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CEO Salaries and Pharmaceutical Costs

I had a conversation recently with someone who was quite upset about how much money pharmaceutical companies spend on CEO compensation -- at a time when many people are not able to afford necessary medicines.

While I do not support restricting or limiting compensation, I also often scratch my head and ask, “Does it really make sense for a corporation to give someone tens of millions a year to run a company?”  Beyond a certain point, there's no useful way to spend the extra money.  Someone who gets $30,000,000 in a year is grossing more than $82,000 per day, or $575,342 per week.  How many steaks can you eat, how many vacations can you take, how many homes can you occupy, how many Ferraris can you drive?

Still, I thought it would be interesting to see how much pharmaceutical makers are spending on CEO compensation, and if this might be a factor in the costs of lifesaving pharmaceuticals. Forbes keeps track of the top 400 CEO compensation packages for American corporations.  Pharmaceutical company CEOs are NOT unusually highly paid.  There are a few pharmaceutical CEOs in the top 100, but only a few.  By comparison, other sectors, such as health care, communications, entertainment, consumer products, and stuff of questionable actual value, are more common in the top 100 list. UnitedHealth Group's CEO is the top: $101,960,000.

When I started digging into the details of these compensation packages, however, I noticed something very interesting, of which David E. I. Pyott of Allergan (a drug company) is pretty typical: The vast majority of the compensation is stock gains, not salary or bonuses. Of Pyott's $33.76 million compensation, $30.64 million was stock gains -- not salary, bonuses, or other forms of direct compensation. In practice, this means that what the company actually wrote him checks for was about $3 million; the rest is the result of stock option grants.

This is partly because of a law the Democrats passed in the 1990s that prohibits corporations from deducting as business expenses any CEO or other top officer salaries that exceeds $1 million a year. Before this law, most corporate officer compensation was salary; afterwards, it was typically stock options, which I am afraid may have encouraged a more short-term view of appropriate corporate governance.

If you have never been part of a stock option grant arrangement, I should explain that it is not generally a gift.  You get the right to buy stock at a certain price, set such that if you manage to increase the value of the company, your stock options will become worth a pile of money. If the stock price does not rise, or falls, those options are often worthless. Without knowing the details of Pyott's option grant, I can't even begin to estimate what it actually cost Allergan to give him stock options that netted him more than $30 million, but I am guessing that the out-of-pocket cost was a tiny fraction of that — probably no more than a million or two million dollars.

High CEO compensation troubles me from a moral standpoint (although that does not mean that it is the government’s job to do anything about it). But let’s say that Pyott worked for Allergan for $200,000 a year, and the corporation took that $5 million or so that they saved for his salary, bonus, and stock options, and used it to lower the cost of their pharmaceuticals. Allergan's 3rd quarter 2011 net sales was $1.311 billion;  multiply by four to get a rough net sales of $5.244 billion. What would knocking $5 million off Allergan’s net sales save their customers at the pharmacy cash register? About .09% of the sale price. This is trivial.

Pyott isn't the only well compensated executive with Allergan, I'm sure.  But what if the next twenty executives with Allergan were compensated at an average of 1/4 of Pyott's level?  Multiply by five, so another $25 million savings would reduce drug costs by another .47% at the cash register: again, downright trivial.

There are certainly aspects to how pharmaceutical companies operate that artificially drive up costs, no question. There are legitimate questions about whether they spend too much money marketing their patented products when generic, out-of-patent products are often as effective, or almost as effective. But this focus on CEO salaries is missing the point: it may be obscene, but it has essentially nothing to do with the cost of these drugs to customers.