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?
We all know there are exorbitant salaries out there. Basketball star Shaquille O'Neal just got a huge contract for playing a game! But the difference between Shaq and many of the outrageously paid CEOs is that he actually helps his team win.
Even when companies lose big, CEOs win big. Every contract should be a "win-or-go-home." Losing should feel like losing to the leader.
There is so much executive talent that isn't even tapped. So much passion that would be applied for reasonable amounts. So many ready to make a difference without putting such a dent in stockholders' profits. If a CEO ends up with a Shaq-like salary, make him/her earn it first. 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.
I feel this is linked to the increasingly short span of CEOs at the helm and the continuous push for immediate results, at times quarter to quarter. This obviously implies that CEOs need to be remunerated at even higher amounts to offset the burnout risk. Secondly, most organizations prefer to hire CEOs from outside instead of internal talent. Most of these companies are at the cusp of major strategic transformation, so they feel an external hire with fresh ideas and thinking will break the mold, leapfrog the organization to the next level, and lead them through the paradigm shift. Also, in most cases, an external CEO is probably the "easiest, politically correct" option, especially in midsize to large maturing or mature organizations where there would typically be two or three close contenders for the top job. Given the high stakes involved and the attendant risks, the compensation naturally has to be pegged higher for external hires who would typically come from a "better, more successful" organization than the incumbent organization.
From my perspective, nothing about CEO compensation seems to be "efficient."
Simple things that customers have to deal with are not getting answered, like half an hour on phone trees before reaching someone. Customers can't even reach people in those positions who could do something about the problem.
CEOs shouldn't get a dime if they can't fix these and many other problems like it that customers deal with daily. Just as it took a U.S. State Senator to get some action on the county, state, and city roads issues near me, one should have access to the CEO who can make things right.
It grieves me that the only way to even find out the name of a CEO is often to look in the area on the web site for Investor Relations rather than Customer Service ... as if the company is only interested in serving their investors.
CEO compensation should go to fixing problems, not to multiple houses, boats, and airplanes for an individual.
I think these high executive compensation packages are also necessitated by the reduced "lifespan" of chief executives. Unlike the past, CEOs in today's operating context are expected to deliver results quarter by quarter and hedge the risk of uncertainty in their contract through a high degree of compensation. One way to balance this could be to give them some time to settle into their role and deliver value over a period of time. Part of the excessive compensation is a trade-off with the longevity of contract.
In terms of global trends, CEOs will continue to get paid extremely well because of the nature of their role and the challenges they face. The advantage of an internal CEO is that you don't have to pay a premium over and above the benchmarks for your own people and their compensation can be managed internally. However, in instances where an external CEO is required to kick-start the organization, you would need to pay the premium. One way could be a definite linkage between corporate results and executive compensation so that the package is tied up with the corporate results. Boards should lead the way in designing this linkage.
The assessment of "real" contributions by CEOs, at times, may be arbitrary: There may or may not be a logical nexus between compensation and performance. What ought to be relevant is the cutting-edge work of the CEO, which would be demonstrably reflected in the overall performance and growth of the company.
My thought: The CEO market for mega organizations operates in a synthetic universe—one that differs largely by scale alone. We ought to adjust our comparison metrics accordingly from those employed successfully in smaller organizations. We see the same breakdown of comparisons when we attempted to use Newtonian physics to explain quantum mechanics. Thankfully, advances in physics helped open our minds to more careful thinking.
In the global market for executive talent, CEO compensation can get rationalized only if the investor profile in huge corporations changes toward a more distributed profile. Boards are often dominated by a restricted number of players. The debate on outsider CEOs bears little relevance here. Insider CEOs may also grant themselves lavish compensation with the complicity of boards. Nothing can substitute for the role played by a diverse, alert, and ethical board. It is high time that CEO salaries were openly structured around the concept of Economic Value Added (EVA). Decisions on CEO compensation should be built on the art of collective decision making, the economics of risk and leadership, and the mathematics of performance accounting.
Compensation accountability appears to be inversely proportional to the size of the organization. This is my second small company in the healthcare sector, and the salary, bonus, and option payout have all been directly or indirectly through the market—the result of my performance as measured by company progress. The recent payoff of Carly Fiorina at HP appears to have been not performance-driven, but a result of the market perception of the scarcity of CEOs for large companies and their resulting pay packages.
My experience—after being in a large company in middle management positions for eighteen years before small company "C" positions for the last eight years—is that small companies do not provide cover, momentum, or place to hide. Large organizations provide cover augmented by momentum that requires a longer period of time to see true performance.
The price of a CEO for any company seems to run on a scale based on size. The ultimate problem with that is the large failure effect—even failure at a large company leads to huge-scale wealth for a CEO, hence HP's payoff of a $42 million package. Large companies may want to look for talent among CEOs in smaller companies who are used to accountability.
In my view, a revamp of the market system will be required to control the many governance issues including transparency and agency issues. CEO compensation is only the tip of the iceberg.
CEO compensation has received some attention in the media lately. In boom times it is a non-issue because shareholders are reaping rewards from companies doing well in the market in the form of increased share prices and dividends. It is only when the economy has dampened and the shareholders are not satisfied that executive performance and compensation become a "hot" issue. Therein lies the problem.
Corporate governance and the balancing act of shareholder interests and sustainability of the company are relegated to the functioning of efficient markets. America has already seen the results of such failure. Regulation has already tried stepping in with no avail. SOX, 404, and other such acts can police corporate America, but cannot replace effective management that is required through the participation of shareholders. And 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.
Should we go down the regulatory path or let the markets undertake a corrective measure in due time? I believe neither one will be effective because compensation regulation will do irreparable damage to the talent market and rewards system. Markets are not effective right now due to the way governance mechanisms are skewed in favor of institutional investors. Only the introduction of increased participative retail and individual shareholders will help to establish prudent governance in firms. Now the questions are (1) How can we change this landscape to make the corporate mechanics more real and transparent? and (2) How do we make the quarterly results of the firms more real to investors, rather than a constant cry for increased outlook at any cost?
I don't know if we have an efficient market from the perspective of companies seeking to pay CEOs, but I'm puzzled as to a slightly different perspective.
There are only 500 chances in the world to be a Fortune 500 CEO. There are probably thousands, if not tens of thousands of people qualified to take those jobs. Of those, thousands would probably be inspired enough to work for a modest salary (say, $60,000) or even pay for the privilege of being able to head up an organization like that. After all, the power and influence alone is a pretty heady reward.
In startups, we choose executives for their passion, commitment, and vision. Most executives come on board knowing they're not likely to make a nine-figure income from their job. They do it for the intangibles.
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?
CEO compensation should be based on a formula to streamline the compensation effect on all company employees regardless of whether the CEO is from within or outside the organization. The formula should be based on the following factor: percentage of profit over productivity improvement.
This percentage should be calculated through the assessment of existing market share, market trends, risk associated to the product of the organization, and the purpose of the organization vs. achieved market share after a specified period, future innovation in product line by competitors, achievement ratio in redefining the organization's purpose of existence, and response lead time to upcoming events and issues of concern to the clients of the organization.
There is no single answer to the CEO compensation question. The boards of directors must have at least some understanding of their requirements before they make a decision on whether to hire an outsider. If they are in a maturing industry that requires a "shakeout" in order to get the company back on track, it might be worth bringing in a "hired gun."
The bigger question is: "How did things get so bad?" If the boards of directors were doing their job all along, the need for a shakeout would never arise. Maybe the problem is more related to boards as a governing body that acted irresponsibly. Those boards that recognize the need for change early can use the existing talent to make it happen, and save both money and careers.