to executives’ stock option compensation because that form of payment is not
expensed on the firm’s income statement. Robert A.G. Monks, The Emperor'sNightingale: Restoring the Integrity of the Corporation in the Age of Shareholder Activism(Boston: Addison-Wesley Pub Co, 1999), 59-62.
70 To illustrate how the tax subsidy provided to a qualified plan operates, consider thefollowing examples involving a hypothetical firm and employee. Assume both face a
40 percent tax rate on all of their income, including capital gains. And assume that both41

Retirement Benefits

Given the opportunity, boards might well prefer to offer executives
qualified retirement plans. A qualified pension plan, however, can use only
about $200,000 of annual compensation as the basis for determining benefits
under the plan. For example, a plan that promises to pay all retirees,
annually, 50 percent of the compensation earned during their last year ofservice cannot pay a retired executive more than $100,000 annually, even if
the executive earned $1 million of compensation during that final year. As aresult, firms cannot use qualified plans to provide executives with pensions
that are similar in size to their annual compensation. For this reason, most of
the pension benefits that firms provide to executives come from nonqualified “supplemental” executive retirement pensions (known as“SERPs”).71
SERPs differ from typical qualified pension plans in two critical ways.
First, they do not receive the favorable tax treatment enjoyed by qualified
plans. Unlike the case of a qualified plan, no investment income goesuntaxed under a SERP. The company pays taxes on the income it must
generate in order to pay the executive in retirement. If the money had been
are able to earn, between the pre-retirement period and retirement period, a pre-tax
return of 100 percent on their investments.
Example 1: The employee invests for retirement outside a qualified plan. Suppose thatthe firm pays the employee $100 in the pre-retirement period. The firm deducts $100
from its taxable income, reducing its tax liability by $40. The employee pays $40 intaxes, takes the after-tax income of $60, and invests it. The $60 grows to $120 by theretirement period – a gain of $60. This $60 gain triggers a tax liability of $24 (40 percent
of $60), leaving the employee with $96 ($60 + $36) when he or she retires.
Example 2: The firm invests for the employee’s retirement under a qualified plan. Now
suppose the firm contributes the $100 to a qualified pension plan in the pre-retirement
period. The firm again deducts $100 from its taxable income, reducing its tax liability
by $40. The $100 grows to $200 by the time of the employee’s retirement – a gain of$100. The $200 is distributed to the employee, who pays a tax of $80 (40 percent of$200), leaving the employee with $120 -- $24 more than if the employee had received$100 from the firm in the pre-retirement period and saved for his or her own
retirement. The gain to the employee does not come at the expense of the employer: inboth examples, the employer incurs an after-tax cost of $60 in the pre-retirement
period. It pays the employee or contributes to the employee’s qualified plan $100, andhas its tax liability reduced by $40.
71 Clark Bardes Consulting reports that almost 80 percent of responding firms use
SERPs. Clark Bardes Consulting, “Executive Benefits: A Survey of Current Trends:
2001 Results,” p. 33.

42

Retirement Benefits

distributed as salary, on the other hand, the executive who invested themoney for retirement would have to pay taxes on any income generated.
Thus, the effect of the SERP is to shift some of the executive’s tax burden to
the firm.72
If the employee and the firm are subject to the same tax rate and areable to earn the same pre-tax rate of return on their investments, a SERP
cannot reduce the amount of taxes paid by the parties. For every dollar theemployee’s tax burden is reduced, the firm’s tax burden is increased by one
dollar. Unlike a qualified plan, the SERP provides no tax efficiency benefit
to the parties.73
72

A firm can shelter from taxation the investment income on funds set aside forfinancing executive pensions by investing these funds in life insurance policies on the
lives of its executives and other employees. This tax-sheltering mechanism, however,involves significant costs, which are borne by the company rather than the executive.
If, on the other hand, the executive received the funds to begin with, he or she would
also be able to shelter the investment returns from taxation by purchasing a variableannuity, at no cost to the company.
73 To illustrate the effect of a SERP on the tax burdens of the parties, consider thefollowing example and explanation, which builds on the examples provided in note 2.
Assume again that both the firm and the executive face a 40 percent tax rate on all of
their income, including capital gains. And assume that both are able to earn, between
the pre-retirement and retirement periods, a pre-tax return of 100 percent on theirinvestments.
Example 3: The firm invests for the executive’s retirement under a nonqualified plan.
Suppose a firm seeks to use a SERP to give an executive the same retirement paymentthat it gives the employee in example 2 using a qualified plan. As in the case of theemployee, the firm sets aside $100 to fund the executive’s pension, which grows to$200 by the time the executive retires. The $200 is distributed to the executive, who,
like the employee, pays a 40 percent tax on the retirement distribution – a tax of $80.
This leaves the executive, like the employee in example 2, with $120, $24 more than theemployee in example 1 made.
Now let us consider the effect of the SERP on the firm. In examples 1 and 2, discussed
in note 2, the firm reduces its tax liability by $40 in the pre-retirement period when it
pays the worker $100 or contributes $100 to the worker’s qualified pension plan. In
example 3, the firm reduces its tax liability by $80 in the retirement period when it pays
the executive $200. However, the firm must add to its taxable income in the retirement
period the $100 gain on the funds it previously invested for the executive’s retirement,
and this increases the firm’s tax liability in the retirement period by $40. The net effectof the $200 payment to the executive and the $100 gain is to reduce the firm’s tax
liability by $40 during the retirement period.

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Retirement Benefits

In reality, of course, the situation is more complicated. 74 In manycases the total tax liability faced by the parties will be affected by whether
the executive or the firm saves for the executive’s retirement. Even if thefirm and the executive are able to earn the same return on their investments,
they may face different tax rates. Suppose, for example, that an executive
investing his or her own funds for retirement in the stock market, paying a
low long-term capital gains tax rate of 15 percent, while the firm pays taxes
on the income generated for the executive’s retirement at the highest
corporate tax rate of 35 percent. In such a case, shifting retirement savings
from the executive to the firm would be tax inefficient and reduce theamount of value available to the two parties. On the other hand, if the firm
had no taxable earnings and was not expected to pay taxes for aconsiderable amount of time, the reverse might be true: shifting retirementsavings from the executive to the firm might be tax efficient. 75
Similarly, even if the firm and the executive face the same tax rate, theinvestment returns available to the firm may be higher than those available
to the executive. For example, firms having difficulty raising capital may
enjoy a higher expected rate of return on new investments than the market
Had the firm reduced its tax liability by $40 in the pre-retirement period, rather thanduring the retirement period, it could have invested the $40 and earned a pre-tax
return of $40 (100 percent ) by the retirement period. That $40 would also have beentaxed at 40 percent, leaving the firm with $64. But by reducing its tax liability in theretirement period, the firm has only an extra $40, $24 less. The firm is thus worse off
than in example 2, where it received the same $40 reduction in its tax liability in the
pre-retirement period. The $24 gain to the executive from the use of a nonqualified
plan designed to put the executive in the same position as an employee under aqualified retirement plan comes at the expense of the firm.
74 For an explanation of the tax effects of using arrangements such as SERPs to defer
compensation under various scenarios, see Myron S. Scholes, Mark A. Wolfson, Merle
Erickson, Edward L. Mayview, and Terry Shevlin, Taxes and Business Strategy: A
Planning Approach, 2nd edition (Upper Saddle River, N.J., Prentice Hall., 2002), pp. 18185.
75 The tax efficiency of a SERP will also be affected by expected changes in the firm’s(or the executive’s) tax rate change over time. For example, if the firm is losing money
and thus unable to get a current tax benefit by deducting executive compensation in
the current period, but is expected to be subject to a higher tax rate in the future,deferring an executive’s compensation will , be tax efficient, all else being equal.

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Retirement Benefits

generally. (This is unlikely to be the case for companies with easy access tocapital, as such companies are unlikely to have unutilized investments withreturns much higher than the market.) If the firm has better investment
opportunities, having it invest for the executive’s retirement will be efficientfor both parties, even if their tax rates are identical.
However, there is no reason to believe that, absent a tax subsidy, it isgenerally efficient to have the firm save for the executive. On the contrary,
there are good reasons to think that it is inefficient for many firms to save for
their executives’ retirement, given individuals’ low long-term capital gains
tax rate. It is telling that firms providing SERPS to executives do not offer
nonqualified retirement plans to other employees. Consider the case where
it is efficient for a firm to provide a SERP to its executives because the firmhas better investment opportunities than they do. In such a case, it should
also be efficient for the firm to provide nonqualified retirement to its nonexecutive employees who supplement their qualified pensions with personal
retirement savings. Yet firms rarely if ever do so. That fact suggests that
there is little benefit to shifting employee retirement savings from theemployee to the firm, absent the tax subsidy provided to qualified plans. Yet
in 2002 more than 70 percent of firms provided non-qualified SERPs to their
executives. 76 The second important difference between executive SERPs andqualified pension plans for non-executive employees concerns the risk borneby the firm and by the participant. Qualified pension plans offered to lowerlevel employees are usually based on a defined contribution. The firm commits
to contribute a specified amount each year. The value available to an
employee upon retirement depends upon the performance of the plan’sinvestments. The risk of poor investment performance falls entirely on theworker.
In contrast, SERPs are defined benefit plans, which guarantee fixed
payments to the executive for life. All of the CEOs in the S&P ExecuComp
database have defined benefit plans.77 These plans shift the risk entirely tothe firm and its shareholders. No matter how poorly the firm and its

76 Clark Bardes Consulting, “Executive Benefits: A Survey of Current Trends: 2003
Results,” p. 26.
77 Steven Balsam, An Introduction to Executive Compensation (San Diego: Academic
Press, 2002): 175.

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Retirement Benefits

investments perform, the executive is guaranteed a lifelong stream of
payments.
Given that arm’s length negotiations with most employees lead todefined contribution arrangements, why should arm’s length bargaining
with executives yield such a different result? If anything, defined benefit
plans should be more valuable to regular employees and thus a form ofcompensation that is more efficient for these workers than it is for
executives.
Unlike most executives, ordinary employees are unlikely toaccumulate substantial wealth over their lifetimes. They are likely to be
more dependent on their pensions to meet their financial needs in retirement
and less able to bear the investment risks associated with defined
contribution plans. Executives faced with defined contribution plans, on theother hand, could easily insure themselves against poor investment
performance by using some of their already high salaries and option-based
compensation to buy fixed annuities that would provide them withguaranteed payments. If only one of the two groups could receive defined
benefit plans, arm’s length contracting would predict that employees, notexecutives, would get them.
Camouflage Benefits
Although the efficiency benefits of providing executives with definedbenefit SERPs is far from clear, such plans do considerably reduce thevisibility of a substantial amount of performance-insensitive executive
compensation.
In their annual public filings, firms must publish compensation tables
indicating the dollar value of different forms of compensation received by
the current CEO and the four other most highly paid executives of the firm.
The numbers in these tables are the most visible indicators of executive
compensation in public firms. They are easily accessible to the media andothers reading the public filings. Indeed, the standard databases of executive
compensation, which are used by both financial economists andcompensation consultants, are based on these numbers.
Although deposits to a defined contribution plan must be reported in
the compensation tables, the increase in the present value of an executive’s
defined benefit plan is largely hidden from view: firms are not required to46

Retirement Benefits

include that data. Furthermore, because the executive is no longer an officerof the firm when the pension payments begin, his or her compensation neednot be included in the published tables then, either. Thus, the value of an
executive’s pension never appears in the place where the media andresearchers collect most of their information about executive compensation.
And because the value of an executive’s pension payouts is obscured, theperformance-insensitivity of such payments also gets little notice.
Consider a situation in which a CEO serves a company for ten years
and then receives a payment annually, for life, that almost equals thecompensation earned during his or her last year of service. In such a case,the total value of the pension payments may in the end exceed the value ofthe salary payments made during the CEO’s actual tenure. Unlike the salaryamounts, however, the pension values will never appear in the firm’s public
compensation tables.
For example, when IBM CEO Louis Gerstner retired after about nine
years of service, he was entitled to a $1,140,000 annual pension beginning atage 60. In addition, he received a SERP plan that, according to the formulaprovided in IBM’s proxy filings, would pay out over $2 million per year
after he retired.78 If Gerstner were to receive these two pensions for 20 years,
their $60 million total would easily dwarf the approximately $18 million insalary he received while CEO. The retirement sums will comprise the largest
single component of his fixed compensation, which is completely decoupledfrom company performance. GE’s former CEO, Jack Welch, left his firm withan annual pension of almost $10 million.79 Given his age, he is likely toreceive more than $100 million in retirement payments, none of which will
ever appear in the firm’s compensation tables.
Not surprisingly, SERP plans are designed and marketed specificallyas ways to increase compensation “off the radar screen of shareholders.”80
Indeed, according to media reports, some directors have voted to adopt

78See
http://www.aspanet.org/publications/COLUMNS/archives/2003/07/thayer0703.ht
ml (last visited March 15, 2004).
79 Paul Hodgson, “Golden Parachutes and Cushioned Landings,” The Corporate
Library (February 2003), p. 14.
80 Cynthia Richson, quoted in Liz Pulliam Weston, “Despite Recession, Perks for Top
Executives Grow,” Los Angeles Times, 1 February 2002, p. A1.

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Retirement Benefits

SERPs only after being reassured that the amounts involved do not have tobe reported to the public.81
To be sure, although neither the increase in value of the SERP plan
before retirement nor the amount of payments after retirement appears in
the compensation tables, the existence of SERPs and the formulae underwhich payouts are made must be disclosed in the firm’s SEC filings.82 But it
is difficult for anyone without actuarial or financial training to estimate
accurately the value – and thus the cost to the company – of these future
payments.83 As noted above, firms are not required to supply, and usually
do not provide, any estimate of the value of a particular executive’s defined
benefit pension plan.
Indeed, it is often difficult even to figure out the total SERP liability ofa firm with respect to its executives as a group. A firm must report only one
figure: the sum of the liabilities associated with all of its plans that are“unfunded” or “underfunded” (i.e., plans for which the firm does not haveassets set aside to cover the plans’ liabilities fully).84 The Financial
Accounting Standards Board (FASB) does not require that liabilities
associated with SERPs be itemized separately.85 Thus, firms can simply
report one number that represents all the liabilities associated with
underfunded qualified plans and unfunded SERPs.

81 See Glenn Howatt, “HealthPartners Ex-CEO Reaped Board’s Favors: Secret Deals
Contributed to $5.5 million Package,” Star Tribune (Minneapolis), 17 January 2003, p.
A1. The Star Tribune reported that the HealthPartners board adopted a SERP for the
CEO “after receiving assurances that the supplemental retirement plan wouldn’t haveto be reported to the public…” and “rejecting a suggestion that awards in the plan betied to company performance.”
82 In addition, firms are required to file a letter with the Labor Department indicating
the number of executive pension plans and the number of participants. However, not
all firms comply with this requirement. Ellen E. Schultz, “Big Send-Off: As Firms Pare
Pensions for Most, They Boost Those for Executives,” Wall Street Journal, 20 June 2001,
p.A1.
83 See Joann S. Lublin, “Executive Pay under the Radar,” Wall St. Journal, 11 April
2002, p.B7; Anne Fisher, “Proxies: The Treasure Is Still Buried,” Fortune, 8 June 1998, p.
285.
84 See Financial Accounting Standard no. 132 (revised 2003).
85 See Financial Accounting Standard no. 87 (1985).

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Retirement Benefits

Although they are not required to do so, some firms do report the
total obligations arising under SERPs. These figures can be staggering. In
2000, for example, GE reported a $1.13 billion pension liability forexecutives.86 Unfortunately, GE did not report what portion of this amount
was due specifically to its CEO and other top executives. Most companies,
however, do not even break down pension liabilities into separate categories
for executives and other employees.
Before concluding our discussion of retirement plans, it is worth
noting at least one way in which executives’ plans may not be asadvantageous to their beneficiaries, relative to the plans of lower-level
employees. Firms using qualified plans are required, as a condition forfavorable tax treatment, to set aside assets to ensure that they can pay their
liabilities under the plans. Given that executives’ SERP plans would not
qualify for the favorable tax treatment even if they were so funded, firms do
not bother funding SERP plans. Executives’ retirement benefits are thus atgreater risk of nonpayment than the benefits of ordinary workers—andCongress is considering legislation that would make it difficult for firms toshelter executives from this risk.
In the past, however, firms facing financial problems often purchased
insurance policies that guaranteed payment of executive retirement benefits,
simply gave the money to the executive or a designated trust, or took othersteps to guarantee the benefits against insolvency.87 Delta Airlines, forexample, set up an executive-protecting arrangement shortly after
September 11, 2001, when it appeared that terrorist attacks could ruin theairline industry.88 Although putting the money beyond the reach of thefirm’s creditors triggers a tax liability for the executive, firms often “gross
86 Ellen E. Schultz, “Big Send-Off: As Firms Pare Pensions for Most, They Boost Those
for Executives,” Wall St. Journal, 20 June 2001, p. A1.
87 Clark Bardes Consulting reports that 86 percent of firms responding to a survey use
security devices to protect SERPs to the greatest extent possible. See Clark Bardes
Consulting, “Executive Benefits: A Survey of Current Trends, 2001 Results,” p. 33; Ron
Suskind, “More Executives Get Pension Guarantees to Protect against Takeovers,
Failures,” Wall St. Journal, 5 July 1991, p. B1; Theo Francis and Ellen Schultz, “AsWorkers Face Pension Cuts, Executives Get Rescued,” Wall Street Journal, 3 April 2003,
p. C1.
88 Theo Francis and Ellen Schultz, “As Workers Face Pension Cuts, Executives Get
Rescued,” Wall Street Journal, 3 April 2003, p. C1.

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up” the payment to cover part or all of that liability.89 It was reported in 1991
that approximately 50 major companies had set up fully guaranteed
executive pension plans.90 This practice may have been much morewidespread; many firms, fearing criticism that they are insulating managers
from the effects of their own failures, fail to announce the existence of suchguarantees.91
Deferred Compensation
Deferred compensation is a second technique used to transfer large
amounts of mostly performance-insensitive value to executives without
attracting much shareholder attention. Many executives choose, or are
sometimes even required, to defer receipt of compensation until some futuredate. In the meantime, the deferred compensation “builds” according to a
formula devised by the firm. Executives do not pay taxes on the originalcompensation or on the accumulated increase until they receive payment,
which often occurs after they leave the company. At that time, the firm takes
a tax deduction for the amount paid. Most large companies have plans of
this kind.92
Deferred compensation plans differ. Some firms require thatmanagers receiving salary in excess of $1 million, which would otherwise be
nondeductible under Section 162(m), defer the excess. Other firms havepurely elective plans. Some arrangements permit deferral of salary only;
others also allow deferral of long-term incentive compensation and gains
from the exercise of stock options or the sale of restricted stock. Companies
frequently provide matching contributions, with the amounts varying from89 Theo Francis and Ellen Schultz, “As Workers Face Pension Cuts, Executives Get
Rescued,” Wall Street Journal, 3 April 2003, p. C1.
90 See Ron Suskind, “More Executives Get Pension Guarantees to Protect against
Takeovers, Failures,” Wall St. Journal, 5 July 1991, p. B1.
91 See Ron Suskind, “More Executives Get Pension Guarantees to Protect against
Takeovers, Failures,” Wall St. Journal, 5 July 1991, p. B1.
92 Clark Bardes Consulting reports that close to 93 percent of firms responding to asurvey say they had such plans in 2002. Clark Bardes Consulting, “Executive Benefits:
A Survey of Current Trends: 2003 Results” p.2.

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Retirement Benefits

firm to firm. At some companies, contributions are awarded at the board’s
discretion. At others, they are determined by formulae.93
Plans also differ in how the deferred compensation is “invested,” i.e.,
how the amount owed to the executive at the end of the deferral period isdetermined. Many companies provide a guaranteed rate of return (or aguaranteed minimum rate) on the funds.94 Firms grant extra benefits to
executives by providing rates of return that are higher than the market rate.
For example, in 2001, at a time when one-year Treasury bills offered returnsof 3.39 percent to 4.63 percent, both GE and Enron guaranteed executives a
12 percent rate of return. Other firms offer a market return plus a premium.
For example, Lucent has offered the return on the ten-year Treasury bill,plus 5 percent. 95
Difference from 401(k) Plans
Deferred compensation arrangements appear analogous to thefamiliar 401(k) plans used by many employees. But, as in the case of SERPs
and the qualified retirement plans offered to lower-level employees, there
are some important differences.
The 401(k) plans give workers an opportunity to put money indesignated investment instruments; whatever the investments, employees
get the same pre-tax returns they would receive by investing in similar
instruments outside the 401(k) plan. In contrast, executives’ deferredcompensation arrangements often provide higher returns than thoseavailable in the market.
In addition, 401(k) plans are given a tax subsidy, while executive
deferred compensation plans are not. Under a 401(k) plan, a fraction of theemployee’s salary is placed in a tax-deferred account. The firm may also
93 For example, when Sears Roebuck & Co. executives postpone bonuses and longterm incentive pay, they receive an additional contribution equal to 20 percent of theamount deferred. Ellen E. Schultz and Theo Francis, “Well-Hidden Perk Means Big
Money for Top Executives,” Wall St. Journal, 11 October 2002, p. A1, A9.
94 Liz Pulliam Winston, “Despite Recession, Perks for Top Executives Grow,” L.A.
Times, 1 February 2002, p. A1.
95 See Joann S. Lublin, “Executive Pay under the Radar,” Wall St. Journal, 11 April
2002, p.B7.

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Retirement Benefits

make a separate contribution to the account. As in a qualified retirement
arrangement, the funds are invested and grow tax-free. Neither the firm nor
the employee pays taxes on the income and capital gain generated in theaccount. Employees do not pay taxes on the contributions or the increase
until they withdraw the funds. The employer, on the other hand, gets a
deduction for both its contribution and the employee’s contribution to the401(k) plan. By placing current compensation in a 401(k) account, theemployee gains the benefit of tax deferral without the employer’s loss of atax deduction.96
Firms could provide deferred compensation to executives through401(k) plans. However, there are limits on how much money can becontributed annually to a 401(k) account. For the tax year 2004, employees
covered by such a plan ordinarily cannot defer more than $13,000 ofcompensation.97 In order to provide executives with amounts exceeding thislimit, firms implement deferred-compensation arrangements outside the96

To illustrate how the tax subsidy provided to a 401(k) operates, consider thefollowing examples involving a hypothetical firm and employee. As in the SERP
examples found in note 2 (examples 1 and 2), assume that both the firm and theemployee face a 40 percent tax rate on all of their income. Assume also that both areable to earn, between the pre-retirement and retirement periods, a pre-tax return of 100
percent on their investments.
Example 4: The employee saves outside the 401(k) plan. Suppose the firm pays theemployee $100 in the pre-retirement period. The firm deducts $100 from its taxable
income, reducing its tax liability by $40. The employee pays $40 in taxes, and invests
the after-tax income of $60 in an ordinary, non-qualified investment account. By theretirement period, the $60 grows to $120 – a gain of $60. The employee pays a tax of$24 on the gain (40 percent of $60), leading to an after-tax gain of $36. The employee isthus able to withdraw a total of $96 ($60 + $36).
Example 5: The employee saves under a 401(k) plan. Now suppose that the employee
contributes $100 of compensation income to a 401(k) account. The firm again deducts$100 from its taxable income, reducing its tax liability by $40. The $100 grows to $200
by the time the employee withdraws the funds from the 401(k) account. The employee
pays a tax of $80 (40 percent of $200), leaving the employee with $120 -- $24 more thanin example 4, where the employee received $100 from the firm in the pre-retirement
period and saved the money outside of the 401(k) plan. The $24 gain to the employee
does not come at the expense of the employer.: In both example 4 and example 5, theemployer pays the employee $100 in the pre-retirement period, thereby reducing its
taxable income by $100 and its tax liability by $40.
97 Internal Revenue Code, section 402(g)(1)(B).

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tax-advantaged framework of 401(k) plans. Executives’ deferredcompensation is therefore not based solely, or even primarily, on 401(k)plans.
Rather than contribute a portion of the executive’s compensation o an
account where the investment grows tax-free, the firm simply withholds
part of the executive’s pay and credits the executive each year with a prespecified return on the money, allowing it to “grow” over time. The
withheld compensation, along with the appreciation credited to it by thefirm, is paid to the executive at a later date.
The company pays taxes on the income it must generate in order to
pay the executive the promised buildup of the deferred compensation. If, on
the other hand, the deferred compensation had been distributed when it was
originally owed the executive, the executive would have invested the money
and paid taxes on any income generated. Thus, as in the case of a SERP, theeffect of executive deferred compensation is to shift some of the executive’s
tax burden to the firm.98
If the employee and the firm are subject to the same tax rate and areable to earn the same pre-tax rate of return on their investments, executive
deferred compensation, like a SERP, cannot reduce the parties’ joint tax
burden. While every dollar of deferred compensation lowers the executive’staxes, it boosts the firm’s taxes by one dollar. Like a SERP, and unlike
qualified 401(k) and retirement plans, deferred compensation plans for
executives provide no tax efficiency benefit.99
98 A firm can shelter from taxation investment income on funds set aside for financing
executive pensions by investing these funds in life insurance policies on the lives of its
executives and other employees, but this will impose other costs on the firm. See note
4.
99 To illustrate the effect of executive deferred compensation arrangements on the tax
burdens of the parties, consider the following example and explanation, which refer toexamples 4 and 5 provided in note 29.
Example 6: The firm offers the executive deferred compensation outside of a 401(k)plan. Assume, as in examples 4 and 5, that both the firm and the executive face a 40
percent tax rate on all of their income, including capital gains. And assume that bothare able to earn, between the pre-retirement and retirement periods, a pre-tax return of
100 percent on their investments.
Suppose a firm seeks to use deferred compensation to give an executive the same (100percent) return the firm provides the employee in example 5 using a 401(k) plan. As in
the case of the employee, the firm sets aside $100, which grows to $200 by the time the53Retirement Benefits

As in the case of SERPs, of course, there will be many cases in which
deferred compensation outside 401(k) plans can increase or reduce the total
amount of value available to the executive and the firm.100 Even if the firm
and the executive are able to earn the same return, they may face different
tax rates. If the firm faces a lower rate than the executive, it might well beefficient, from the perspective of both parties, for the firm to defer
compensation and bear the (small) tax cost. Even if the firm and theexecutive face the same tax rate, the investment returns available to the firm
may be higher than those available to the executive (although, as we notedin our discussion of SERPs, this is unlikely to be the case for companies witheasy access to capital). If the firm does have better investment opportunities,

executive withdraws the deferred compensation and the buildup credited to thedesignated amount of deferred compensation. The $200 is distributed to the executive.
Like the employee, the executive pays 40 percent tax on the retirement distribution – a
tax of $80. This leaves the executive, like the employee in example 5, with $120, $24
more than the employee saving on his own ended up with in example 4.
Now let us consider the effect of the executive’s deferred compensation arrangementon the firm. In examples 4 and 5, the firm reduces its tax liability by $40 in the preretirement period when it pays the worker $100 or contributes $100 to the worker’s
qualified pension plan. In example 6, the firm reduces its tax liability by $80 in theretirement period when it pays the executive $200. However, the firm must add to its
taxable income in the retirement period the $100 generated to boost the executive’s
withdrawal payout from $100 to $200—which in turn increases the firm’s tax liability
by $40. The net effect of the $100 gain and the $200 payment to the executive is to
reduce the firm’s tax liability by $40 during the retirement period. The firm is thus
worse off than in example 2, where it received the same reduction in its tax liability inthe pre-retirement period.
Had the firm reduced its tax liability by $40 in the earlier period, it could haveinvested the $40 and earned a pre-tax return of $40 (100 percent) by the retirement
period. The $40 would have been taxed at 40 percent, leaving the firm with $64. By
reducing its tax liability in the retirement period, the firm has only an extra $40, $24
less. Thus, the $24 gain to the executive from the use of a deferred compensation
arrangement designed to put the executive in the same position as an employee undera qualified 401(k) comes at the expense of the firm.
100 For an explanation of the tax effects of deferred compensation under various
scenarios, see Myron S. Scholes, Mark A. Wolfson, Merle Erickson, Edward L.
Mayview, and Terry Shevlin, Taxes and Business Strategy: A Planning Approach, 2ndedition (Upper Saddle River, N.J., Prentice Hall., 2002), pp. 181-85.

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having it invest for the executive’s retirement may yield a larger retirement
pie, even if their tax rates are identical.
As we noted in our examination of SERPs, however, there is no reason
to believe that, absent the tax subsidy provided by qualified plans, there is
generally a benefit to the parties if the firm defers the executive’scompensation. In many cases, the tax burden on the firm is greater than thetax benefit to the executive, thus increasing the total tax the two parties pay
to the government. Consider, for example, the case in which an executive is
promised a return that is linked to a stock index. If the executive invests themoney in shares of a stock index fund, the gains will be taxed at the longterm federal capital gains rate, which in the highest bracket is 15 percent (asof 2003101). If, instead, the firm invests the money – in those shares, otherinvestments, or its own business – the gains could be taxed at the highest
marginal rate for firms, 35 percent.102
Yet 90 percent of firms provide such arrangements to their executives.
103
As in the case of SERPs, there are good reasons to think it inefficient for
many of these firms to being do so. It is curious that firms offering
nonqualified deferred compensation arrangements to executives do not offer
such nonqualified plans to other employees. After all, if nonqualified
deferred compensation is efficient for certain executives and firms because
the firms have better investment opportunities than the executives,
nonqualified deferred compensation should also be efficient for the nonexecutive employees of these firms, who supplement their 401(k) plans –101 IRC. Sec. 1 (2003).
102 IRC. Sec. 11 (2003). As in the case of SERPs, a firm can reduce the tax cost ofdeferred compensation by using company-owned life insurance. Recall that under thisstrategy, the firm uses after-tax dollars to buy insurance on the lives of its executives
and other employees. Part of the premium is invested, increasing the “cash value” ofthe policy. The policy is then cashed out when funds are needed to pay deferredcompensation. The tax savings come from life insurance policies’ capacity to shelter
from taxes the buildup of the cash value. However, the use of a life insurance policy to
avoid taxes gives rise to transaction costs. A 1996 study found that 70 percent of the
1,000 largest firms did not use insurance for funding deferred compensation, whichsuggests that these costs can be quite high. See Christopher Drew and David Cay
Johnston, “Special Tax Breaks Enrich Savings of Many in the Ranks of Management,”
New York Times, 13 October 1996, sec. 1, p. 1.
103 Clark Bardes Consulting, “Executive Benefits: A Survey of Current Trends: 2001
Results.”

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Retirement Benefits

which allow only a modest contribution annually -- with their own personal
retirement savings. The fact that firms rarely if ever provide lower-level
employees with the option of non-qualified deferred compensation
arrangements in addition to their 401(k) plans suggests that there is asignificant cost to firms in deferring executive compensation apart from401(k) plans.
Camouflage Benefits
Although it is far from clear that deferred compensation
arrangements provide efficient-contracting benefits, their camouflage value
is substantial. Deferred compensation must be reported in the compensationtables in the year in which it would otherwise have been received. However,the substantial benefit conferred by deferred compensation – the tax-freeand often above-market buildup over time -- is usually not salient.
Even assuming that the nominal rate of return used by a deferredcompensation arrangement is no higher than the market rate, the effective
interest rate earned by executives is higher than it appears because of thesubstantial tax benefits. Executives must pay taxes on investment income
earned outside deferred compensation arrangements, but investing withinsuch plans provides them, at the expense of the firm, with a tax-free buildup. Thus, as long as the rate of return in deferred compensation
arrangements is above the after-tax rate of return, the executive makes
substantial gains that do not show up in the compensation tables. The New
York Times reported, for example, that CEO Roberto Goizueta of Coca-Cola
was able to defer taxes on $1 billion of compensation and investment gains
over a 17-year period.104 Coca-Cola picked up the tab, paying taxes on theearnings needed to cover the returns credited to Goizueta’s deferredcompensation account.105
As also noted above, 401(k) plans offer lower-level workers returns
equivalent to those available in the bond or stock markets, but manydeferred compensation arrangements provide executives with substantiallyhigher returns. These executives are thus receiving investment income that
104 See “Tax Deferred Pay for Executives,” New York Times, 18 October 1996, p. A36.
105 According to Coca Cola’s annual reports to shareholders, it paid taxes on its
income in every year of Goizueta’s tenure except 1992.

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is not only tax free for them (at the expense of the firm) but also abovemarket. The benefits from these above-market returns, which may be quite
large, can also be hidden to a significant extent.
The SEC requires firms to include in the compensation table for each
executive only the above-market interest earned that year on deferredcompensation. In the case of a guaranteed interest rate, “above-market”
interest is defined as returns in excess of 120 percent of the applicable
federal rate (AFR) used by the IRS at the time the guaranteed interest rate isset, multiplied by the amount of deferred compensation. As a result of the
SEC’s definition of “above-market rate,” a firm can provide its executives
with rates of return that may be higher than they could get on their own—
and the firm need not include this benefit in the compensation tables.
The threshold used by firms for “market” long-term rates of return is
especially generous because boards can reset interest rates whenever doing
so benefits executives. If market interest rates and the AFR rise so that thecurrent guaranteed rate is not especially attractive, the firm can simply
adopt a new, higher, guaranteed rate. As long as the reset rate is lower than
120 percent of the new, higher AFR, the additional interest accruals need not
be reported in the compensation tables. If, however, market interest rates
and the AFR fall, the firm can continue to pay at the old guaranteed rate,
which is now above market. And because the AFR used for the disclosure
threshold is that prevailing when the guaranteed interest rate was initiallyset, no matter how low market rates drop, the above-market interest paid tothe executive never appears in the compensation tables.
Finally, even benefits that come from rates of return exceeding the
SEC’s threshold are unlikely to be fully reflected in the compensation tables.
The reporting requirement ends when the executive retires, but theexecutive often has the option to continue enjoying the above-market rates.
Thus these extra earnings paid to retirees -- which can be quite substantial -never appear in the firm’s publicly filed compensation tables.
As in the case of SERPs, deferred compensation plans for executives
are in one respect less advantageous to their beneficiaries than the 401(k)plans provided to lower-level employees. The 401(k) plans are backed bytheir assets, which cannot be seized by the firm’s creditors. In contrast,
deferred compensation is merely a promise by the firm to pay compensationin the future. The executives owed this compensation are thus unsecured
creditors who may not be paid in full if the firm becomes insolvent. As with57

Retirement Benefits

SERPs, Congress is considering legislation that would make it difficult forfirms to shelter executives from this risk.
To date, however, executives have faced much less risk than might
appear. Again as with SERPs, many firms have taken the additional step ofusing “security devices,” such as trusts, to ensure that funds will beavailable to the executives. In addition, executives are usually free towithdraw deferred compensation at any time – such as when inside
information suggests a firm is about to fail. Shortly before Enron filed forbankruptcy, for example, its executives withdrew millions of dollars ofdeferred compensation. Thus, executives’ risk of losing deferredcompensation due to company insolvency has been minimal.
For executives and their friends on the board, SERPs and deferredcompensation have thus provided a means for channeling large amounts ofmoney to the executive in a way that, under current disclosure regulations,has been difficult for outsiders to understand. As one compensation analyst
pointed out: “The disclosure of the myriad executive compensation plans –pension, supplemental executive retirement plans, deferred compensation,
split dollar life insurance – is not adequate in answering a fundamental
question: What is the projected value of these plans to the executive upon
his retirement?”106
Perks in Retirement
Many compensation contracts promise executives a substantial
stream of perks after retirement. For example, many executives receive acertain number of hours of corporate aircraft use annually for themselves,and sometimes for their families and guests as well. Some executives haveeven received unlimited lifetime use of corporate aircraft.107 Other perks that
often follow the executive into retirement are chauffeured cars, personal
assistants, financial planning, home security systems, club memberships,
sports tickets, office space, secretarial help, cell phone service, and access tocompany dining and fitness facilities.108 Outgoing IBM CEO Lou Gerstner,
106

Gretchen Morgenson, “Executive Pay, Hiding Behind Small Print,” New YorkTimes, 8 February 2004, Section 3, p.1.
107 The Corporate Library, Special Report: “The Use of Company Aircraft” (October2001).
108 See Joann S. Lublin, “Executive Pay under the Radar,” Wall St. Journal, 11 April

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Retirement Benefits

for example, was given access to apartments, planes, cars, home security
services, and financial planning. Terrence Murray, former CEO of
FleetBoston, received 150 hours of company aircraft use, a chauffeured car,an office, office assistants, financial planning, and a home security system.
Another common benefit is giving contributions to the retiring CEO’sfavorite charities. For example, FleetBoston gave $3.5 million incontributions to Murray’s favorite charities he ability to direct the firm’scharitable contributions. And Ford promised retiring CEO Jacques Nasser
to endow a scholarship in his name at the educational institution of his
choice (along with a new car each year, financial planning assistance, anoffice and an assistant). 109
Most of these perks cost the company more than may be apparent at
first glance. Consider retiree use of corporate jets, now a common perk.
Although the marginal cost of allowing a retired executive to use thecompany jet may appear limited,110 consider such an executive’s flight fromNew York to California and then back several days later. Because the New
York-based aircraft and flight crew will return to the East Coast after
dropping the retired executive off, the actual charge to the company is tworound trips: a total of eight takeoffs and landings and approximately 20
hours of flying time most likely costing -- for fuel, maintenance, landing
fees, extra pilot and crew fees and incidentals, and depreciation (an aircraft’s
operating life is reduced for every hour it flies and, more importantly, forevery takeoff and landing) –- at least $50,000.111 Henry R. Silverman, CEO of
Cendant, was promised lifetime use of the corporate aircraft or, if the plane
were in use, an equivalent chartered plane at a direct cost of thousands ofdollars per hour.112
2002, p.B7; Gary Strauss, “CEOs Cash In after Tenure,” USA Today, Money Section, 25
April 2002, p1B.
109 See Joann S. Lublin, “Many Former Chief Executives Get Lush Perks and Fat Fees
for Limited ‘Consulting’ Work,” Wall Street Journal, 13 September 2002, p. B1.
110 This misperception led one compensation consultant to label jet use as “anefficient way of delivering something of value to the executive.” Yale D. Tauber,
quoted in Joann S. Lublin, “Executive Pay under the Radar,” Wall St. Journal, 11 April
2002, p.B7.
111 We would like to thank Marc Abramowitz and Yitz Applbaum for useful
discussion on the cost of operating corporate jets.
112 The Corporate Library, Special Report: “The Use of Company Aircraft” (October

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Retirement Benefits

Firms do not regularly provide post-retirement perks to lower-level
employees. There is good economic logic to avoiding such in-kindcompensation. Promising a retiring employee $10,000 a year for travel
expenses is less efficient than providing $10,000 in cash. The reason isstraightforward. If the retiree views travel as the best way to spend $10,000,
the cash and the travel coverage will have identical utility. However, cash issuperior if there are any possible circumstances in which the retiree would
prefer spending some or all of the money on goods or services other thantravel, because the retiree will receive greater utility at the same cost.
A retiree’s needs and preferences are likely to change over time. Thus
economic logic suggests that if in-kind retirement benefits are provided,
they should not be provided for long periods. Yet such long-term, in-kindbenefits are often provided to retired CEOs: for example, Louis Gerstner ofIBM received use of a plane, cars, offices, and financial planning services forten years.
Although post-retirement perks are unlikely to be an efficient form ofcompensation, they are an effective way to camouflage it. Non-monetaryperks in particular enable the board to provide additional value to
executives without ever including the expected benefits in compensationtables or even placing an explicit monetary value on them. The value of suchperks is not reported when they are agreed to, and the firm incurs theexpenses only after the executive has left, at which point any value provided
is no longer included in the compensation tables—the records most salient
to outsiders and, importantly, the basis for most studies and comparisons.
Consulting Contracts
Like perks, consulting contracts provide substantial value to retired
executives. They usually offer the retiring CEO an annual fee for “being
available” to advise the new CEO for a specified amount of time per year.
Approximately 25 percent of CEOs negotiate a post-retirement “consulting”
relationship with their old firm.113 Such contracts often extend for the life of
the retiring executive, or if not, then for a very long period of time.

2001).
113 Ira Kay, cited in Gary Strauss, “CEOs Cash In after Tenure,” USA Today, Money
Section, 25 April 2002, p 1B.

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Retirement Benefits

For example, AOL Time Warner is paying retired CEO Gerald M.
Levin $1 million per year to serve as an adviser for up to five days permonth.114 In 2000, retiring Carter-Wallace CEO Henry Hoyt was promised
annual payments of $831,000 for the same monthly obligation.115 Verizon coCEO Charles Lee negotiated a $6 million consulting contract for the first two
years of retirement. Delta Airlines CEO Ronald Allen’s 1997 retirement
package provided him with a seven-year, $3.5 million consulting deal underwhich, according to Delta’s public filings, he was “required to perform his
consulting services at such times, and in such places, and for such periods aswill result in the least inconvenience to him.”116 Allen or his heirs will beentitled to the annual fee of $500,000 even if he is totally disabled or dead.117
The evidence indicates that these consulting arrangements are largely
a severance payment to the departing executive disguised as compensation
for post-retirement work. For better or worse, new CEOs hesitate to contact
previous CEOs for advice.118 For example, Ronald Allen reportedly “rarely
talks” with the new Delta chief executive, Leo Mullin. Even compensation
consultants acknowledge that retired executives add little if any value to thefirm under these arrangements. According to Frank Glassner, CEO of
Compensation Design Group, most of these consulting contracts are merely
a way of increasing the severance payment to the departing executive.
According to another executive compensation expert, Alan Johnson, “mostformer CEOs are doing very little for what they’re getting paid…. Usually,
the demands [from new management] are miniscule.”
Like post-retirement perks, the consulting payments to retired
executives never find their way to the compensation tables because theyoccur when the executive is no longer an officer. However, these contracts
enable boards to provide retired executives with something more valuable

114 Joann S. Lublin, “Many Former Chief Executives Get Lush Perks and Fat Fees for
Limited ‘Consulting’ Work,” Wall Street Journal, 13 September 2002, p. B1.
115 Gary Strauss, “CEOs Cash In after Tenure,” USA Today, Money Section, 25 April
2002, p.1B.
116 Ibid.
117 Joann S. Lublin, “How CEOs Retire in Style,” Wall St. Journal, 13 September 2002,
p. B1.
118 The examples and quotations in this paragraph are taken from Joann S. Lublin,“How CEOs Retire in Style,” Wall St. Journal, 13 September 2002, p. B1.

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Retirement Benefits

than in-kind perks: dollars.119 Retirement consulting fees are essentially acash severance payment, turned over in installments.
If these fees are just a form of cash severance, what is the advantage of
packaging them as consulting agreements? Besides ensuring that thepayments are kept out of the compensation tables, the consulting fees
obscure the cost of the arrangement. Although the firm discloses theexistence of the consulting arrangement, it does not disclose its total dollar
value. Furthermore, the future expenditures appear legitimate to observers
who believe the outgoing CEO will in fact provide advice to new
management. Needless to say, these consulting agreements do not tie theretired executive’s pay to any personal contribution to shareholder value
either before or after retirement.
De-coupling Pay from Performance
Although succeeding chapters will discuss at length the insufficientcorrelation between pay and performance in executive compensation, it isworth pausing here to note that the retirement payments we have describedin this chapter are largely insensitive to managerial performance. SERPs
simply provide executives with some additional multiple of their cash
compensation that is largely independent of performance. Deferredcompensation provides value to executives through the tax-free income
buildup at favorable rates that are not affected by managers’ performance.
Likewise, post-retirement perks and consulting fees are generally fixed inadvance, rather than made contingent on future performance.
It could be argued that these retirement benefits reflect arm’s length
contracting because they provide performance-insensitive compensation in amore tax-efficient way. According to section 162(m) of the Internal Revenue
Code, firms cannot deduct more than $1 million in non-performance-based
pay for any given executive. However, firms can circumvent this problem bypaying performance-decoupled compensation after the executive retires,
when the rule does not apply. If for some reason it were efficient to provide
119 Of course, there are cases where even these outlays are hidden by the provision of
in-kind value rather than cash. For departing CEO Hugh McColl’s continuing “advice
and counsel,” Bank of America is providing him or members of his family with 150
hours of flying time on corporate aircraft. See Gary Strauss, “CEOs Cash In after
Tenure,” USA Today, Money Section, p. B1. This perk has a value of $500,000 or more.

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Retirement Benefits

executives with large amounts of performance-insensitive compensation,
there would indeed be tax advantages to doing so though retirement
benefits rather than through additional cash salary. The channeling of value
through retirement benefits not only keeps the compensation out ofshareholders’ sight but also beyond the reach of section 162(m).
It is doubtful, however, that the tax advantages of these retirement
benefits justify their use. Providing incentives to improve performance isoffered as a primary justification for large executive compensation packages.
Thus, there are reasons to doubt that efficient, arm’s length contracting
would de-couple so much of an executive’s pay from actual performance.

63

CHAPTER 9: EXECUTIVE LOANS“As of December 31, 1997, the outstanding principal balances of the … loans
to [officers and directors] … which are guaranteed by Conseco were as
follows: Mr Hilbert, $81,644,353; Ms Cuneo, $21,489,945, Mr. Dick,$42,657,845; Mr. Gongaware, $16,998,753…..”
Conseco’s 1999 Proxy Statement
Executive loans were once widely used to provide managers with asubstantial amount of performance-independent pay in a way that escaped
outsider attention. As with retirement benefits, the considerable value
provided by loans was largely not reflected in the compensation figures
used by the media, corporate governance reformers, and financial
economists studying compensation.
The Use of Loans
In the past, firms could camouflage non-option pay by granting loans,or guaranteeing third-party loans, to the CEO and other top executives onvery favorable terms.120 Most of these loans were unsecured or secured onlyby the firm’s stock. In addition, most of the loans carried below-market
interest and a substantial number were interest-free. Finally, many of theseloans were ultimately forgiven.
When WorldCom, Kmart, and other firms that had made large loans
to executives filed for bankruptcy in 2002, the loans received a significant
amount of negative public attention. This led Congress to include in the
Sarbanes-Oxley Act of 2002 a prohibition against company loans to directors
and officers, with narrow exceptions.121 Existing loans, however, were
exempted from the prohibition. As a result, directors and executives
continue to reap the benefits from billions of dollars in existing loans.122
120 Gary Strauss, “Execs Reap Benefits of Cushy Loans,” USA Today, 24 December
2002, p. 1B.
121 See 15 U.S.C. 78m (k); David S. Hilzenrath and Helen Dewar, “Senate Votes toCurb Insider Lending,” Washington Post, 13 July 2002, p. A13.
122 Paul Hodgson, “My Big Fat Corporate Loan,” study by The Corporate Library,
December 2002, p.1.

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Executive Loans

Our goal is to understand the forces that have shaped executive
compensation. Thus, it is quite helpful to reflect on the past use of loans,even though new executive loans have, for now, been taken off thecompensation menu. Their past ubiquity can teach us how boards andmanagers selected from among available compensation devices those thatprovide significant camouflage, even when these arrangements wereunlikely to be efficient.
Among the most notorious executive loans are those that were
granted to WorldCom CEO Bernard Ebbers.123 Between September 2000 andthe beginning of 2002, WorldCom directly or indirectly extended hundredsof millions of dollars—approximately 20 percent of the cash on the firm’sbalance sheet—in unsecured loans to Ebbers to help him pay off margindebt in his personal brokerage account. . In exchange, Ebbers promised not
to sell his WorldCom shares. The loans were made at floating interest rates
that hovered between 2.15 percent and 2.35 percent. These rates were well
below the prevailing rates for large-margin accounts – even though, unlike
margin loans, the loans made to Ebbers were unsecured.
When Ebbers left WorldCom, he still owed the firm $408 million. He
promised to satisfy these remaining obligations and, under the terms of his
severance arrangement, he had until 2008 to do so. Much of that $408 million
will probably never be recovered. With WorldCom in bankruptcy, thecompany shares that Ebbers agreed to hold are now almost worthless.
WorldCom reported in May 2003 that he had failed to make the firstpayment due under the terms of the arrangement.124 Had Ebbers taken out aregular, higher-interest, secured margin loan from a broker, the lenderwould not have suffered such a fate. The shares would have been sold tocover the loan when the stock price was still high enough to make thispossible.
Other firms have extended or guaranteed large loans to executives.
For example, in 1999, Conseco guaranteed loans of $175 million to its CEO
and $375 million to other executives to buy company stock. When the stock

123 Amy Borrus, Mike McNamee, and Susan Zegel, “Corporate Probes: A Scorecard,”
Business Week, 10 June 2002; Andrew Backover, “Questions on Ebbers Loans May Aid
Probes,” USA Today, 6 November 2002, Money Section, p. 3B.
124 Dana Cimilluca, “Former Worldcom CEO Ebbers Misses Loan Payment,” Toronto
Star, 17 May 2003, p. C4.

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Executive Loanslater lost most of its value,125 Conseco lent the executives millions of dollars
to pay interest on the loans.126 The total amount of the loans exceeded
Conseco’s 1997 net earnings of $567 million.127 Hundreds of millions ofdollars of these loans had not been paid back by the end of 2002. Similarly,
Comdisco guaranteed more than $100 million to its executives to buy
Comdisco shares whose price subsequently plummeted.128 Tyco lent its CEO$62 million for “relocation costs.”
Although most executive loans were smaller than those granted byWorldCom, Conseco, Comdisco, and Tyco, the practice was widespread.
According to a study by The Corporate Library, more than 30 percent of the
1,500 largest U.S. firms disclosed cash loans to executives in their 2002
regulatory filings.129 The average size of the cash loans was about $11
million. The total amount of insider indebtedness under the loans was $4.5
billion. Although many cash loans were stock-purchase related, many were
for home improvements, investments, or other purposes apparently
unrelated to employment. For example, manufacturer Flextronics lent
executives money to invest in technology startups.130 More than 25 percent of
the firms reporting executive loans did not bother to report their purpose.131
Arm’s Length Contracting?
Most employees who need loans turn to banks, not to theiremployers. Clearly, if it were more efficient for firms to act as theiremployees’ banks, they would do so across the board, not only forexecutives. Presumably, firms do not regularly operate as their employees’
125 The loans made by this company are described by Gary Strauss, “Don’t Bother
Paying Us Back, Many Boards Tell CEOs,” USA Today, 13 November 2001, p. 1B.
126 Debra Sparks, “The Mother of All Stock Option Plans,” Business Week, 23
November 1998, p. 158.
127 Ibid..
128 Sandra Jones, “Comdisco in Face-Off over Loans, Trying to Get Execs off Hookwith Bank One,” Crain’s Chicago Business, 27 May 2002.
129 Paul Hodgson, “My Big Fat Corporate Loan,” Study by The Corporate Library,
December 2002.
130 Flextronics 2002 proxy statement.
131 Paul Hodgson, “My Big Fat Corporate Loan,” Study by The Corporate Library,
December 2002, p. 3.

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Executive Loansbanks because they lack a comparative advantage over outside banks inproviding banking services. Because executives have at least as much accessto banks as other employees, one certainly would not expect firms, acting at
arm’s length, to extend loans to executives but not to other employees.
Indeed, Kathleen Kahle and Kuldeep Shastri have concluded that most firmsthat lend to executives have higher lending costs than do conventional
lenders.132
Approximately 40 percent of loans are provided to enable executives
to purchase more stock in their firms.133 It is often argued that lending
money to executives at favorable rates for that purpose benefits shareholders
by aligning executives’ interests with their own. However, even if it weredesirable to give managers a financial incentive to borrow money topurchase shares, the loan does not have to be extended by the firm.
Suppose, for example, that a firm wishes to encourage an executive totake out a $1 million loan to purchase shares. It may do so by offering tolend him money directly at a rate that is (say) 2 percent below market.
Alternatively, the firm can promise a manager that, after she takes out abank loan at the market rate, the company will pay her 2 percent of theoutstanding balance each year until the loan is repaid. As we will discuss
below, the direct loan, which was commonly used in the past, is far lesstransparent than the latter method.
Interestingly, firms extending loans to executives to buy company
stock take few if any steps to prevent managers from simultaneously sellingshares they already own. As a result, loans enabling managers to buy 100
shares of company stock increase managerial ownership by an average of
only 8 shares.134 This pattern makes it difficult to justify loans as an efficientdevice for increasing executive share ownership.

132 Kathleen M. Kahle and Kuldeep Shastri, “Executive Loans.” Journal of Financial andQuantitative Analysis, forthcoming. Kahle and Shastri estimate that the average stockloan, which typically is offered to executives at a below-market interest rate, hashistorically cost a firm borrowing in the corporate debt markets $2 in interest for every$1 in interest savings made available to the executives. The authors of the study
assume that the firm borrows at the prime rate and that the executive is able to borrowagainst the shares at the broker’s call rate.
133 Ibid, p.9.
134 Ibid, p.5.

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Executive Loans

Camouflaging Subsidized Rates
An important way in which executive loans benefit executives isthrough their favorable interest rates. An executive who borrows money atan arm’s length basis from a bank is required to pay the market interest rateon the loan. But about 50 percent of companies granting executive loanscharge no interest, and the remaining companies charge rates that are on
average significantly below market rates. The difference between the market
interest rate and the reduced rate charged by the firm represents a form of
ongoing compensation for as long as the loan remains outstanding.
Bernard Ebbers, for example, was able to borrow money fromWorldCom at an interest rate of about 2.15 percent at a time when Charles
Schwab was charging 5.75 percent on large margin loans.135 Because 5.75
percent presumably reflected the going market rate for margin loans,
WorldCom allowed Ebbers to save more than $3.6 million per year ininterest costs for every $100 million he borrowed from the company. Thus,
borrowing $400 million from WorldCom at 2.15 percent would thus havesaved Ebbers about $14 million annually. The interest savings for Ebbers
came at a cost to WorldCom. Instead of lending the money to Ebbers at 2.15
percent, WorldCom could have lent it to others buying stock on margin (orto any borrower with a similar risk profile) and charged an interest rate of
5.75 percent. Thus, the millions of dollars in benefits accrued by Ebbers
imposed an approximately equal cost to WorldCom.136
Notably, if Ebbers had borrowed $400 million from a bank at 5.75
percent and WorldCom had paid him $14 million each year to cover thedifference between the 5.75 percent and 2.15 percent interest rates,
WorldCom would have had to report the $14 million as compensation in the
135 Christopher Byron, “Bernie's Bad Idea,” Red Herring, May 2002, p.92.
136 Kathleen Kahle and Kuldeep Shastri report that the average size of loans given to
executives (including both CEOs and junior managers) for purchasing stock was $2.5
million. The average interest rate was 2.3 percent below the prime rate and 1.1 percent
below broker’s call. See Kathleen M. Kahle and Kuldeep Shastri, “Executive Loans.”
Journal of Financial and Quantitative Analysis, forthcoming. On the assumption that thefirm borrowed at prime and that the executive could obtain a margin loan at broker’s
call, they estimate that the average loan cost the company $63,000 per year, or 9 percentof the executive’s total compensation, but provided a benefit of only $28,000 to the
executive.

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Executive Loansfirm’s publicly filed compensation tables. Providing this value throughsubsidized loan arrangements, however, enabled WorldCom to exclude thebenefit from its compensation tables completely.
As we explained in chapter eight, firms are required to include in
their annual public filings compensation tables indicating the dollar value ofdifferent types of executive pay. The numbers in these tables are the mostvisible indications of executive compensation. In the category of “otherannual compensation,” firms are required to disclose the difference between
the actual interest paid on executive loans and the “market rate.” However,the SEC has not clearly defined the term “market rate” and firms have often
used the ambiguity to exclude – in whole or in part – the interest subsidy
from the compensation tables. WorldCom, for example, excluded from its
compensation tables the implicit income given to Ebbers via the loans,
despite the fact that the rates were far below the prevailing rates on marginloans. WorldCom later explained that it had (conveniently) interpreted thelow floating loan rates to be “market rates” because these were the rates atwhich WorldCom itself was borrowing under one of its credit facilities. This
“trick” enabled the company to exclude from its compensation tables abenefit to Ebbers worth millions of dollars each year.
Note that, for tax purposes, Ebbers was required to report as income
the difference between the rate he was charged and the Internal Revenue
Service’s “applicable federal rate” (AFR) for the loan. Thus, Ebbers shouldhave reported that he was receiving, with respect to each new loan fromWorldCom, imputed annualized income equal to the difference between therate on the WorldCom loan and the AFR at the time the loan was granted,
multiplied by the amount of the loan. During the period in which theseloans were extended, the AFR was always higher than 2.15 percent, and it
was above 6 percent when Ebbers first started borrowing from WorldComin September 2000. Thus, Ebbers was required to report on his federal
income tax returns millions of dollars of compensation income resulting
from these “market rate” executive loans.
To be sure, the existence and terms of loans to executives were usuallyreported by firms as part of their disclosure of related-party transactions in
SEC filings. However, the information reported in this section does notinclude the implicit income generated by the low-rate loans. The existence
and magnitude of this implicit income would be apparent only to a careful
reader. One would have to obtain information about market rates, calculate

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Executive Loansthe implicit income, and add it to the information in the compensationtables. Providing executives with benefits that are not included in thecompensation tables has a considerable camouflage effect. It is likely to hideor reduce the salience of a potentially significant element of compensation.
Loan ForgivenessThe practice of loan forgiveness enhanced the camouflage benefits ofexecutive loans.137 An executive who borrowed money from a bank would
be required to pay the money back with interest or face the prospect of thebank seizing his or her property. Not surprisingly, firms that lent money totheir own executives were much more lenient. More than 25 percent of thefirms whose public filings revealed whether repayment was required
indicated that they had forgiven or were forgiving loans.138 It has been
estimated that as much as $1 billion of the loans extended before SarbanesOxley will eventually be forgiven.139 Firms often “gross up” the forgiven
loans: they make a large cash payment to the executive to cover income
taxes arising from the forgiveness, as well as the additional tax liability
associated with the cash payment.140
In a substantial number of cases, the loans (or the interest payments
owed on them) were eventually forgiven either while the executive was stillat the company or when he or she left. In many cases, the firm explicitly
committed at the outset to full or partial loan forgiveness if certain
conditions were met, such as the executive remaining employed for a
specified period. The value provided by these “retention loans” was almost
137 Kathleen M. Kahle and Kuldeep Shastri report that in the period 1996-2000, 12.6
percent of executive loans in their sample were forgiven, and the interest was forgiven
in another 10.2 percent of the cases. See Kathleen M. Kahle and Kuldeep Shastri,“Executive Loans.” Journal of Financial and Quantitative Analysis, forthcoming.
However, most of this activity took place before NASDAQ crashed. The rate offorgiveness in the period 2000-2002 is likely to have been much higher.
138 Paul Hodgson, “My Big Fat Corporate Loan,” study by The Corporate Library,
December 2002, p. 2.
139 Ralph King, “Insider Loans: Everyone Was Doing It,” Business 2.0, November
2002, p.82.
140 Paul Hodgson, “My Big Fat Corporate Loan,” study by The Corporate Library,
December 2002, p. 2.

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Executive Loanscompletely performance-insensitive; all the executive had to do was remain
at the firm. In addition, these loans offered camouflage benefits as comparedwith regular salary arrangements. In particular, the large amount of cash
provided up front was not reported in the compensation tables; the firm was
required to report income to the executive only when it forgave the loan. In
addition, the firm reported the income not as “salary,” which istransparently not performance-sensitive, but rather as “other annualcompensation,” which may or may not be performance-sensitive.
When loans were made for the purpose of purchasing stock, there
was probably an implicit understanding that if the price of the stock fell
substantially, the firm would forgive the loan or at least not demand
repayment while the price remained down. Such an arrangement would
have been similar to, but usually less tax efficient than, granting theexecutive an option to buy shares at a price equal to the amount owed on theloan. From a camouflage perspective, an important difference was that an
option grant had to be reported as long-term compensation in the executive
compensation tables, while a loan to buy stock did not. Thus, the firm could
provide the executive with something economically similar to an option
without reporting its value in the publicly filed, highly visible compensation
summary tables at the time the loan was extended.
Down the road, if the stock price went up, the executive repaid theloan, and any profit made on the shares did not have to be reported ascompensation. If the stock price remained below the amount owed, and theloan was actually forgiven, the resulting compensation was reported in thecompensation tables only in the year the forgiveness took place. Becausesuch forgiveness often took place when the executive left the company, theamount forgiven was included in the compensation tables at a time whenthe executive was much less concerned about shareholder outrage.
Camouflaging the Sale of Shares
Yet another way in which loans facilitated camouflage was by hidingfrom investors the magnitude of managers’ stock sales. Each year, hundredsof executives used to make swaps under which loans were repaid withcompany stock.141
141 See David Leonhardt, “It’s Called a ‘Loan,’ But It’s Far Sweeter,” New York Times, 371

Executive Loans

Before the Sarbanes-Oxley Act of 2002 took effect, executives sellingstock in the open market had to report the sale by the tenth day of thefollowing month. But when executives gave stock to the company to repay
loans, they had to report such transactions only within 45 days after the endof the fiscal year in which the transaction occurred. Thus, the loans enabledinsiders to hide their stock sales for up to a year.142
For example, in 2001, Tyco’s CEO, Dennis Kozlowski, returned $70
million worth of stock to the company, partly to repay loans, even as hecontinued to say publicly, to preserve investor confidence, that he rarely
sold his Tyco shares.143 The transaction was disclosed to the SEC only muchlater, after the stock price had fallen substantially.

February 2002, p. 1.
142 We discuss further the relative lack of restrictions on insider trading in chapter
fourteen.
143 David Leonhardt, “It’s Called A ‘Loan,’ But It’s Far Sweeter,” New York Times, 3
February 2002, p. 1; Joann S. Lublin, “Under the Radar: As CEO’s Reported Salaries
and Bonuses Get Pinched, Many Chiefs are Finding Hidden Ways to Increase Their
Compensation,” Wall St. Journal, 11 April 2002, p. B7.

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