By Salvatore Babones
Why are corporate chief executive officers so highly paid?
Modern American Fortune 500 CEOs have incredibly demanding jobs leading large, complex organizations. They have to take big risks and at any minute face dismissal for underperformance.
Academic research shows that executive pay is not mainly driven by job demands or pay for performance.
At least, that’s one version of events.
Only about 20-25 percent of CEOs are fired. The rest either leave through planned retirements or as the result of mergers and acquisitions — in which departing CEOs usually receive handsome “golden parachutes.”
And those demanding, epic 100-hour work weeks? CEOs spend many of those “work” hours talking deals on the golf course, entertaining clients at lavish meals, and traveling by private corporate jet.
Academic research shows that executive pay is not mainly driven by job demands or pay for performance. High CEO pay is driven mainly by poor corporate governance resulting in a “Lake Wobegon effect.”
Corporate board compensation committees routinely determine CEO pay by comparing the compensation of their CEOs to the compensation of other, successful CEOs in the same industry. Of course, all boards think they have better than average CEOs. If they didn’t think their CEOs were above average, why would they keep them?
Companies that use pay consultants pay their CEOs more.
The Lake Wobegon effect is named for humorist Garrison Keillor’s fictional Minnesota town in which “all the women are strong, all the men are good looking, and all the children are above average.”
The Lake Wobegon effect runs especially strong in companies that hire pay consultants to benchmark their CEO salaries against others in their industries. Companies that use pay consultants pay their CEOs more and pay them more in stock, compensation that’s less visible in company accounts than cash, according to a 2009 report in the journal Academy of Management Perspectives by Martin Conyon, Simon Peck, and Graham Sadler. These effects appear even after appropriate statistical controls have been made for company performance and CEO experience.
The root cause of the Lake Wobegon effect is pay benchmarking. In a simulation study published in 2010 in the American Journal of Sociology, Thomas DiPrete, Gregory Eirich, and Matthew Pittinsky show how benchmarking practices result in a multimillion dollar game of leapfrog.
Each year corporate boards evaluate their CEOs. They only compare their CEOs to CEOs at “successful” companies, leaving out failed CEOs and bankrupt companies, and find their CEOs to be slightly better than these already better than average peers. As a result, they leapfrog their executives’ pay to the top third of the industry pack. The next year other boards leapfrog their executives, and so on, and so on.
As the leapfrogging process continues year after year, CEO pay grows at a faster and faster rate.
It wasn’t always this way. CEO pay hardly increased at all from the 1930s through the 1970s. Research published in 2010 in the Review of Financial Studies by Carola Frydman of MIT and Raven E. Saks of the Federal Reserve shows that the average American CEO in the 1970s earned about 4 percent more than the average CEO did in the 1930s, adjusted for inflation.
Since the 1970s CEO pay has risen by 686 percent.
Frydman and Saks report that since the 1970s CEO pay has risen by 686 percent. Not coincidentally, contemporary CEO pay practices date to the late 1970s and early 1980s. Back when companies gave CEOs cash raises based on annual performance reviews, just like the rest of us, CEO pay grew modestly every year, just like pay for the rest of us, if at all.
The average S&P 500 CEO now makes over $10 million a year, according to the annual Executive Excess report from the Institute for Policy Studies. The AFL-CIO reckons that the ratio of chief executive pay to median worker pay rose from 42-1 in 1980 to 343-1 in 2010.
Over in the UK they’re taking this problem seriously. The final report of the UK High Pay Commission concluded that “top pay is a symptom of market failure based on a misunderstanding of how markets work at their best.”
“It is through looking at executive remuneration that we see the classic problems of corporate governance laid bare,” the Commission said. In other words, the Commission found that corporate pay practices — not the demands placed on executives — are responsible for high executive pay.
Executive pay is now seen to be so ridiculously high that even investors are unhappy. According to the Wall Street Journal, a recent survey by executive consultants Towers Watson shows that “companies that give their CEOs high pay opportunities are more likely to receive lower levels of shareholder support.” You don’t have to be a socialist to be angry over CEO pay.
Executives involved in many of the largest corporate collapses in American history were extraordinarily well-paid.
The money at stake is enormous, but in the end the problem for shareholders isn’t the pay itself. A company with a billion dollars in profits can afford a $10 million CEO. The problem is what CEOs will do for the money. If history is any guide, they’ll do anything. It’s worth rolling the dice and risking bankruptcy for your company if the potential payoff is a multi-million dollar bonus.
Executives involved in many of the largest corporate collapses in American history were extraordinarily well-paid. Richard Fuld (Lehman Brothers), Bernie Ebbers (Worldcom), Kerry Killinger (Washington Mutual), Kenneth Lay (Enron), and Stanley O’Neal (Merrill Lynch) all had seven-digit annual pay packages.
Moving beyond specific cases, CEO greed has been shown to be related to a host of negative outcomes. One way to measure greed is to ask how much CEOs pay themselves compared to what they pay their top management team. This is called the “CEO pay slice.”
The CEO pay slice reached a historical minimum in the 1960s and has been growing ever since. As I have reported elsewhere, between 1993 and 2006 CEOs at America’s top 1500 public companies received average annual raises of 8.8 per year, while their corporate seconds-in-command received annual raises averaging 5.4 per year, thirds-in-command 5.2%, fourths-in-command 5.0 per year, and fifths-in-command 4.6 per year.
That’s greed at its most transparent.
The CEO pay slice is associated with lower profitability, lower stock returns, and a range of other negative outcomes. All this is true even after appropriate statistical controls have been made, according to a 2011 paper in the Journal of Financial Economics by Lucian Bebchuk, Martijn Cremers, and Urs Peyer. Greed is not good.
CEO greed has been shown to be related to a host of negative outcomes.
George Washington University Law School Professor Lawrence A. Cunningham suggests a remedy for the most egregious cases of CEO greed. Writing in May 2011 in the Iowa Law Review, he suggests shareholders take advantage of a little-used principle of the common law of contracts: contractual unconscienability.
Contractual unconscienability arises in “pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive.” Professor Cunningham writes that “for those outraged by lopsided corporate executive compensation, this … offers an appealing new legal theory … to police them.” I agree.