Bogus Bonuses and C.E.O. Salaries
One of the most common justifications for hefty C.E.O. compensation packages is that if the leaders of industry are not paid well, the so-called best and brightest will no longer flock to fill the corporate ranks, and will instead go elsewhere. High salaries (and bonuses, etc) are said to both motivate and retain these brilliant minds.
While this sounds somewhat plausible, as it turns out, a new study shows that it’s just not true. One driver of executive pay, called the peer-group benchmark, compares the salaries of executives among ostensibly similar companies as a way of keeping salaries competitive and within reasonable market limits. The problem is, this measure assumes that a C.E.O. at one company could pick up and leave for greener pastures at another, which, as it turns out, is a false presumption.
The study, conducted by Charles M. Elson and Craig K. Ferrere, shows that many of the skills C.E.O.s possess are specific to the company in which they are acquired, and are not readily transferable to other companies. Their analysis shows that almost every attempted transplant at the top ranks has resulted in failure.
What this means is that all this benchmarking makes the market of C.E.O.s seem like a market with high mobility, allowing for C.E.O.s to move to other companies when in fact a C.E.O. who manages one company well is unlikely to be successful in another. Therefore, a company looking for a C.E.O. cannot actually consider all C.E.O.s as potential candidates. Benchmarking, then, is little more than a way to inflate executive salaries by comparing jobs in markets that are essentially incomparable.
Ultimately this study shows that determining executive salaries needs to be reevaluated and reconfigured with an eye to empirical data, even if that means reducing C.E.O. pay. After all, we are all shareholders in these companies and they are giving away our money for what turns out to be no good reason.
The Honest Truth About Dishonesty: How We Lie to Everyone - Especially Ourselves
Only one small problem: these are not rational decisions, and they are made by people who are in transit- the CEO, the Board, etc- so why not get as much as possible while you can? If performance was the main metric, most CEO’s would owe money to the company they run.
Salary should be a function of an employee’s importance to the company. Determining importance is again a function of many parameters (impact on company’s profitability, culture, goodwill among few others)
Sorry Dan, this time I beg to differ from you!
Best,
Nidhi
I disagree with the posters above. If true, this study concludes with a very powerful and important finding indeed. It may take time, but in a down phase of the business cycle it’s plausible to me that shareholders (led of course by a small set of larger investors) could come to ask deep questions about massive compensation packages. Excellent.
The CEO peer-group approach issue is similar to arbitration in baseball. With the top levels of pay established by the very best players, average players could go to arbitration and be awarded a salary not quite as high as the best performers, but much more than they would have garnered by negotiation without the possibility of arbitration. This cycle reinforces itself when those average but highly paid players become peer group members for other players in arbitration. Eventually, the entire population is paid much more than a free market would permit, and the worst performers are the biggest winners.
The NFL doesn’t use that approach, and as a result the larger disparities in pay better reflect the differences in player values to each franchise.
If CEO’s skills are not easily transferable as suggested then doesn’t that imply a smaller job pool for companies to choose from? Doesn’t market dynamics of supply and demand then dictate higher wages for CEO ‘s?
Jim, the smaller pool of candidates also means a smaller number of opportunities if you buy into the non-transferability thesis. Say, Company X has three CEO candidates, all current VPs within the company and all making $700K. Any one of them will likely make the move for an increase to $1 million, even though CEOs at two other companies of comparable size are making $4 million and $5 million. The other company data becomes irrelevant because the VPs can’t transfer their skills to those companies.
Having said that, I don’t completely buy into the non-transferability argument. A successful senior executive may be recruited by other firms within the industry because her skills are indeed relevant and useful.
Well stated. Individual Value Proposition. This concept is valid across the executive ranks. Specific industry knowledge, industry contacts and industry persuasiveness dictate transferability. Bob Nardelli is a great example of this. He was a very successful leader at GE but his capabilities did not transfer to Home Depot or Chrysler. My opinion is that his value proposition was specific to a conglomerate with an energy division.
This time Dan varies off course to engage in the politics of class envy. There are more than a few things wrong with the study. As a CEO, I can tell you that I have great mobility/opportunity within my industry, but less so across industries – but you could pay me more to make the jump and give it a try. But there are dozen/scores of companies I could move to IF I were doing well with my existing company relative to my peer group. If I wasn’t, why would anyone hire me anyway?
The envy is just silly: If my pay were zero dollars, the impact on shareholders’ return and employee pay would also be zero (simple math of only one salary) but the people to whom Dan would direct this study data would all feel better. Fortunately, business and investment isn’t about what makes people feel better! Your retirement income depends on that.
If I create wealth for individual shareholders and diverse pension plans who are trying to meet their monthly pension payment responsibilities and thousands of 401K accounts who hold my stock, the wealth created is enormous; people all over the country benefit by growth of their stock accounts for their retirement. If the company performs poorly relative to its industry peers, stock accounts all across the country perform poorly too. Paying great people well to lead a company that has that kind of impact is a corporate board responsibility, and its a surprisingly cheap investment given the scope of impact. Just like in the NFL, great players command significant salaries and are sought after in the NFL, not to play in the NBA. But they might try it if someone offered enough!
Just for fun, compare salaries of actors and professional athletes to those of CEOs; you might conclude that these groups are overpaid relative to the financial return they bring. Are we concerned about paying $80 million per movie to Will Smith (way more than most CEOs make per year)? Do we express angst that the make-up artist makes $20/hour in comparison? No, we don’t give that a thought because it isn’t politically expeditious at the moment. We assume that smart people decided this was worth it, and Will Smith agreed too.
On the flip side, paying a CEO or any executive exceptionally well when performance is low relative to a industry peer group, is also bad for business as it rewards the wrong behavior. If Will Smith (for example) didn’t draw the fans (and movie investor returns, local theater popcorn sales, etc.) he wouldn’t be getting that kind of pay either.
The study in question makes some clear distinctions between musicians, athletes and CEOs. In the movie/music business, the actor/musician is purported to BE the product (if you discount screenwriters, directors, lyricists, song-writers, publicists, etc!) and hence can be contrasted to the CEO& corporate team. I say…not so fast….how would Peyton Manning do without a great offensive line? How many flop movies has Bruce Willis delivered? It isn’t just the actor/athletes. True, though, that the CEO is seldom the ‘product’ – exceptions might be Warren Buffet, Jack Welch, Lee Iaccoca, Steve Jobs, Bill Gates, etc. Say the name – you know the company.
When people hire an actor or a CEO, the investors/Board of Directors is placing a bet. A bet that this new hire will replicate success he has achieved in one arena/stage/firm is transferable to the current situation. The CEO, too, knows that it might not work out. He wants to be compensated for the (possibly long shot) risk he is taking going outside his comfort zone, and understanding that failure lends a prolonged stink to the rest of entire working life. The CEO is in effect making a wager too, that leaving the cocoon of success in his current assignment (why else would he be pursued if not successful?) will be good for his ‘statistics’.
And Board do foolish things (like fire Steve Jobs for a Pepsi product in early Apple days). Liken this to medical ‘cures’. When the patient (company) is failing, people (boards) resort paying exorbitant amounts for miracle cures. People still do foolish things every day.
Ultimately, informed intelligent people – with full knowledge of the risks and rewards – on both sides of the equation come to an agreement that makes both parties happy in the marketplace whether it be a player gate share, movie rights, or music royalties. There is no ‘empirical data’ the study would desire to regulate salary for a new player in a new team; life is a crap shoot at best. This is people trying find ‘pay equality utopia’ like regulators try to create in other areas of our lives.
Is this what we want? Would you like some regulations and ‘empirical data’ deciding your salary? Would you like to be prohibited from getting more (risky) money at a start-up company you are passionate about but ‘your experience isn’t directly transferable’?
Yes, there are lots of horrific examples of CEO pay out there. But there are overpaid teachers (really sore spot for me), actors, and athletes, too. Yes, capitalism is a bad system sometimes; it just happens to be better than anything else every tried. Tinkering with the market never works in the long term – but then….oh, don’t get me started….
“Yes, capitalism is a bad system sometimes; it just happens to be better than anything else every tried.”
False! Nordic social democratic states with more regulated capitalist sectors and larger public sectors consistently outperform the US on important social metrics (fighting poverty, access to health care and education, and so on).
The flaw in your reasoning is to assume one of two extremes – either all capitalism everywhere or soviet statism. But mix in between is where all real countries are. And the US should move further towards an economy that counters current regressive distributive mechanisms.
Very well said!
I just want to add as the wife of a family practice doctor who is also the CMIO of his hospital, that often you feel that there is no amount of money that is compensating your life for the stress and Inconvenience you deal with in certain jobs in this country. How do you really measure the amount of time and stress that someone undergoes when they are in a position that is more than clocking in and out from 8 to 5?
The long hours that extend late into the evenings and all throughout the weekends, the constant feeling that you cannot relax and enjoy yourself because there’s somebody somewhere needing something from you, the depression and the anxiety that people undergo because of the stress of these jobs. Dealing with other professionals second guessing your decisions, being sued, etc. There is a huge amount of responsibility on these professionals’ shoulders.
And whether it’s an athlete who allows his body to be beat up and possibly destroyed for the rest his life (do some research on the life span and quality-of-life of these athletes), or a CEO of a major corporation, or a physician, or whomever: We have to take into consideration that these bonuses just might be a drop in the bucket compared to what they are giving up in their life. Like family time, health, peace of mind.
Have you considered that many many ordinary workers have extreme stress at their jobs also? At every job I’ve had there was time constraints which one had to fit into no matter what else is going on in one’s life, there’s competition in any office, usually there’s at least one person who is low on the “social” totem pole and that alone can kill a job for an otherwise hardworking intelligent person who is doing their job well. Many very low level jobs actually have weekly account of performance numbers and warnings to go with it! Of course skilled professionals should get higher pay,,but the way you tell it less skilled workers have carefree work experiences.Please consider a different approach.
“there are overpaid teachers” – totally. There are too many people who are in the “Quit and Stayed” category of contribution to their team, company, society… they show up, they do the minimum and they leave… these are the true overpaids.
……There are too many people who are in the “Quit and Stayed” category of contribution to their team, company, society… they show up, they do the minimum and they leave……
Really? How do you define “the minimum” especially in terms of “contribution to their…society”? In any case, the way I see it, neither progress nor lack thereof is the product of an overabundance or insufficiency (respectively) of participant effort. We are not living thousands of times better than the Ancient Romans, for instance, because we are putting in thousands of times more effort than them. The difficulty lies in figuring out the right thing to do (and having the opportunity to do it), not in doing somewhat more than the minimum.
zzzTheDay: I don’t see why you’re attacking Ariely for being “political” in this post — he’s simply citing a study suggesting that CEO pay based upon “benchmarking” makes unrealistic assumptions about transferability of skills. If you believe *your* skills are more transferable than most CEOs of large publicly-traded companies, then congratulations on that — but it doesn’t invalidate the thesis of the study. If you want to call into question assumptions or methodology used in the study itself, then by all means do so, of course, but I’m afraid you’ve just attempted to invalidate data with an anecdote.
In response to your comment “Is this what we want? Would you like some regulations and ‘empirical data’ deciding your salary?”, again you seem to be making assumptions about the politics of the author without justification. The term “regulation” was neither stated nor implied. Boards of directors (we’re talking about publicly-traded companies here, not the “CEOs” of SMBs who are their own boards) have to use *some* metric to decide on CEO salaries, and what this study shows is that “benchmarking” is not a very sensible way to do it. It’s the boards themselves who need a better approach, not some nefarious government regulator that you seem to be so twitchy about.
What this study doesn’t completely address, however, is the mechanism by which salary inflation has taken place — “benchmarking” is at least partly to blame, but that doesn’t explain *why* many boards accept this as a valid measure. But there has been a fair amount of evidence to suggest that the cozy relationships between (many, though obviously not all) CEOs and their Boards that are meant to oversee them has led to some failures of oversight, particularly in the realm of compensation. This is what shareholders should be concerned with.
A useful study would focus on why Boards of Directors feel that a new CEO will bring in more than his compensation when the compensation is so high. If it’s behavioral economics that we’re interested in, what is driving the behavior of those making the offer? Why don’t the Boards lower their offers and see if anyone bites? Or is it that the CEO’s deliver, and that’s why the offers keep going up?
The ratio CEO pay to pay for hourly workers in the US is higher by a tremendous order of magnitude than it is in any other developed country. Are we doing that much better–or any better–than Japan or Germany?
As far as compensating people for the tough, stressful, nasty things they do, the toughest, most stressful, nastiest jobs, e.g. nurses aid, data-entry operator, etc.–are the most poorly paid.
I struggle to see how CEO compensation can be determined by the value that the CEO contributes to the company, given the difficulty of measuring the latter. Say a CEO approves a good idea from one of his reports (that a worse CEO would have killed), and this idea is then well executed by the people directly involved in its creation and the result is an extra $100M in profits for the company. How much of that value is contributed by the CEO? There are also many signs that there is an over-abundance of people both willing and capable of performing a CEOs duties. The former means that a CEOs life is seen as less unpleasant than that of people in lower roles. The latter is evidenced by many startup founders capable of performing quite adequately, the abundance of management consultants, executive coaches, etc., and the fact that the public memos/articles/speeches produced by most CEOs are notable for their lack of any special insight (there are very few moments of “wow, he’s obviously capable of seeing things that the average person would not see!”).
In other words, CEOs benefit from (recursive) hierarchy (the person directing other people is, at every level, expected to make more than the people he directs) and, therefore, are simply in a position to extract, rather than create, value. The result is the dependence on credentialism observed during the hiring process. Unlike in sports or even in entertainment (where plenty of unknowns can be discovered while past hit makers can quickly fade), the main filter for senior positions is past experience in other senior positions.
It ought pass without saying that many CEO’s are vastly overcompensated for the contributions they make. But to the extent that their skills are indeed non-transferable, these become specialized and therefore more valuable to their respective companies, not less.
We ought to have laws limiting or barring bonuses for CEO’s and other executives during quarters of financial loss, in addition to instituting a higher minimum wage.
http://whatdirectdemocracymightbe.wordpress.com/2012/07/20/morality-and-the-minimum-wage/
I think what’s missing here is a discussion of the systemic effects of CEO pay: after all, boards are trying to get the best result for the company, not an award for “fairest salaries”.
For example, the average actor/sports figure is poorly paid, despite the massive salaries at the top, because their employment market is structured as a tournament. Drug dealers of course are famously in the same boat. People are willing to make sacrifices along the way for an almost vanishingly small chance at a big prize.
Couldn’t the same thing be happening with executive pay? I’m thinking of all those professional service “boutiques” that even to attract second tier talent need to pay higher entry level salaries & offer better work/life balance and better conditions because the people who sign up to those companies are giving up on the chance of a multi-million dollar partner salary at a top firm.
Tournament system wouldn’t be the only systemic effect, of course. For example I can imagine people lifting their games when playing in “the big leagues” while working for a company with a highly paid CEO, etc. Intuitively I do think executive pay gets a bit ridiculous, but I’d like to understand the bigger picture.
I would just like to post something a friend of mine showed me. It’s about the performance vs. pay discussion. I can’t say anything about the validity of it, but nonetheless if it bears even some truth it is very interesting.
All these theories presume that there is a general public interest in the salary of a CEO. A CEO is expected to provide good stewardship for a company and keep it a viable economic enterprise for a specific group of stakeholders (eg stockholders, etc.) A CEO’s compensation should be based on his organization’s assessment of his/her worth in that circumstance. The rest is just twaddle. It is the Board’s responsibility to get the best value for a CEO’s service. The alternative, I suppose, is some sort of executive compensation department of the government to control things. Seriously? We want to go down that road?
The idea is not to have better PEOPLE trying to figure out the ‘right’ CEO compensation but to have a better SYSTEM for figuring out how much value a CEO actually contributes, particularly compared to any person who would be willing to take on the role in return for much less.
As many studies have shown (with, if memory serves, Ariely involved in one of them), human beings are great at determining relative value (is A more valuable than B?) but terrible at determining absolute value (how much do you think A is worth?). Why is CEO compensation typically in the 7-8 digits? Would the performance of people applying for the job drastically decrease if it were 6-7? Could the performance be significantly improved if it were made 8-9?
Right now, we have no good way of answering those questions. No board wants to experiment and there is no analytical framework.
Yes, and the CEOs pay huge fees to consultants to construct specious analyses and comparisons to justify CEO looting. It is a kind of corruption.
Nah – CEOs deserve as much money as their boards and owners afford them … who cares why they decide to justify it. If the company can afford it, the CEO must be doing it right! Hey, does anybody know anybody looking for a CEO?
This might be another interesting additional perspective:
http://redaccion.nexos.com.mx/wp-content/uploads/2012/02/1118373109.full_.pdf
Seven studies using experimental and naturalistic methods reveal that upper-class individuals behave more unethically than lower-class individuals.
In studies 1 and 2, upper-class individuals were more likely to break the law while driving, relative to lower-class individuals. In follow-up laboratory studies, upper-class individuals were more likely to exhibit unethical decision-making tendencies (study 3), take valued goods from others (study 4), lie in a negotiation (study 5), cheat to increase their chances of winning a prize (study 6), and endorse unethical behavior at work (study 7) than were lower-class individuals.
Mediator and moderator data demonstrated that upper-class individuals’ unethical tendencies are accounted for, in part, by their more favorable attitudes toward greed.
This is an interesting bias. Maybe CEO just thing that they are good at everything regardless of what it is. Golf, for example.
Goodness, if some of the railing responses attacking this research (and unfortunately, Dan himself) don’t substantiate “Predictably Irrational” behavior…I don’t know what does!
Ferry, there’s another study that also demonstrates the those of privilege are substantially less empathic than those arising from meager means. Other studies identify those that are obsessed with the pursuit of extrinsic goals (money, image, status) are measurably less happy than people that are motivated by intrinsic goals and values (personal growth, authentic relationships, service to others). It has to do with something called “hedonistic adaptability”, more is never enough as extrinsically motivated people trap themselves on the hedonistic treadmill. I wish them luck in their “pursuit of happiness”!
Yesterday, a report went out over the business wire that Steve Ballmer, the CEO of Microsoft, had his bonus cut to around $650,000. Why? Sales dropped 9% at Microsoft last year. Funny, if I recall, when I was a salesman in the field, if sales in my territory dropped 9% not only would I not have seen a dime in incentive pay, I probably would have been on the street looking for work.
Great info, Dan! Keep up the great work.
Also, there are a couple of major misconceptions (M) out in the public domain, which based on my humble perceptions, I would like to address (A).
M1) The CEO is the head of a Company and he is ultimately responsible for what goes on in the Company.
A1) The CEO is the “Accountable Manager” responsible by law, however the true head of a Company is the Owner or Owners; however it seems to me that the Owner(s) have no legal accountability; I have seen many so called “hatchet man” CEOs who came in, gave nice speeches and then chopped the Company into pieces just to prepare it for the forthcoming merger and the sake of “shareholder value’; after the job was done, they took their bonus and ran to the next bloodbath. People seem to be oblivious to not look behind the curtain to understand the “higher reasons” driving sometimes seemingly irrational events…. So, I would agree, that yes, some CEOs have to be seriously compensated for all their highly unethical skills of “preaching water” and “getting drunk”, while the audience (employees) is exhilarated by a drop of water on their heads.
M2) The CEOs income is the published income from the Company he works for.
A2) Many CEOs are members of Foundations, Members of the Board of other Corporations, where they also receive hefty compensation. Try to look into the “Corporate Governance” section of various corporations and you would be surprised by the names of the members of the Board.
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