According to Edgar Woolard, former CEO of Du Pont, the primary cause is that most boards want their CEO to be in the top half of the CEO peer group because they think it makes the company look strong. “So when Tom, Dick and Harry receive compensation increases in 2002, I get one too, even if I’ve had a bad year. We stopped doing that at Du Pont in 1990 … Instead, we use the pay of the senior vice presidents – the people that actually run the businesses – as a benchmark and then decide how much more the CEO ought to get,” notes Woolard.
Stanford professor Jeffrey Pfeffer suggests that there is nothing in the process of setting CEO compensation that produces a pay-performance link. Companies and their compensation consultants choose a set of similar comparison firms, often on the basis of size and industry, and then compute the median pay for CEOs of these comparable companies. Setting aside the tendency to game the choice of comparisons, which is plentiful, what is most visible in the discussion of compensation is the median figure.
Precious few companies take variables like company performance into account when determining compensation. So, what the compensation committee sees is not an equation relating pay to company-specific factors, but just the median. The tendency to pay at least at the median is overwhelming. And because the comparable firms have been picked partly on the basis of their similarity in size, it’s not surprising that size looms large as a determinant of compensation. Moreover, because firms rely on comparables, if none of the comparison companies base pay on performance, neither will the focal company.
A recent academic study in the UK supports these conclusions. While confirming that thousands of research studies on top management pay in public companies, using a variety of statistical and modeling techniques applied to different company samples, failed to find a relationship between pay and performance, the research did find a strong relationship between pay and company size: larger companies pay executives more. One meta-study concluded from US evidence that firm size accounts generally for more than 40 percent of the variance in total CEO pay, whereas firm performance accounts for less than 5 per cent of the variance.
So the conclusion is: The pay–performance link is unproven. And size does matter.
How has this come about and why has it become the toxic issue that it has?
In my view it’s not complex as the simple mechanics of reward as detailed above is itself broken and not fit for purpose. If it’s remuneration committees then who appoints them in the first instance. Would they then displease those that appointed them (turkeys voting for thanksgiving comes to mind). Similarly if it’s ‘independent’ consultants then don’t you think they might want a repeat gig so they will also want to please, flatter and be loved.
No it comes down to one word – GREED. An ethical issue and therefore one of corporate governance. What is needed is a real linkage to performance and it shouldn’t be beyond our ingenuity to come up with a formula that includes a proper risk and reward element unlike the present ‘reward for failure’ culture that has infected major public and private corporations.
We then naturally come on to the whole subject of Incentives and Greed – see my previous blog on this.
To which I add:
The massive pay gap between CEOs and their employees originated with the work of a McKinsey consultant, and has grown since the 60s.
It’s now reported that the average Fortune 500 CEO makes 354 times the average wage of their employees. Some executives make 1,000 times. This just can’t be right, just or sustainable.
Cleaning out the stables. A Herculean task. Hercules please step forward.
Trevor Lee, EP International
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