Trouble at the top

I see in the news that CEOs are still getting pay rises bigger than their employees. CEOs pay has grown almost 10% in the past year, they say, compared with a 2.9% rise in average ordinary time earnings (and 1% consumer price inflation).

This is a trend that has been going on for quite a while, and it is much more of an issue in other places like the UK, where the government is requiring listed companies to have a shareholder vote on executive pay that will bind the company, and in the US, where recently the New York Times reported on 25 companies who paid their CEOs more than the companies paid in taxes. Cue dismay and disgust.

It does seem to be an issue all around the world, although these guys say it is mostly a US problem:

American chief executives received roughly four times what their Swedish counterparts in comparably sized companies did and 3.1 times that of a Japanese chief at a comparably sized company.

The average CEO at one of the 500 biggest US companies was paid $10.5 million a year in 2012, roughly split one third salary, one third other benefits, one third shares. Nice work if you can get it, although CEOs a bit longer in the tooth probably remember 2007 as the halcyon days – average US big-company CEO compensation peaked at $17 million each that year. And spare a special tear for poor Mr Dauman at Verizon who took home $84.5 million in 2010 but could only manage $43 million in 2011.

The ratio of CEO pay is obviously high enough to be a cause of significant political controversy, although CEO pay is not as high these days as it was earlier in the 2000s  relative to production worker pay on this data.

The golden goose

So why is this happening. Have we we got more companies that need leaders, driving up demand? Or perhaps fewer people coming out of CEO school looking for sandpits, reducing supply? Or maybe the value of what CEOs do has gone up over time somehow.

You can take your pick from a large number of hypotheses out there in the land of the commentariat. A selection of ideas follows.

  • Some, like these folk in the Wall Street Journal, argue CEOs generate their remuneration (which is often linked with share prices) from manipulating short-term results to drive up the value of their options, and don’t worry enough about long-term company health.
  • The Economist says that the increasing divergence between CEO pay and the pay of the unskilled worker is effectively due to globalisation. Referring to the UK, it says that CEOs with relevant skills are increasingly hard to find as companies diversify and internationalise (although presumably the HR department doesn’t lack for people willing to put their hat in the ring for $10 million a year). More soberingly, there is less to distinguish an unskilled worker in the UK from one in India or China these days, pushing down wages at the bottom end of the labour market as jobs move to where labour is cheapest.
  • Warren Buffett, billionaire investor, is on record as saying (see page 16 of his 2005 report to shareholders) “Too often, executive compensation in the U.S. is ridiculously out of line with performance”, and he particularly criticised large CEO exit payments:

Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets.”

(Mr Buffett is not so indiscreet as to reveal how much time he has spent cleaning toilets in his lifetime).

  • The misalignment Mr Buffett talks about could be because compensation of executives in the US is more like a process of executives using their power to influence their own compensation and extract as much as they can rather than pay arrangements that are aimed at maximising shareholder value.
  • Or it might be because no Board wants to admit that they have a below average CEO by setting a below average pay package in this era when everyone knows what CEOs earn (although I think the world would be a better place if information on what people earned was more freely available).
  • Some say CEOs are mates with the people who set their pay and there is an unspoken rule that if they get approved higher salaries, then they will reciprocate when it comes to making the decisions for others. Or that those advising the relevant peeps on what the CEO should be paid are conflicted by other valuable work that they are doing for the CEO. Or that more generally, there just isn’t sufficient connection between company results and what the boss gets paid.
  • Paul Krugman, Nobel Prize winning economist, argues that the upsurge in executive pay was brought about by political and social factors, including an environment where the media and politicians are less likely to criticise inflated pay rates, weaker unions, and a sharp decline in marginal tax rates.
  • These academics argue that it is basically because the value of the companies CEOs run has gone up – similar to the Economist’s argument. So compensation for executives at the largest companies has risen because the market capitalisation of the largest companies has gone up. If you want to be paid more, work for a bigger company. Although reportedly business services, computers and banking are exceptions – they get paid more anyway. Leading some to say that “perhaps chief executives can add more value in more dynamic sectors”.

Or you might not really care why it happens, but just want it to stop.

Input to output ratio

Interestingly, precisely none of these people think high CEO pay has anything much to do with CEO performance itself. Which leads us on to the interesting question of whether CEOs actually matter at all.

And that in turn leads us on to this really interesting Atlantic article. I quote.

In their groundbreaking “Leadership and Organizational Performance: A Study of Large Corporations,” first published in 1972 in American Sociological Review, Stanley Lieberson and James O’Connor … asserted that the CEO’s influence was seldom decisive in a company’s performance…. “Industry effects,” such as the amount of available capital and the stability of the market, accounted for almost 30 percent of the variance in corporate profits. “Company effects,” such as the firm’s historical place in the corporate pecking order, explained about 23 percent. “CEO effects” explained just 14.5 percent. And even this impact should be viewed skeptically: it unavoidably bundles CEO actions that were genuinely smart and skillful with those that were merely lucky.

Which, if true, means that your task as the CEO is to get your company into an area that is growing quickly. Jeffrey Immelt, the CEO of General Electric (the third largest company in the world by some measures), is reported to have said “Not only could anyone have run GE in the 1990s, [a] dog could have run GE. A German shepherd could have run GE.” Previous CEO Jack Welch more or less agreed with this assessment.

Others are even more sceptical about the value of CEO. The article again:

James March, a management professor at Stanford, says that in any well-run company that’s conscientious about grooming its managers, candidates for the top job are so similar in their education, skills, and psychology as to be virtually interchangeable. All that matters is that someone be in charge. “Management may be extremely difficult and important even though managers are indistinguishable,” he writes. “It is hard to tell the difference between two different light bulbs also; but if you take all the light bulbs away, it is difficult to read in the dark.”

Eek. How much do we pay them again to keep the lights on?

Silver linings

The Atlantic eventually conclude with two interesting points:

  • One, it is important to ask not whether CEOs add any value, but when they add value, i.e., in what circumstances do you want a rockstar CEO and when would rather have someone less dramatic and ultimately less change-oriented.
  • Two, good CEOs can improve things a little bit. Bad CEOs can really stuff things up. I think anyone who has ever had a boss or been a boss knows this. It is much much easier to stop/ruin/doubt/undermine than it is to support/improve/really add something useful.

I note the irony in Atlantic feteing the then CEOs of Research In Motion, Mike Lazaridis and Jim Balsille, whose “newest BlackBerrys are flying off the shelves”. No more. This is Research In Motion’s share price  for the last five years (the article was written June 2009). Mr Balsille is particularly infamous for saying that he wasn’t worried about the iPhone, and didn’t think it would affect sales of Blackberrys. That said, they got the last laugh, to the tune of $12m between them when Research In Motion finally showed them the door.