From the Trenches

Projecting Executive Pay Levels

To put recent executive pay trends into perspective, let me describe the Rule of 72. There’s this unique approximation where if you divide a compound interest rate into the number 72, it will give you the approximate number of years for a sum to double. So, for example, 4% into 72 implies that in 18 years, one’s principal sum will double. If you had $10 at 8% interest, it would double in 9 years; 10% in 7.2 years, and so on.

If you are dealing with numbers that have an increase rate of 12%, whether they are average CEO incomes or benefit costs, the sums will double in 6 years. If they were increasing at only 1.2%, it would take 60 years. That’s about what is happening right now with average peoples’ wages versus executive pay, doubling in 60 years versus 6. We’ve seen very anemic wage and salary growth these past four quarters; 0.3% was a good 90-days growth rate in 2011. Meanwhile, executive pay just keeps moving upward! ¹

This is not a new issue. Writer and management consultant Peter Drucker suggested that management’s pay should be a fixed multiple of the employers’ average workers’ pay. He talked and wrote about it in 1970s, as did I in a 1974 article in Compensation & Benefits Review, “What Are ‘Average’ and ‘Above Average’ Salaries,” stating that the gap was widening and worth noting. ² But unlike Professor Drucker’s suggestion to do a bit of social engineering, the article focused on a management construct, a construct being a systematic framework for thinking about a problem influenced by, but not limited to, theory, common practice and prevalence of use.

The article’s underlying theme was the emerging use of peer comparisons, something today that is an accepted principle for Certified Public Accountant and American Society of Appraisers business appraisals, just like it is for real estate appraisals. That is, find 5 to 10 peer organizations, determine the average pay of executive jobs for these competitors, and since you have a CEO who is undoubtedly “above average,” then he or she should be paid “above this peer average.” (Many corporations express above average as paying at the 75th percentile.) Nothing wrong with this, except that everyone is doing the same thing. Everyone has an above average CEO, CFO, and so on. We saw it as a problem in 1974, but it wasn’t my discovery. I discussed it with Bob Sibson, the founder of the firm Sibson & Company in his firm’s office in Princeton in 1972, and he’d been talking about it since 1960. He was concerned then and gave me the idea for the article. Many have seen this “Occupy Wall Street” coming for 60 years!

In the 1980s, I returned to this subject in one of ERI’s early newsletters; however, I quickly found that if you wanted to sell products, it was best to not discuss such things. Salary survey providers like ERI are rewarded for silence when it comes to voicing opinions. That is, we show the means, but we don’t suggest what they mean. CEOs become very offended when you discuss their pay. This is not good if you are trying to sell data to their firms, not good at all. If you are in the trenches, you must keep your head down.

Let’s do the math. At 2.4%, which is a good approximation of average earners’ wage growth the previous decades, $10,000 turns into $20,000 in 30 years. In contrast, $100,000, a comparison executive pay level increasing at 12%, turns into

That’s $20,000 compared with $3,200,000 from what was $10,000 and $100,000. That basically describes what has unfolded over my work career—what I’ve seen, that is, not what I’ve been paid. In 30 more years, the wage earners’ $20,000 will be $40,000 and will be compared with $102,400,000. That’s a ratio of 10:1, to 160:1 to 2,560:1.

Folks are camping in the parks talking about a 1:320 ratio in 2012 as “America has a new monarchy, corporate executives ruling over corporate serfs.” Think of what they will be saying when the ratio is 1:10,000 just 12 years after it hits 2,560, because the Rule of 72 isn’t magically going to stop working in the year 2040!

Who are the serfs, you might ask. They are the hundreds of thousands of college graduates who have taken educational loans with little chance of repayment at the forecasted low salary and wage growth equation that currently exists, if they can even find a job. The bankruptcy reforms of the last decade have made escape from this debt equivalent to IRS (Internal Revenue Service) tax or credit card debt forgiveness. Today, we have more college loan debt in America than credit card debt.

But I digress, except to make the point that what we are talking about is an economic construct, one that professionals have talked about for 60 years. If we have youngsters camping in our parks, sitting on city hall steps, concerned over having inadvertently entered serfdom and the disparity between the average wage and those at 320 times what the average employee earns, think about what will happen when the ratio hits 1:10,000.

The logic governing executive pay increases is a battle gone wrong in the process of happening; we should all have been able to see it coming because the problem is worse than what I’ve explained. My example started with a wage earner at $10,000 and an executive at $100,000. Those numbers reflect 1952-1953 when Ted Williams made that much for the season and the United States had a marginal tax rate of 92%. ERI indices for February 2012 showed that the 2.4% used for serfs’ wage/salary growth is too high and that the 12% for executives is too low. On three counts, my example understates the problem. The 2040 multiples will be much higher. There is nothing on the horizon that even hints at changing the peer comparison construct for executive compensation, and we know the cold mathematics of the Rule of 72 won’t change.

Not concerned, you say? In a few more years, the ratio will be 1:10,000: One person will make what 10,000 of their employees make in total, just because he or she is a “top manager” and the board uses a peer comparison construct to assess next year’s pay horizon. To do nothing is just as much of a decision as to make a change. The United States can’t continue on this peer comparison construct in determining executive pay . . . it just can’t.

We don’t have enough parks.

Other Trends Threatening Our Economy

Where else do we see the Rule of 72 affecting our data? Today, the Government reports 22 million contingent or temporary workers, individuals who are either contract staffing (a nice name for employee leasing) or simply paid with a written check, a 1099, and forgotten. Now I won’t discuss the various Congressional and Obama Administration efforts today to address this problem because they minimize it as a “nanny issue”; I just want to work backward through the Rule of 72 with you. If, in 1985, there were 687,500 temporary workers, ³ how many times does this 0.7 multiply (1.4, 2.8, 5.5, 11, 22) to double this value? That’s an approximate 14% increase rate to get to 22 million, 687,500 doubled 5 times in 26 years. What happens if 14% holds true for the next decade? That’s 44 million in 5 years, 88 million by 2022 . . . I’ll stop there. America has but only 140 million people working.

This problem is one that affects the funding of retirement plans, including Social Security, one that exists because one does not have to include temporary employees in health insurance plans, play the system for lower workers’ compensation rates or worry about wrongful termination or discrimination claims. Social Security was constructed on the assumption that employers would have employees. The Rule of 72 is cruel. It continues no matter what words are spoken by the politicians. Twenty-two million temporary employees will become 44 million. Even if it takes longer than projected, the construct to escape government- or company-sponsored plan contributions is pointing in the wrong direction.

And speaking of doom or gloom, let’s discuss the Rule of 72 and health care. Benefits are a wonderful place to apply the Rule of 72. Here’s a graph we’ve been using at ERI for 25 years.

If you note, we forecasted long ago that 2014 would be a magic year, the year in which health care costs increasing at much higher rates than salaries would surpass wage costs for the beginning employee. It got here quicker than we thought. This year, ERI’s annual family coverage for just Blue Cross Premera will be $22,800. One can hire a minimum wage worker for $18,803 in Washington state (our new rate as of January 1, 2012; 24% higher than Utah). When I interview an unskilled employee, he or she is thinking of a starting salary and I am thinking of the Blue Cross billing. They want to know what their monthly salary is and I’m worrying about their children’s health, worrying about discriminating in favor of young single adults. (By the way, if you do the math, if ERI had an employee-pay-all plan, then these Washington state employees would receive no take home pay. That tells you almost everything you need to know about why wages are stagnating in America, and why housing values are not going to rebound anytime soon, if mortgage payments are a ratio of take-home pay.)

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The escalation of health care cost is not an actuarial dynamic like salary increase or pension costs. They are not costs that can be decided in a management budget meeting. Health care costs are driven by litigation, pharmaceutical prices, an aging population, related service providers and their lobbyists and technology advances—not the demand and supply for care. Back in 1974, drug costs were 5% of the cost of health care premiums. Today, they are almost 50%. In the 1970s, pharmaceutical costs were minor. Today, they are determinative. That’s why when the Republican Congress and President in 2004 (let’s give them their due for passing this) gave Social Security recipients drug coverage, they increased Medicare recipient health care costs from $24,000 to $36,000 annually, which when added to the wage/salary replacement component of $14,000, provides a total benefit of $50,000 a year rather than $36,000 for a Social Security Disability Insurance (DI) recipient, all without a tax increase. When people tell me they should have better drug coverage under Medicare and that “they’ve paid for it,” my answer is, “No, you haven’t.”

You hear politicians complaining about the nation’s new health care path. I believe it is all words; we can’t go back, the Rule of 72 is grinding away. Here’s the trend (available at http://stateofworkingamerica.org/charts/employer-sponsored-health-insurance/).

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The eventual answer will be no health care for the masses unless something is done. Someone’s ox has to be gored among the employers, employees, agents, accountants, Voluntary Employees Beneficiary Association bankers, compliance agencies, lawyers, brokers, hospitals, professional care staff, health care insurance carriers, self insured stop-loss carriers, third-party administrators, drug companies and these 14 providers’ lobbyists. Everyone is scurrying not to be in the sights of those about to be hurt. For all the political posturing, take my word for it—if there is not a new construct, many employers will have to drop their health insurance plans. Many companies’ (like ERI’s) health care premiums are advancing at rates of greater than 20% a year. Insurance companies’ executives are living for the moment in 2012, they are trying to maximize profits while they can. Health care costs (if you measure it in terms of midsize companies’ premium costs) are now doubling every 4 to 6 years. Look at what people do, not what they say. Some new construct is on its way—it has to be—otherwise the Rule of 72 will grind most people out of the system, the young among us first, those a rational society would want to be the healthiest.

Want a solution? Focus on the sick and the health care providers, along with a “payor/administrator.” Cut everyone else out of the equation: the lawyers, the property and casualty insurance carriers, the brokers, the banks, the third-party administrators, the consultants, the agents and all their lobbyists. By leaving so many “pigs” around the trough, the new national health plan promises that “all” will get hurt, most of all, those without lobbyists: the nurses, doctors, other care providers and the sick.

Let me repeat, the cost of annual health premiums to employers is getting too high to finesse. If employers have to drop their coverage, they will do it passively by requiring employees to pay portions that they can’t afford. When a certain percentage of employees have opted out, the carriers will decline to offer coverage because of adverse selection. The window for some other change has passed. What’s coming has left all the players at the trough. If the proposed “individual mandate” is struck down by the courts, all players will squabble and the tide will continue to roll in. If it is not struck down, all the players are still at the trough and the tide will continue to roll in.

Here’s another Rule of 72 example: The U.S. Social Security Administration sent a task force to our offices to discuss ERI’s work in identifying job work measures used to match jobs for salary surveys and complementarily in order to assess whether an individual had, or no longer has, the physical or mental cognitive capacities for the work in a particular job. It is a simple comparison of “typical job work measures” found in an occupation versus the individual’s residual capacities (after an injury, unemployment etc.). It is what private disability carriers look at: the capacities needed to handle a job and the capacities of the individual now limited by a disability. That is, for those of you not familiar with this, Social Security is not just a retirement plan. It is the world’s largest DI plan.

Perhaps you’ve heard that Social Security’s DI recipients’ rolls are increasing. Some suggest abuse of the system based on the numbers being reported. I quote: “The share of the U.S. population receiving Social Security Disability Insurance benefits has risen rapidly over the past two decades, from 2.2 percent of adults age 25 to 64 in 1985 to 4.1 percent in 2005.” ⁴ So, in 20 years, the percentage of U.S. DI recipients have almost doubled, and we all know that with the Rule of 72, that means the growth rate is over 3.6% for those who are becoming disabled. It appears that the more we try to keep the work environment safe, evidence suggests that it is becoming more dangerous.

Keep in mind that DI is really “early retirement” and that individuals go off the rolls after they reach retirement age.

If the Rule of 72 holds true, by 2040 we will have 12% of America’s working age workforce on their “full age 67-68 year benefit” with Medicare coverage for life after 2 years. Do you know how many people come off DI each year compared with the 5 million who apply? How many DI recipients reenter the workforce? Fourteen thousand, which has been a constant number year after year, which is statistically zero! To entice someone out of early retirement who is paid under DI, You have to replace $50,000 in pay and benefits with an employer who has a benefit plan richer than Medicare. The construct is in place, nothing can change the numbers. Unless you can change that construct, the trend upward continues.

In 50 years, the Rule of 72 tells us that you will have 20% of the U.S. population on early retirement under DI. And this could happen sooner. If any of you know how to play this system and no longer wish to work, I suggest you meet with a lawyer with the National Organization of Social Security Claimant (NOSSCR), find an local judge that approves appeals at a rate of over 90% and talk about the “pain and suffering” mental cognitive difficulty you are having. You don’t have to pay the bill, the NOSSCR attorney collects $5,300 only if you win your claim in appeals, which 9 out of 10 times you will with the right judge. It used to be that “disability” was about the physical components of the job. The mental cognitive capacities now account for 37% of determinations, up from 5% just 20 years ago. Five percent to 37% in 20 years; use the Rule of 72 on this, and you’ll see that played out, we will soon all be residually incapacitated cognitively and mentally.

Not possible, you say. Well, the United Kingdom and Sweden have warped what was their public retirement system into disability and welfare programs. Rather than 4%, they are approaching 12% and 16%, respectively. Others have taken this course of removing the unskilled from the available workforce, because the true measure is “lessened capacities” and not “disability.” This, by the way, is also the U.S. definition. It hurts the Treasury, but it helps unemployment numbers. If you are not following this discussion, think back to the 1990s political campaigns when welfare reform was a topic. DI has solved this “problem.” Now the problem becomes funding Social Security, but that’s for our children, right? Welfare reform is no longer a political hot button. We’ve solved the problem by printing money.

Here’s another look among the trees from ERI data. Do you know that ERI finds firefighters are among the fastest growing occupations in America, growing at a rate of 8%? Many government jobs are among the fastest growing, with prisons and Homeland Security leading the hiring. You can see where government employment is going. Ask yourself this: “If we were to lay off half of the firefighters in America and make smoke detectors connected to central agencies mandatory, what would be the cost savings?” What would the cost of a few houses burning be compared with the unfunded benefit promises of municipalities for public employees who are rarely used. No one is asking these types of questions. Rather, we are increasing our fire protection forces, increasing our police forces, and we now have our own Department of Homeland Security with its own military force, the Coast Guard. Economically, with the Rule of 72, one has to ask where the construct of government growth will stop. It is very doubtful that the private economy can continue to fund this growth. Someday, we might all be working for the government, especially if health care is nationalized.

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From this perspective of deep within the trenches, not being able to understand the subtleties of “the American Forest,” let’s talk about shuffling the cards. We’ve a problem in America, as can be illustrated by executive compensation growth. But that’s not the same thing as “wealth growth,” and that’s where another real issue lies. There’s an ever-increasing disparity between the rich in America and those who either work, or those who don’t work. The Rule of 72 “widening percentage” is thought to be as high as 10% for those with wealth and those without (this is why Switzerland taxes wealth). We’ve had two great shuffling of the cards in America’s history that reset the Rule of 72 back to zero base. One was the immigration of second and third sons and daughters and the Homestead Act around 1900. The other was World War II and the GI. Bill where 10 million Americans benefited (out of a population of 140 million) that ended in 1952. We are going to have 400 million citizens as a nation by 2050. What is going to shuffle the deck in America? Are we going to become a class society like the United Kingdom? What construct do we have in America today that allows for the shuffling of the cards?

Conclusion

These are tides. The Rule of 72, and the mathematics of compound interest won’t change. If you’ve seen the movie No Country for Old Men, there’s a line at the end: “You can’t stop what’s coming.” It’s a great line because constructs and the Rule of 72 keep grinding away. We make the easy decision to “let things be, let the next generation solve the problems.” Those are decisions. To not do something is a decision.

In summary, these are the falling bombs that ERI sees from the trenches, down in the dirt, looking up from our data mining. Great battles are about to erupt regarding the following:

The Rule of 72 grinds away. Compensation and benefits hold key constructs in the coming economic tidal wave. We can’t repeal base 10 math, but we can change constructs. That said, my career of 40 years has seen no change in any of the constructs discussed. As Americans, we believe we can solve problems, but there are problems that can’t be solved, constructs that cannot be changed.

There is one saving grace, although it makes U.S. human resources problems much like Greece and the European Union, a state operating within a “united” structure. To a great extent, law, insurance, accounting and medicine are state licensed and controlled. By looking at what other states and regions of the country are doing, one should be able to stay out of major harms’ way. Knowing that the issues that surround you are created by constructs that are not changing, one can plan to stay safe—barring the random stray bomb. And looking at history, we can see that Rome did not solve its citizenship problems quickly, that it took a while for them to stop building fences like Hadrian’s Wall and that Switzerland did not create a reasonable national health construct in a day’s time. Life will go on, and it is always better to focus on problems that can be solved, behaviors that can be changed using data that are factual and numbers based—not prose-driven mythical fantasies or wishful thinking, which is an easy place to go for someone down in the trenches with the world changing.