These committees are elected by shareholders but are not perfect agents for them. Compensation committees typically react to the agitation over pay levels by capping—explicitly or implicitly—the amount of money the CEO earns.
How often do shareholder activists or union leaders denounce a corporate board for under paying the CEO? Most critics of executive pay want it both ways. Imposing a ceiling on salaries for outstanding performers inevitably means creating a floor for poor performers. Over time, by cutting off the upper and lower tails of the distribution, the entire pay-for-performance relation erodes.
When mediocre outfielders earn a million dollars a year, and New York law partners earn about the same, influential critics who begrudge comparable salaries to the men and women running billion-dollar enterprises help guarantee that these companies will attract mediocre leaders who turn in mediocre performances.
Admittedly, it is difficult to document the effect of public disclosure on executive pay. Yet there have been a few prominent examples. Bear, Stearns, the successful investment bank, went public in and had to submit to disclosure requirements for the first time.
A public outcry ensued. More recently, we interviewed the president of a subsidiary of a thriving publicly traded conglomerate. For one, because his salary would have to be made public—a disclosure both he and the CEO consider a needless invitation to internal and external criticism. We are not arguing for the elimination of salary disclosure. Indeed, without disclosure we could not have conducted this study. The costs of negative publicity and political criticism are less severe than the costs to shareholder wealth created by misguided compensation systems.
But the level of pay does affect the quality of managers an organization can attract. Companies that are willing to pay more will, in general, attract more highly talented individuals. So if the critics insist on focusing on levels of executive pay, they should at least ask the right question: Are current levels of CEO compensation high enough to attract the best and brightest individuals to careers in corporate management?
The answer is, probably not. These simple propositions are at the heart of a phenomenon that has inspired much handwringing and despair over the last decade—the stream of talented, energetic, articulate young professionals into business law, investment banking, and consulting.
Data on the career choices of Harvard Business School graduates document the trend that troubles so many pundits. And Harvard Business School is not alone; we gathered data on other highly rated MBA programs and found similar trends. A highly sensitive pay-for-performance system will cause high-quality people to self-select into a company.
Creative risk takers who perceive they will be in the upper tail of the performance and pay distribution are more likely to join companies who pay for performance. Low-ability and risk-averse candidates will be attracted to companies with bureaucratic compensation systems that ignore performance. Compensation systems in professions like investment banking and consulting are heavily weighted toward the contributions made by individuals and the performance of their work groups and companies.
Compensation systems in the corporate world are often independent of individual, group, or overall corporate performance. Moreover, average levels of top-executive compensation on Wall Street or in corporate law are considerably higher than in corporate America. Most careers, including corporate management, require lifetime investments. Individuals must choose their occupation long before their ultimate success or failure becomes a reality.
For potential CEOs, this means that individuals seeking careers in corporate management must join their companies at an early age in entry-level jobs.
The CEOs in our sample spent an average of 16 years in their companies before assuming the top job. Of course, many people who reach the highest ranks of the corporate hierarchy could also expect to be successful in professional partnerships such as law or investment banking, as proprietors of their own businesses, or as CEOs of privately held companies. It is instructive, therefore, to compare levels of CEO compensation with the compensation of similarly skilled individuals who have reached leadership positions in other occupations.
The compensation of top-level partners in law firms is one relevant comparison. These numbers are closely guarded secrets, but some idea of the rewards to top partners can be gleaned from data on average partner income reported each year in a widely read industry survey.
Partners at the very top of these firms earned substantially more. Compensation for the most successful corporate managers is also modest in comparison with compensation for the most successful Wall Street players.
Here too it is difficult to get definitive numbers for a large sample of top executives. The Wall Street surveys for are not yet available, but consistent with high pay-for-performance systems, they will likely show sharp declines in bonuses reflecting lower industry performance.
The compensation figures for law and investment banking look high because they reflect only the most highly paid individuals in each occupation. Average levels of compensation for lawyers or investment bankers may not be any higher than average pay levels for executives.
The very best lawyers or investment bankers can earn substantially more than the very best corporate executives. Highly talented people who would succeed in any field are likely to shun the corporate sector, where pay and performance are weakly related, in favor of organizations where pay is more strongly related to performance—and the prospect of big financial rewards more favorable.
Some may object to our focus on monetary incentives as the central motivator of CEO behavior. Are there not important nonmonetary rewards associated with running a large organization?
Benefits such as power, prestige, and public visibility certainly do affect the level of monetary compensation necessary to attract highly qualified people to the corporate sector.
Moreover, because nonmonetary benefits tend to be a function of position or rank, it is difficult to vary them from period to period based on performance. Indeed, nonmonetary rewards typically motivate top managers to take actions that reduce productivity and harm shareholders. Executives are invariably tempted to acquire other companies and expand the diversity of the empire, even though acquisitions often reduce shareholder wealth.
As prominent members of their community, CEOs face pressures to keep open uneconomic factories, to keep the peace with labor unions despite the impact on competitiveness, and to satisfy intense special-interest pressures. Monetary compensation and stock ownership remain the most effective tools for aligning executive and shareholder interests. Until directors recognize the importance of incentives—and adopt compensation systems that truly link pay and performance—large companies and their shareholders will continue to suffer from poor performance.
Routinely misused and abused, surveys contribute to the common ills of corporate compensation policy. Surveys that report average compensation across industries help inflate salaries, as everyone tries to be above average but not in front of the pack. Surveys that relate pay to company sales encourage systems that tie compensation to size and growth, not performance and value.
The basic problem with existing compensation surveys is that they focus exclusively on how much CEOs are paid instead of how they are paid.
Our focus on incentives rather than levels leads naturally to a new and different kind of survey. Our survey considers incentives from a variety of sources—including salary and bonus, stock options, stock ownership, and the threat of getting fired for poor performance.
It includes only companies listed in the Forbes executive compensation surveys for at least eight years from through , since we require at least seven years of pay change to estimate the relation between pay and performance. Compensation surveys in the business press, such as those published by Fortune and Business Week, are really about levels of pay and not about pay for performance. The methods adopted by Fortune and Business Week share a common flaw.
CEOs earning low fixed salaries while delivering mediocre performance look like stars; on the flip side, CEOs with genuinely strong pay-for-performance practices rank poorly. By all accounts, Mr. Surveys ranking Eisner and Iacocca low are clearly not measuring incentives.
We estimated the pay-for-performance relation for each of the companies for which we have sufficient data. The results are summarized in the four nearby tables. Three of the tables include results for the largest companies ranked by sales. The 25 CEOs with the best and worst overall incentives, as reflected by the relation between their total compensation composed of all pay-related wealth changes and the change in the value of stock owned , are summarized in the first two tables.
With a few exceptions, it is clear that the best incentives are determined primarily by large CEO stockholdings. Although one has to recognize that there is statistical uncertainty surrounding our estimates of pay-related wealth sensitivity, no CEO with substantial equity holdings measured as a fraction of the total outstanding equity makes our list of low-incentive CEOs.
As we point out in the accompanying article, an important disadvantage of corporate size is that it is extremely difficult for the CEO to hold a substantial fraction of corporate equity. The inverse relation between size and stockholdings and therefore the negative effect of size on incentives is readily visible in the much higher sensitivities shown for the top 25 CEOs in smaller companies, those ranking from to in sales. Again, the importance of large stockholdings is clear.
Indeed, one problem with current compensation practices is that boards often reward CEOs with substantial equity through stock options but then stand by to watch CEOs undo the incentives by unloading their stockholdings. Boards seldom provide contractual constraints or moral suasion that discourage the CEO from selling such shares to invest in a diversified portfolio of assets.
Pay-related incentives are under the direct control of the compensation committee and the board. Each of these estimates is given in the table, along with the sum of the effects in the last column. The table makes clear that the major contributors to pay-related incentives are stock options and the present value of the change in salary and bonus. See Robert Gibbons and Kevin J. See Jerold B. Warner, Ross L. Watts, and Karen H. The sample includes 21, workers aged 21 to 65 reporting wages in consecutive periods.
See Kenneth J. These findings come as the coronavirus pandemic has worsened inequality across the world, exposing low-income populations to greater health risks, job losses and declines in wellbeing. These divides have come into sharper focus than ever as awareness grows of the value of ' essential' workers — who often have few employment rights and little pay.
The result is mounting confusion and anger over the extraordinarily high salaries that top bosses continue to earn. With these deep-set inequalities laid bare, the question for many is how these huge pay packets ever came about. By whom and how they are given the green light and, crucially, should they continue to have a place in post-pandemic society?
Some people see high pay appropriate for visionaries like Elon Musk, but these pay packets are more perplexing for average CEOs, who aren't exceptional talents Credit: Alamy. The executive pay gap has its roots in the policies put forth in the s by the Reagan administration in the US and the Thatcher government in the UK.
Their political philosophies drove deregulation, privatisation of the public sector and free-market capitalism. There was one system to evaluate everybody's pay," says Sandy Pepper, an expert in executive pay at the London School of Economics. This month, Pepper published a paper exploring why the pay gaps have opened up between CEOs and the wider workforce. But he says the previous system "broke down" when executive pay became connected with share prices, and "asset-based rewards" took off under the prevailing neoliberalism.
Pepper says the underlying logic was to pay the CEO according to a company's financial performance, since they were the most important factor of success. So, on top of basic salaries, CEOs were given performance-related bonuses and stock options allowing them to buy company shares for a set price. Ocado declined request for comment. At the same time, the proportion of UK businesses owned by individuals dropped precipitously.
Shareholders grew in power, and their demand for booming stock prices led to booming pay packets for CEOs — in turn signed off by boards of directors eager to please their investors. Robin Ferracone, CEO of Farient Advisors, an international executive-pay consultancy, agrees with these "price-driven" salaries. However, in reality, the system of calculating CEO remuneration is more complicated.
Companies rely on compensation committees, mostly made up of board members and executives from other companies that meet once a year. Besides the more traditional measures of past experience and performance, committees use benchmarking as a key part of the process — working out how the CEO's compensation will compare to those at similar companies, according to Steven Clifford, a former CEO and author of The CEO Pay Machine.
Often the sum will be in the 50th, 75th or 90th percentile, therefore constantly maintaining or increasing pay, he writes. A study in in the Journal of Financial Economics concluded this system of compensation committees is accelerating pay inflation "because such peer companies enable justification of the high level of their CEO pay". Bonuses are then agreed as a way to measure performance, either increasing based on financial measures or provided in sum if specific goals are met.
As shareholders have grown in power, their demand for high share prices has nudged up CEO pay Credit: Alamy. Both the process for base pay and for bonuses are seen by workers' representatives as problematic because boards, not wanting to upset the leader of their company who could leave or fire them, therefore push up pay. CEOs who can successfully steer their companies through rough economic seas and still come out in the black are often rewarded with substantial performance bonuses and other financial incentives to ensure their continued leadership and company loyalty.
There are some CEOs who technically earn little to no money in actual salaries. Because they already have considerable personal wealth, some CEOs ask only for a nominal annual salary for tax purposes.
CEOs often earn more money through profit-sharing plans, performance bonuses and patent or licensing royalties. By not accepting an actual yearly salary from the company, a CEO can appear to be motivated by other reasons beside personal gain. While many CEOs do make so much money from their company's performance, they also understand their skills and business acumen are in large demand in the marketplace.
Struggling companies routinely seek out talented CEOs with proven track records to help them avoid financial collapse. Because of this constant demand and short supply of qualified CEOs, many companies pay incredibly high salaries in order to keep their top executives satisfied.
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