Season Investments


Unintended Consequences

Posted on March 1, 2016

“You can put wings on a pig but you can’t make it an eagle.” – President Bill Clinton

2016-03-01_Dominos.jpgIt is everyone’s favorite time of the year where we are all inundated with sound bites, headlines, and advertisements telling us why we should or should not cast our vote for a particular Presidential candidate. One of the many topics of discussion this election season has been the large gap between the level of compensation paid out to top executives (the so called 1%) versus the pay for the average American worker (the other 99%). Statements against excessive executive compensation have been made from both sides of the isle from each party’s leading Presidential candidates.

“Something is wrong when top CEO’s earn 300 times more than the typical American worker.”
     – Hillary Clinton

“CEOs make 300 times what their workers make. That is simply immoral and must be dealt with.”
     – Bernie Sanders

“You see these guys making these enormous amounts of money. It’s a total and complete joke.”
     – Donald Trump

For those old enough to remember, this may sound like a familiar tune as then Presidential hopeful Bill Clinton ran on a very similar platform in his 1992 race for the White House. His campaign happened to coincide with a mild recession here in the US during which time average American voters were upset that company executives were getting raises while unemployment amongst the working class continued to rise. Shortly after being elected and with the help of Congress, President Clinton amended the tax law in order to address what he called “excessive executive pay.” Section 162(m) of the US tax code was amended to include a compensation deductibility limit of $1 2016-03-01_Bill_Clinton.jpgmillion on a handful of executive level salaries for publicly traded US companies. But a curve ball was also thrown in that excluded “compensation tied to performance” from the million dollar cap. The idea of performance based compensation was championed by many economists who felt the biggest issue with executive compensation was a pay structure that promoted a “fat cat” mentality.

The exclusion of performance based compensation from the new tax law gave rise to the now commonplace practice of awarding stock options as a form of compensation. For those unfamiliar with exactly how a stock option works, allow us to provide some background. An option gives someone the right, but not the obligation, to purchase (call option) or sell (put option) a stock at a predetermined price on or before the expiration date of the option contract. Let’s say we are given a call option which expires in one month on a stock with a strike price of $50. If in one month, the stock is trading for more than $50/share, we can exercise our call option and buy shares below the market at our strike price of $50. If the stock were trading at say $60/share, the value of this call option would be $10/share since we could purchase the stock at $50 and then turn around to immediately sell it at $60 in the open market for a riskless profit of $10/share. If, on the other hand, our stock is trading at a price below $50 at the expiration of our contract, then our call option has no value since there is no riskless profit to be made and we would be better off simply buying the stock in the open market versus paying $50/share.

The idea of awarding executives with stock options was that it solved the principal-agent problem by aligning their incentives with that of the stockholders (e.g. a higher stock price). In addition everyone thought this form of compensation was “free” because unlike a salary that has to be paid in cash out of the company’s bank account, stock options could be given at will and new shares of stock could be created to fulfill the stock option contracts. To put it another way, base pay hit the Income Statement as an expense while stock options were not accounted for under GAAP (Generally Accepted Accounting Principles).

This form of performance based compensation exploded in the mid to late 90’s as the stock market roared to new highs on a daily basis. As such the average pay for CEOs at big corporations went from $4 million in 1992, the same year Clinton ran on a platform of curbing “excessive executive pay,” to topping out at  $19 million at the peak of the Tech Bubble in 2000 (ironically enough the end of Clinton’s Presidency). The chart below shows that CEO pay at top US companies dramatically outpaced the grown in not only the pay of typical workers, but also shareholder gains as measured by the total return of the S&P 500.


To make matters worse, the new tax law didn’t even put downward pressure on base pay packages as companies were more than willing to exceed the $1 million deductible limit in order to attract and retain the right talent. The unintended consequence of Clinton’s new tax law had the exact opposite effect on executive compensation compared to its intended goal. To paraphrase his own words from the opening quote, “You can put wings [new regulations] on a pig [existing laws], but you can’t make it an eagle [fixing the problem].”

The rising tide of the stock market during the 1990’s hid the fact that stock options were costing shareholders large sums of money by diluting their ownership in the company. This fact was not lost on famed investment guru Warren Buffett who wrote about the egregiousness of stock options in his 1998 letter to Berkshire shareholders.

This Alice-in-Wonderland outcome occurs because existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are a huge and increasing expense at a great many corporations…In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost.

After the Tech Bubble burst and more attention was given to executive stock options, FASB amended the GAAP rules to account for stock option based compensation as a cost on the income statement. This is most likely the main reason why CEO pay has yet to eclipse its 2000 peak.

That being said, average CEO pay at the 350 largest US corporations is roughly 300 times the size of an average American worker’s paycheck. For comparison purposes that same ratio stood at 20 back in 1965, close to 30 by 1978, and was still hovering around 120 in 1995. Famed author and business consultant Peter Drucker was very outspoken about his belief that CEO pay should not exceed 20-25 times the average salary in the company because it undermined the smooth functioning of the business as well as created tensions in society as a whole. In the mid 1980’s furniture maker Herman Miller decided to adopt a compensation limit of 20-to-1 for their CEO after consulting with Drucker on the matter, but in 1997 they abandoned the policy because they needed to remain competitive and pay more money to top level executives in order to attract and retain the right talent.

It appears that no matter how hard we may try to correct the issue of income inequality, our best intentions fail and in some cases, due to unintended consequences, create an even bigger problem. The point of this week’s post is not to defend or villainize executive compensation, but rather to point out that is naïve to think that we can fix something in isolation like excessive executive compensation without creating a litany of unintended consequences in our wake. Staff writer Alan Sloan for the journalistic non-profit ProPublica, summarized this sentiment in regards to the upcoming Presidential election perfectly when he wrote:

On the campaign trail these days, Republicans say that eliminating the corporate income tax (Sen. Ted Cruz) or cutting it sharply (Donald Trump) will set off a hiring boom. Democrats say that jacking up tax rates (Sen. Bernie Sanders) or changing capital gains rules (Hillary Clinton) will reduce the advantages that rich people enjoy over the rest of the populace.

It’s impossible to know whether any of these ideas will become law. But based on history, it’s a safe bet that if they do, they are not likely to produce the results their proponents predict.

So as you digest the litany of campaign promises and sound bites headed our way over the next several months, remember that nothing happens in a vacuum and as such changes to a complex system can produce a stream of unintended consequences.

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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