Income inequality in the U.S. is a recurrent theme in the U.S. today, and CEO pay is an item that gets attention. [Forbes has noted that]between 1978 and 2018, U.S. workers have seen their incomes rise by 12%, while CEOs have seen their incomes increase by 1008%. As of 2018, the CEO-to-worker pay ratio hit an all-time high of 278-to-1 up from 58-to-1 in 1989 and 20-to-1 in 1965.
One must keep in mind that the CEO’s compensation typically comprises salary, bonuses, share options or grants, and other valuable perks. So what drives compensation, and are they paid for performance?
What Drives Compensation
The Compensation Committee
The company’s Board of Directors, their Compensation Committees, and compensation consultants determine the CEO’s compensation. As Warren Buffett perfectly described the process, “The human relations director comes in and recommends a consultant to the Board’s comp committee. The human relations director is an employee of the CEO, his or her salary gets determined by the CEO, so what kind of a recommendation do you make to the comp committee? I don’t think comp committees should have consultants. If you don’t know enough about the game to work out a fair compensation arrangement, get off the committee and put somebody on there who does know … they just don’t want somebody who knows something about comp on the comp committee.” The failures of compensation committees are legendary; however, nothing seems to change, primarily because of the CEO’s control of the Board, and in many cases, the CEOs sit on each other’s boards.
The Ratchet Effect
Compensation consultants usually present the Board the pay of other CEO’s of other firms in their industry in terms of averages and rankings by quartiles. Similarly to our beliefs that our children, like those of Lake Wobegon, are all above average, boards believe their CEO is above average because:
- the CEO usually picks the Board and so they tend to like the CEO and believe the CEO is excellent; and
- if the CEO were below average, the Board would have failed in its job to choose a good CEO, and no one will admit they failed in their selection.
Thus, if the CEO is above average, then they must be compensated above average. However, if every CEO is above average, they must all be paid above average, the ratchet effect kicks in, and as Warren Buffett has this as, “Ratchet, Ratchet, Bingo!” Of course, if the CEO is thrilled with the consulting firm’s work and recommends them to other CEOs they know and so the ratchet effects continue unabated.
Many point to “Say-on-Pay” as a mechanism whereby shareholders can express their view on executive compensation and can prevent excessive CEO pay. However, this say-on-pay is just an excellent way of appearing to provide some form of checks and balance while not changing the flaws in the system. The major of people assume that a say-on-pay vote is a vote to approve the executives’ compensation for the current year. To quote an old friend, “Let me disabuse you of this notion.”
Say-on-pay votes ask shareholders to opine retrospectively on the compensation of named executives, rather than on the company’s compensation program going forward. Say-on-pay does not dictate actual executives’ pay.
Furthermore, in the U.S., say-on-pay votes are non-binding advisory votes by shareholders. Since it is an advisory vote, even if a say-on-pay proposal failed to receive majority support, this would not prevent a company from implementing its pay practices.
While say-on-pay allows shareholders to engage with companies to encourage good governance practices and alignment with company performance, the most significant influence on executive compensation is the compensation consultants and proxy advisors. Ultimately the decision on executive compensation is that of the Board.
Pay for Performance
Lastly, we get to the main reason for the high level of pay, Pay for Performance. For years, CEOs and their supporters, e.g., compensation committees, compensation advisors, have staunchly defended the level of compensation to CEOs because of “Pay for Performance,” the idea to align CEO compensation to the company success, and the CEO’s performance provides value to the organization.
So, do these compensation plans drive performance?
For about 25 years, I have said the job I want is “F##k up CEO,” or to put it politely, “Pre turn around CEO.” You get paid a lot of money to join the company, while as the CEO, you get paid an excellent salary to destroy the company, and then you get paid a whole bunch more money to leave. These jobs are out there, and I have seen many people get them, and here is a list just to name a few:
- Carly Fiorina, CEO of HP. Fiorina was a great self-promoter, busy pontificating on the lecture circuit and posing for magazine covers. During her tenure at HP, the company’s value fell 65%. Fiorina made over $100MM at HP, including a $65MM signing bonus, and termination package of\\ $21 million in cash, plus stock and pension benefits worth another $19 million.
- Bob Nardelli is a multiple offender. Nardelli was CEO of both Home Depot and Chrysler. His tenure at Home Depot was marked by losing market share, alienating executives, downplaying customer service, and no growth in shareholder value. While at Home Depot, he made over $65MM in cash salary, plus cash bonuses, and his exit package was $210MM. He was then hired by Cerberus to run its struggling Chrysler unit. There, the company took billions in government aid, went into liquidation, and merged with FIAT SpA. His compensation was not detailed.
- Gerald Levin, CEO of Time Warner. During his tenure, he oversaw the acquisition of Turner Broadcasting System and the company’s merger with AOL. Within three years, AOL had lost $200BN in equity value, written down $99BN in equity value. Levin was salary, and bonuses rose from over a $4MM to $11MM year. Besides, he received annual grants of stock options which, when he exercised them in 2000, were worth over $150MM.
- Richard Smith, CEO of Equifax. During his time at Equifax, Smith oversaw tremendous growth; the hack in 2017 brought his tenure to an end. During his time as CEO, Smith earned about $16MM in salary, $24.3MM was in non-stock compensation and $70MM in stock options. The infamous hack in 2017 reduced Equifax’s share value by 20%, and Smith left with $90MM.
There are so many others, including Dick Fuld at Lehman Brothers, Angelo Mozilo at Countrywide Financial, Ken Lay at Enron, but time is limited.
Therefore we there many stories of CEO enriching themselves while the organization fails to perform. However, while stories may be anecdotal, academic research has shown that incentive-based CEO compensation appears to have only a small or negligible impact on firm-level performance, and particularly when firms have weak corporate governance.
A study in the Journal of Management Research in 2018 analyzed the earnings of more than 4,000 CEOs throughout their tenures against several performance metrics. They found virtually no overlap between the top 1% of CEOs in terms of performance and the top 1% of highest earners. Among the top 10% of performers, only a fifth were in the top 10% in terms of pay.
In 2017, only two out of the 20 highest-paid CEOs, who didn’t leave their jobs before the end of the year, landed in the top 20 for shareholder return. According to many compensation consultants, many firms condition a significant share of pay on three-year performance metrics that are only partially affected by a single bad year.
- In 2017, CBS Corp. paid Leslie Moonves, $69.3 million, while total shareholder return was negative 6.2%. In 2016 Moonves was paid $69.6 million when CBS achieved a one-year performance of 37%.
- Comcast Corp’s CEO Brian Roberts’s annual pay has hovered around $33 million from 2015 to 2017, while shareholder returns ranged from 25% to negative 1.1%.
- Allergan PLC’s Brent Saunders received a 700% raise in 2017 to $32.8 million, despite the total shareholder return of negative 21%.
- TransDigm Group Inc’s shares realized returned just shy of 5% for the fiscal year that ended September 30, 2017, including the reinvestment of dividends, while its CEO Mr. Howley earned $61 million, more than triple the $18.9 million he made in 2016.
The Curtain is being Pulled Back
- J.C. Penney approved nearly $10 million in payouts just before its May 15 filing and paid its chief executive, Jill Soltau, $4.5 million. J.C. Penny furloughed 78,000 employees.
- Neiman Marcus Group paid $4 million in bonuses to Chairman and Chief Executive Geoffroy van Raemdonck in February and more than $4 million to other executives in the weeks before its May 7 bankruptcy filing. Nieman Marcus furloughed 11,000 employees.
- Whiting Petroleum Corp paid $14.6 million in extra compensation to executives days before its April 1 bankruptcy.
- Chesapeake Energy Corp awarded $25 million to executives and lower-level employees in May, about eight weeks before filing bankruptcy.
- Hertz paid senior executives bonuses of $1.5 million days before its May 22 bankruptcy. Hertz terminated more than 14,000 workers.
Firms paying pre-bankruptcy bonuses know they will face scrutiny in court on compensation proposed after their filings. Still, the trustees have no power to halt bonuses paid even days before a company’s bankruptcy filing, said Clifford J. White III, director of the U.S. Trustee Program, at the Justice Department. Thus, the firms “escape the transparency and court review.” Also, unsecured creditors and employee pension funds bear the pain in such activities. Concerning employee pension plans, the Pension Benefit Guaranty Corporation usually takes them over, meaning we all pay for the hubris through our taxes.
The spotlight on CEO “Pay-regardless-of-Performance” may lead to a day of reckoning and boards doing their job. There is increased pressure from some large asset managers like BlackRock, but not the majority as I write this.
Thus, while I hope CEOs may truly be paid for performance as this behavior reinforces the inequality of the system, reinforcing the view, “Accountability means lower-level people get financially penalized if they make a mistake, but the CEO never does.” I wouldn’t hold my breath.
Further, if CEOs were paid for performance, the concept might then migrate to Private Equity and Hedge Funds requiring not only pay for positive performance. Given the traditional 2 and 20, forget the 2% of AUM, but tied the 20% to exceeding some external metric, i.e. the S&P 500 for a Private Equity Group. That would really put the cat among the pigeons.
Discover the importance of organizational alignment and agility in this blog post. Learn how establishing a strong CORE and building a strategy around it can lead to sustainable growth and success. Find out how alignment and agility empower your organization to thrive in an ever-changing business landscape.
When you are a busy professional running your own business, it can often feel like there aren’t enough hours in the day to accomplish everything. Being strategic with your time is the best (and possibly the only) way to achieve all of your daily tasks. If you are...
So often, people view leadership as a talent: you’re either born with this quality or you’re not. However, this is not always the case! In reality, good leadership is made up of skills, and anyone can learn how to improve. Some people may pick up leadership attributes...
Do you have questions about how to calculate your business’s sellability score? Whether you’re looking to sell your business in the near future or years from now, understanding your sellability score will help you thrive. The sellability score identifies the...
As an entrepreneur running your own business, you know there are bumps in the road and struggles that both you and your business will face over time. However, with the right people and tools at your disposal, you can anticipate what’s coming, plan for it, and continue...
Every single business in the world wants to evolve and grow. This will happen using a variety of techniques and strategies. In 2022, digital marketing is more than a household name, and most companies will adopt at least a few ideas when long-term planning and coming...
Many entrepreneurs consider executive business coaching when they start struggling on their professional path. A small business coach is an experienced professional mentor who educates, supports, and motivates entrepreneurs. They will listen to your concerns, assess...
Dreams turn into goals when they have a foundation of long-term strategic planning supporting them. They become reality when the ensuing strategic implementation plan is executed properly. With Kaizen Solutions as their strategic planning consultant, small and...
If you are a CEO or key executive who has come to a crossroads or crisis in your career, you'll gain valuable insights and solutions from a peer group connection more than anywhere else. But what is a peer group, and how can that statement be made with so much...
As I mentioned last week, I am down with COVID and tired, so spending more time reading rather than working. I read Bill Browder's Freezing Order this weekend, and I highly recommend it. However, at the end of the book, Browder says that oligarchs, autocrats, and...