The Challenges of Reigning in Executive Compensation

The gap between what CEOs earn and what average employees take home has expanded significantly over the last several decades. Changes that would place some limitations on executive compensation would be welcome by most. However, implementing such changes may be much more difficult than many presume.

One of the most common methods used by corporate boards to set executive pay is benchmarking. Of course, if one believes that compensation is too high for all CEOs, then comparing what an individual earns to what his or her peers earn is unlikely to result in meaningful change.

Another issue relates to the somewhat insular nature of corporate boards. In the post-Enron era there is greater scrutiny of the relationships among board members. However, these rules do not necessarily impact the personal relationships that may exist among board members. Personal relationships, as well as the prestige and compensation that serving on a board provides, can impact a board’s actions.

At Berkshire Hathaway’s annual shareholder meeting earlier this month, executive compensation was a hot topic. Berkshire Hathaway is the largest shareholder of Coca-Cola, and the executive compensation plan proposed in Coke’s proxy statement was deemed excessive by many investors. David Winters, who manages the Wintergreen Fund, was among the most vocal opponents. He mailed letters of objection about the plan to both Coke and Warren Buffett, Berkshire’s chairman.

Mr. Buffett decided to abstain from the proxy vote rather than vote against the plan. However, at the annual meeting as well as in discussions he had with management prior, he did communicate his dissatisfaction with the plan. At this point, it seems likely the plan will be implemented. However, it will happen more slowly than originally contemplated, which will reduce the cost.

More telling were Mr. Buffett’s comments about boards and how they work. Mr. Buffett spoke of how he has voted for compensation plans that he did not agree with. He characterized boards as being part business organization and part social group. Plus, he stated that “so-called independent directors” are receiving $200,000-$300,000 for a prestigious job that only requires about six days of work per year. Directors would like to get more directorships, so they are generally unwilling to rock the boat.

Mr. Buffett, who has served on a number of boards, said he did not recall seeing a compensation committee plan receive a single dissenting vote from the broader board of directors. While he said that was not necessarily the way the board should function, that is what happens.

Based on these comments as well as the other points mentioned above, it seems unlikely that executive compensation will change meaningfully without some type of legislation requiring it.

At BWFA, assessing how management allocates capital (which is shareholders’ money), is part of our investment process. Paying executives is one use of such capital. As a result, we view excessive compensation negatively. We think greater independence is needed and improvements are necessary to the way in which peer benchmarking is used in determining CEO salaries. Greater emphasis should also be placed on long-term rather than short-term results.