I regularly see articles on this topic, but the article in the url below does a good job of undermining the myth that the market for CEOs (and the debate around how much they earn) is driven primarily by performance:
"'Pay for performance' has been the mantra of America Inc over the past few decades. A small circle of influential pay consultants, compensation analysts and academics has argued that American firms must pay top dollar for top candidates because they compete in a global market for talent. They argue that firms have grown more complex and bosses must know how to manage new technologies and the vagaries of globalisation. The controversial corollary is that pay should be allowed to rise ever higher because superior CEO performance is maximising shareholder returns."
This argument has certainly fared CEOs well as their salaries have risen rapidly, especially when compared to leaders in other countries:
"… the median CEO compensation at big American firms in the S&P 500 share index reached $14m last year. America's top earners made far more. Alphabet's Sundar Pichai received a cool $281m. The sums are considerably smaller across the Atlantic, where pay practices have historically been more restrained. The ten best-paid British bosses together did not make as much as Mr Pichai in 2019."
As a result, these expanding pay packets are increasingly coming under scrutiny as the concept of 'performance' is expanding:
"Such numbers were setting off alarm bells before the covid-19 crisis. Now the mass lay-offs and bleeding balance-sheets resulting from the recession have brought it into stark relief."
The cause for concern centers around the construction of executive compensation:
"The favoured measure of performance is a company's total returns, which combine share-price moves with any dividend payouts. As a consequence of a record bull market in equities after the global financial crisis of 2007-09, only brought to a halt by the covid-19 pandemic, executive pay in America shot up into the stratosphere."
Of course, the intellectual underpinnings of this compensation structure is principal/agency theory—the idea that shareholders are the owners of firms (not true, but anyway …) and that stock options effectively align their interests with those of the executives. The extension of this argument is that, if executives are able to create value for the 'owners,' they should also be rewarded. In other words, 'good' CEOs create value for shareholders, which justifies the compensation they receive. In fact, as the article does a good job of pointing out, the relationship between CEO pay and firm performance is weak, at best:
"In 2017 MSCI, a research firm, published its analysis of realised chief-executive pay between 2007 and 2016 at more than 400 big public American firms. At more than three-fifths of the firms, it showed no correlation with ten-year total returns."
This chart in the article demonstrates as well as anything that the relationship between CEO pay and firm performance is virtually nonexistent:
A common phenomenon seems to be that, when the firm performs well the CEO is more than happy to take the credit, but when the firm does badly then the weak performance was due to exogenous factors. The reverse of this can work in the CEO's favor when they benefit from stock market gains that are driven primarily by exogenous factors. For example:
"A recent paper … finds 'strong evidence' that bosses of energy firms see clear pay gains when stock valuations rise as a result of an oil-price spike which they have no way to influence."
In some cases, the discrepancy between pay and performance can be stark:
"The bosses in the top pay quartile made twelve times what those in the bottom quartile did, but produced financial returns only twice as good. The bosses in the second-lowest pay quartile made nearly three times as much as those in the bottom quartile, even though their firms' total returns were actually worse."
There is clear evidence that the practices boards of directors currently use to set CEO pay create perverse incentives and do not achieve what they are designed to achieve:
"Compensation committees often rely on advice—and political cover—from pay consultants. A recent study of 2,347 firms … finds that companies using consultants pay more. Independently, those with higher pay and more complex pay plans are also likelier to hire advisers. Most problematic is their use of pay benchmarking, which has led to the ratcheting-up of pay for all bosses."
Hopefully, boards will come to their senses and develop alternative metrics that capture the performance they aim to reward. Alternatively, why do CEOs need bonuses and incentive structures? Why not just pay them a straight salary and fire them if they do not do their job?
Take care
David
David Chandler
© Sage Publications, 2020
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Pay guaranteed, performance optional
July 11, 2020
The Economist
Late Edition – Final
65
