13 Sep 2006  Op-Ed

Rising CEO Pay: What Directors Should Do

Compensation committees are under pressure to keep CEO pay high, even as shareholders and the media agitate for moderation. The solution? Boards of directors need better competitive information and an ear to what shareholders are saying, says Jay Lorsch. Key concepts include:

  • CEO compensation in the U.S. continues to soar—American CEOs make twice what their European counterparts earn.
  • Shareholders want to moderate pay hikes for top execs, but board members often give more weight to internal organizational pressures.
  • Boards must be more critical of consultant reports, listen to shareholders, and align CEO pay with what is earned by other top management in the company.

 

Ask any thoughtful corporate board member what they are most concerned about these days, and it is not Sarbanes-Oxley. It is CEO pay. Directors worry because shareholders continue to express outrage, and the media attention to the issue will not go away.

Directors are right to be concerned. The long-term trend has been for CEO pay to rise along with the pay for other senior executives, and it is now twice as much as that of CEOs in major European countries, according to Towers Perrin, a global consultancy. A recent study published by the National Bureau of Economic Research indicates that the increase in pay of senior executives and superstars in other fields has been a major source of the rising inequality of wages in the United States. Rising income inequality is political dynamite and damages the reputation of American business, already scarred by recent corporate scandals. Criticisms of CEO pay have two related themes: It is too high, and it not closely related to company performance.

These problems persist for complex reasons even as directors worry about them. The most significant reason is that board compensation committees face pressures to keep raising CEO pay. One pressure is the fear of losing an adequately performing CEO. To make sure this does not happen, compensation committees rely on surveys by compensation consultants about CEO pay in similar companies but without regard to company performance. These surveys report compensation by quartiles, and no compensation committee wants to admit that its CEO is below the median. In fact, most want to place their CEO in the upper quartile. As a result, CEOs are like the children of Lake Wobegon—all are above average.

Another upward pressure occurs when boards are trying to attract a new CEO from outside the company, and they make deals that guarantee the executive will come aboard. This means not only high pay, including incentives for performance, but also guaranteed "good-bye" payments if things do not work out. These are one of the biggest sources of concern.

Rising income inequality is political dynamite and damages the reputation of American business.

The only existing pressure to keep CEO pay "reasonable" other than the directors' consciences is a concern about shareholder reaction to excess compensation, but even well-meaning directors find it difficult to focus on shareholders. Shareholders are a changing and abstract group to the directors, while the CEO who has to be attracted and motivated is real and has an office right down the hall from the boardroom. Not surprisingly then, the upward pressure wins out.

If there were a silver bullet to relieve these pressures, they would not be so persistent. There are, however, a few steps compensation committees can take.

CEOs are like the children of Lake Wobegon—all are above average.

First, they should recognize that consultants' surveys are flawed and are a huge source of the problem. In this regard, directors should at a minimum insist on surveys that reflect company performance. Second, as former DuPont CEO Ed Woolard has suggested, it is helpful to gauge CEO pay in relation to what the next echelon of management is being paid, thus placing the focus on internal equity. Finally, compensation committees should focus more on what the shareholders will accept. As CEO pay rises, it becomes, along with other executive compensation, a larger proportion of the wealth that otherwise would be available for shareholders. And ignoring shareholder concerns will continue to exacerbate the problem.

The SEC's new attention to greater disclosure, while producing more information for shareholders, is unlikely to resolve these problems. In fact, clearer data may give CEOs a basis to insist on higher pay, putting even greater pressure on compensation committees.

Reprinted with permission from "CEO Compensation Troubles," HBS Alumni Bulletin, Vol. 82, No. 2, June 2006.