The CEO Compensation: Heads I Win, Tails you Lose?
Krishnan Ranganathan
All Things Finance + Risk | Market Bubbles and Global Financial Crises | Luxury M&A | Economic Sanctions | Trade Wars | B-School Advisory Board Member | Guest Faculty (Bridging the Gap between Academia and Industry)
The Ecclesiastes 9:11 states, “The race is not always to the swift nor the battle to the strong... but time and chance happeneth to them all.”
Most CEO compensation has 3 parts: salary, short-term bonus, and long-term incentive. No board member asked why this trinity was holy. By 2012, almost all large US firms used it to determine CEO pay.
Let’s take bonus first.
Corporate?America has a bonus system that gives the CEO cash for the short term and equity awards for the long term. Though both are severely flawed, boards assume that two bad practices can achieve the proper balance between short and long-term concerns!
Douglas MacArthur told the Corps of Cadets at West Point: “Duty, honor, country,…those three hallowed words reverently dictate what you ought to be, what you can be, what you will be.” The military believes that the power of this commitment will guide officers to make the right decisions and take the proper actions without the financial reinforcement of duty bonuses, honor bonuses, and country bonuses.
Corporate America worries that if CEOs?are paid only a salary, they will neglect their duties towards investors. So a bonus system, the thinking goes, will likely instil a change in the CEO’s deeds and behavior and assumes the performance pay will cause the CEO to act differently. In other words, the board holds?that the CEO will make the shareholders richer only if he?pockets his share of the loot. Well, this doesn’t display a high degree of trust. The statesman Henry?Stimson famously said, “The chief lesson I have learned in a long life is that the only way you can make a man trustworthy is to trust him; and the surest way to make him untrustworthy is to distrust him.”
Next, let’s look at the role played by compensation?consultants.
Today, almost all large firms retain them. CEO pay is higher at companies that use these consultants. Studies show that?they are hired to justify higher CEO pay to the?board, shareholders, and other?stakeholders.?Here’s what Buffett thinks about them:?‘You?don’t suggest compensation consultants who are Dobermans. You get cocker spaniels and make sure their tails are wagging.” Since there are no standards for CEO perks, the compensation committee is akin to the parent negotiating with a teenager over pocket money: It’s never enough, and all the other kids get more!
Next, what about stock options and buybacks?
In practice, companies don’t buy back stock when the price is low. They buy it when the price is high in order to keep the?price high! In the long run, buying your own stock when it is expensive is self-defeating. But as Keynes?noted, in the long run we are all dead! So living CEOs enjoy maintaining a high stock price by buying back their own stock. This also helps them to get top $ when they encash their stock options and restricted stock.?A compensation system loaded with stock option awards?necessarily embeds pay-for-luck. They give the CEO?huge windfalls when the stock goes up, whether or not his performance, or the company’s performance, has been superior.
Most of a CEO’s success has to do with luck or suitability….being in the right place at the right time. Most recent studies have found CEO effects ranging from a low of 3.9% to a high of 14.7%. Steven Clifford remarks: “When I was in the right place at the right time, I was a genius. When I was in the wrong place at the wrong time, I was a moron. If I was in the right place at the wrong time or the wrong place at the right time and was lucky, I was a leader who could succeed in the face of adversity.”
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In the 1840s, Thomas Carlyle popularized the Great Man Theory of history. His idea was that men who were smart, charismatic, and bold determined the course of history: “The history of the world is but the biography of great men.” Today, any self-respecting university would not tolerate a disciple of this theory. However, a Carlyle follower could be invited to join the board of a Fortune 500 company!
Lastly, what about other common performance measures like EPS or revenue?
Since sunlight is the best disinfectant, surely disclosure is the panacea for everything? But sunshine also makes weeds grow. In 2006, the SEC tried limiting perks by ruling that when a firm CEO’s perks exceeds $10,000, it must disclose. No one seemed to care except for the odd journalist — and, of course, the other CEOs …who now had evidence that the other kids were indeed getting higher allowances! Buffett rightly remarked that envy might be a greater motivation than greed for CEOs.
Plato recommended that a?community's?highest wage shouldn’t exceed 5 times its lowest. In 1977, Drucker wrote that CEO pay should be no more than 25 times an avg?worker's?pay. With American CEO pay at 344 times (in 2022) that of the avg worker, companies are not going to get to Drucker’s number soon, or to Plato’s number ever.
As?Churchill said, “You can always count on Americans to do the right thing—after they've tried everything else.” Should they start with the CEO pay? But then that may be as difficult as killing Count Dracula!?
PS: Well, to be fair, sometimes companies do buy back perks previously awarded. In 2009, the Abercrombie board terminated Mr. Jeffries’s unlimited use of the corporate jet and capped his personal travel?reimbursements at $200,000 pa and gave him a $4m lumpsum?payment in return. A really bizarre model; shareholders would have been better off had Abercrombie continued?Jeffries's unlimited use of the jet and kept the $4m!??
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?? Wonder what they do with that kind of money and what they do to command such money.