A New York Times article titled “CEOs and the Pay-‘Em-or-Lose-‘Em Myth” published on September 22, 2012 has received a lot of attention and discussion beyond its publication date. The article draws two interesting conclusions from the research conducted by two professors at the University of Delaware’s Weinberg Center for Corporate Governance: 1) CEOs can’t readily transfer their skills from one company to another, and subsequently 2) CEOs don’t need to be well compensated to keep up with supposed comparators or competitors, as those comparisons only artificially ratchet pay up.
While it makes for an interesting read, anyone in the compensation trenches – board members, recruiters, human resources executives, compensation advisors, even CEOs – dealing with the attraction and retention of executive-level talent, knows this simply isn’t true. When evaluating any opinion piece it is vital to consider both sides. Below are a few counter points to consider before a company steps into the unknown waters of arbitrary CEO Pay.
CEO’s move. A study conducted by Equilar analyzed 1,500 S&P companies from 2007 to 2009 found there were 387 changes within the CEO position in the three-year period, and 25 percent of those changes were from external hires.
External hire CEOs perform better. A study conducted by Vell (2009) reports that external CEOs perform better than their internal counterparts. Specifically, external hire CEOs had a three year return of 99 percent versus internal hire CEOs, who had a 35 percent return in the same time period. Additionally, conclusions from a Spencer Stuart study determined external hire CEOs are more successful than internal hire CEOs during an economic downtown. Consider General Motors Company after the economic collapse and colossal government bailout of 2009, it took two internal promotions and several failures before Ed Whitaker (former Chairman of AT&T, with no car industry experience) could turn the company in the right direction.
Compression. Compression is a simple concept in the world of generally-accepted compensation planning principles. If you don’t pay executives competitively with the external market, there is a high probability that the employees below the executives are compensated below market, making attraction and retention increasingly more difficult.
Future CEOs are in big demand. The baby boomer generation hit retirement age approximately three years ago (2010) and will continue to retire through 2020. Studies show there are 70 million in the United States. Causing particular concern, the U.S. Census indicates that approximately 35 million generation X and Y professionals will replace these 70 million retirees. A 2:1 replacement ratio creates a serious succession plan problem, and therefore future CEOs are in big demand. If the compensation of the CEO is not market competitive, there is a safe bet that the in-demand CEO successor is compressed and can be easily picked off by a competitor.
The IRS uses comparisons. When arguing its cases, the IRS will need to develop a new section of 162 to include guidelines for determining what is considered “reasonable compensation.” As of now, the IRS considers two important inputs when utilizing market comparisons to determine if a CEO has been overcompensated: 1) companies of similar size and 2) companies of similar type.
Compensation comparisons are an input, but they are not the whole formula. Compensation Committees weigh a number of factors when determining in what manner and how much to pay a CEO. Utilizing market competitive data is only one component. Other factors include: tenure, individual performance, company performance, market forces, economy, etc.
If not market comparisons, then what? Maybe compensation committees could adopt Aristotle’s guidelines that nobody should make more than five times the lowest paid person in the village. Or they may use the more updated version by Peter Drucker suggesting a CEO should be capped at 25 times the lowest paid person. The most recent, real-life version of artificial CEO caps was developed by the Ben & Jerry’s Ice Cream founders in the 1990s reflecting the CEO should be capped at ten times the lowest paid person in the company, which was consequently dropped in 1994 because they had to hire an external CEO to replace the founder. Consider Whole Foods, they use CEO salary caps or at least the congressional debt version of a cap. It started at eight times, then moved to 14 times, then 19 times, and it doesn’t include long-term incentives, which happens to be over 50 percent of a CEO’s compensation.
Why should companies pay competitively? Think about it, if CEO’s, or the companies they work for, did not focus or care about paying competitive wages to employees, the results could be detrimental to not only shareholders but the economy as a whole. It could prompt:
1) Companies to privatize and not allow regular investors a chance to “grow” with the company, a concern the SEC secretly shares.
2) Relocating corporate headquarters and/or relisting in more business friendly environments, thus taking jobs and taxes out of the U.S.
3) CEO’s could retire earlier, consequently exacerbating the talent gap issue.
While the debate rages about CEO pay, the reality is U.S. companies still compete in a free market economy and pay their people the market competitive rate. No different than how these companies set prices for their goods and services. If CEO pay is truly out of bounds, the free market will respond accordingly via natural economic forces such as shareholders selling off the stock, overpriced good and services, etc. While the news is increasingly more opinion and less news, economic myths are myths, and economic reality is the market.
Chris Crawford, COO; Brent Longnecker, CEO; and Todd Henke, Director, are part of the managment team of Longnecker & Associates based in Houston.
Nov 03, 2012 Comments Off on How Full Is Your Bucket?
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