• 01 Aug 2005
  • What Do You Think?

Is There an “Efficient Market” in CEO Compensation?

 
 
There appears to be little or no relationship between the size of American CEO compensation awards and actual corporate performance. Will change come from the increased level of competition among global companies with significantly different approaches to the compensation of senior managers?
 
 
by James Heskett

Summing Up

Paul Jackson sums up the thinking of most respondents to this month's column with the comment, " . . . nothing about CEO compensation seems to be 'efficient.'" Brad Millet adds, "The CEO market for mega-organizations operates in a synthetic universe—one that differs largely by scale alone."

Several respondents offered an explanation for these phenomena. Typical was Rahul Sharma's comment: " . . . these high executive compensation packages are . . . necessitated by the reduced 'lifespans' of chief executives." As Tom Klopack put it, "The price of a CEO for a company seems to run on a scale based on size. The ultimate problem with that is the large failure effect. . . ." Responding to the point that hiring from outside an organization is often a more expensive solution, Balaji Iyengar points out that " . . . in most cases, an external CEO is probably the 'easiest, politically correct' option . . . where there would typically be two or three close [internal] contenders for the top job."

A number of ways of meeting these challenges were suggested. Klopack's was: "Large companies may want to look for talent among CEOs in smaller companies who are used to accountability." Stever Robbins commented, "Why do we even spend our time debating whether a Fortune 500 CEO is 'worth it'? Why, instead, don't we seek to hire people who are so motivated to want the job that they don't NEED a nine-figure inducement to consider showing up for work?" Bill Bittner observed that, "Those boards that recognize the need for change early can use the existing talent to make it happen, and save both money and careers." Anshu Vats said, " . . . unless we can transform the way the market works to bring shareholders into a more active participative role, CEO compensation along with other governance challenges such as agency issues will continue to plague companies." Julie Dotson-Shaffer put it most succinctly: "Every contract should be a 'win-or-go-home.' Losing should feel like losing to the leader. . . . If they do not generate wins for the team, a CEO should get what the rest of us get when we don't deliver: nothing."

These suggestions leave us with some interesting questions. Can effective leaders of small organizations be considered as part of the talent pool for mega-organization CEO positions? Is there something about the need for high compensation and the "score keeping" that goes with it that distinguishes desirable CEO candidates from others? Can (or should) ways be found to involve shareholders more actively in the process of CEO succession? To what extent and how should boards be held accountable for failing to foster "bench strength" that would obviate the need for hiring CEOs from the outside? To what extent, if at all, can markets for CEOs be made more efficient? What do you think?

Original Article

In recent years, investors in U.S. companies have seen their companies' CEOs rewarded with bonuses, stock option megagrants, retroactive monetary awards for past performance, pensions, and other compensation that makes the annual income of even media personalities and the best professional athletes pale by comparison.

Students of efficient markets might argue that these are merely a reflection of the scarcity of supply among those thought to be able to lead large organizations. And yet there is evidence of little or no relationship between the size of CEO compensation awards and corporate performance. Why?

One theory is that the market value of all CEOs is driven by companies hiring leadership from the outside rather than promoting it from within. In other words, there is a market premium paid for outside hires. Hiring from outside often occurs either in organizations with little management depth or those facing a crisis in performance that raises the level of urgency to pay more to get the best. Thus, these situations force upward perturbations as well in the market value of CEOs in companies not facing such crises. The phenomenon would not be relevant if it were not for the role of compensation consultants who measure average CEO compensation and facilitate discussions in which companies are encouraged to adjust salaries to keep pace with some percentile of the average for all companies. The absence of any dampening mechanism in this "market" may help explain why average CEO compensation for decades has borne little relationship to overall corporate performance in the United States.

If the efficient market is not working, what might be done about it? Of course, there is always the regulatory route. For example, the United States does not allow salaries over a certain amount to be exempt from tax. This has effectively capped salaries, but invites unlimited compensation in other forms. Several high-performing companies such as Costco Wholesale and Whole Foods Markets limit CEO pay to some multiple of the average salary paid to all employees. But any unilateral move such as this has to limit the number of candidates willing to consider such CEO positions, even though their willingness might be an indicator of potential success in these jobs. Taking the matter to an extreme, shareholders more frequently might vote not to reelect boards making megagrants to CEOs.

New findings suggest that the efficient market for CEO compensation may, in some respects, be effective. One recent study has found that companies whose CEOs were promoted from within outperform those that replaced their CEOs with candidates from the outside. It is quite possible that this was accomplished at lower levels of compensation as well. But will a more profound impact be the increased level of competition among global companies with significantly different approaches to the compensation of senior managers? That is, will a global market for talent, to the extent that it involves low-paid European and Asian talent, exert significant downward forces on CEO compensation everywhere? What do you think?