How CEO pay is set… from someone who set CEO pay

by philg

“How Companies Actually Decide What to Pay CEOs” (Atlantic) is interesting partly because the writer has personal experience in the area, i.e., he was on public company Boards as they were looting from shareholders to feed top executives. It is also interesting for showing a consequence of basic human psychology:

Once a peer group is established, the next step is to figure out how the CEO’s compensation will compare with those of the leaders at the other companies. If the median pay of a CEO’s peer group is $10 million, should he get $10 million? (I use the male pronoun here because so many of them are men.) It depends on where the company is benchmarked within this group. And every board I have ever sat on or researched benchmarked itself at the 50th, 75th, or 90th percentile, therefore targeting CEO pay at similarly exalted levels. Benchmarking below the 50th percentile says, We are a lousy company and don’t even aspire to be better. So in this sense all CEOs are above average: To be benchmarked at or above the 50th percentile, they need not do anything other than report to a board that considers its own company exceptional.

Executive stock options can be pretty straightforward, e.g., the 10-year right to buy stock at $X per share. Inflation obviously can be a big help to a CEO in this situation. But so can doing a share buyback instead of a dividend:

Paying CEOs in stock further props up their pay: When the economy is thriving, stock prices can rise across the board, and thus most CEOs’ pay rises too. But even if the market cools off, expectations for what CEOs should be paid—as reinforced by benchmarking and other mechanisms described above—tend not to come down when that happens. Moreover, in order to make more money from selling the stock they were given, CEOs can induce a higher share price by having the company buy back its own shares; a share buyback, though, can come at the expense of initiatives that might serve the company better in the long run, including funding research and development or employee training.

I’m not sure what the answer is here other than, perhaps, don’t buy U.S. public equities. In Europe, for example, it would be tough for a mediocre CEO to get paid $20-100 million per year. (I sat next to portfolio manager on a plane recently and she said that she prefers European stocks, which are her specialty, because Europe is just coming out of a recession whereas the U.S. is now in the 8th year of a bull market and the good times have never historically lasted forever.)

8 thoughts on “How CEO pay is set… from someone who set CEO pay”

  1. I endured many pep talks by a Fortune 50 CEO where he repeatedly said his #1 job as CEO was to hire the right people. It always made me wonder: “it that’s true, then why do we need you if there is already a massive HR department whose job is to hire the right people?” (pointing this out, even jokingly, would be career suicide).

  2. You don’t have to be a math genius to see that if every year, public companies set their pay at the 75th %ile of whatever CEO pay was last year then there is going to be a never ending spiral upward and indeed that’s what has happened. Meanwhile, workers on the factory floor are making less than they did in the 1970s on an inflation adjusted basis.

    At the very least, the taxpayers should not be subsidizing this madness. Maybe the deductibility of CEO pay should be capped at say 10x the compensation of the average hourly worker in any company. The shareholders would still get looted (but they are not obligated to buy into US public companies) but maybe this would create an incentive to pay workers more. The current system incentivizes paying the workers as little as possible – if you outsource your IT dept. to India you get a big bonus.

    You could also tax income above a certain level more heavily but this would be going back to socialism like we had in the US in the 1950s under Eisenhower.

  3. “I’m not sure what the answer is here other than, perhaps, don’t buy U.S. public equities.”

    Seems like a problem requiring coordinated action (the actions of any individual CEO won’t make a difference in the big picture). What did you think of the author’s idea of using a luxury tax as a blunt instrument? Similarly, Piketty and Saez suggest that raising marginal income tax rates at the top (as high as 80%!) would strongly reduce executive incentives to extract larger and larger compensation packages.

  5. Numerous corporations seem to be granting huge numbers of options and restricted stock units, so I assume buybacks there are mainly used to control share inflation.

  6. “if there is already a massive HR department whose job is to hire the right people?”

    Have you ever had HR hire a right person on their own? It’s never happened to me.

  7. In a $100 million revenue company, if profits are $2 million and the C-level executive are paid $2 million, then profits equal C-level compensation. In a $10 billion company, if profits are $200 million, C-level compensation is likely to be not more than $20 million, 1/10 of the ratio of the smaller company. Therefore the solution to high CEO pay is more merger and acquisition activity.

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