Blogs & Comment

The problem with CEO pay: it's set by a small, self-selected group

In some cases, exit pay packages for CEOs have been in the hundreds of millions of dollars. A new report out of the U.K. urges reforms.

(Photo: Imagezoo/Getty)

I remember U.S. pay czar Ken Feinberg telling a group of academics he was looking for independent compensation consultants and how, in his words, “there are no independent compensation consultants.” So he turned to academics. He wanted to study the claim by consultants that executives need to be paid extraordinarily high compensation or else they would migrate to other companies and jurisdictions, which—as it turned out—did not happen, Feinberg said, or is a “myth” as was stated in the U.K. this week. Addressing conflicts of interest by compensation consultants is only one of twelve reforms being urged by the “Final report of the High Pay Commission,” a rather scathing U.K. report.

Forthcoming reforms to the way executive compensation is set may include significant and unprecedented changes—well beyond the structural Dodd-Frank reforms in the U.S. Changes that may be termed “radical” by some include: binding and forward-looking voting on compensation by all shareholders; having women and worker representation on compensation committees of boards; regulating remuneration consultants; regulating the disclosure, unnecessary complexity and format of “fair pay” compensation; and having board of director positions advertised and applied for publicly.

A central theme throughout the compensation debate has been that boards and compensation committees—particularly in the U.S. and U.K. (but also elsewhere)—have been incapable or unwilling to address the uncontrolled disparity between pay of CEOs compared to that of other senior management and, in particular, the pay of average workers, even throughout the financial crisis. The market is not really “free,” proponents maintain, but is in reality a “closed shop” (words of the Chairwoman Hargreaves of the High Pay Commission). That is to say that pay is set by a small, heterogeneous, interlocked and self-selected group of management and directors. University of Delaware professor Charles Elson and his graduate student, Craig Ferrere, have documented an annual, compounded structural 17% increase in CEO pay over decades as a result of the way CEOs are paid at or above median and the marketing of peer group data by consultants. In some cases, exit pay packages for CEOs have been in the hundreds of millions of dollars. The public outrage seemingly falls on some or many (but by no means all) tone-deaf boards and senior management teams.

All reforms are now on the table and U.K. Prime Minister David Cameron and Business Secretary Vince Cable have weighed in. Cable, for instance, expressed sympathy with the Occupy movement, calling the current system “dysfunctional” and a failure of corporate governance.

What the Occupy movements have done, it can be argued, is focus the discourse on the consequences of wealth disparity. A Ted Talk by British researcher Richard Wilkinson, for example, focuses on the harm to society that results from economic inequality—notably the gaps within (not between) societies, which includes life expectancy, literacy, infant mortality, crime, teenage births, obesity and mental illness. (Credit goes to former York University student Cliff Davidson for sharing this video with me.) The link between wealth disparity and social harm is an “extraordinarily close correlation,” Professor Wilkinson states.

What the U.K. experience also shows is that regulators are prepared to step in and bridge gaps if industry proves incapable or unable to do so itself. In a speech I gave a year ago, I recommended that North American compensation consultants devise a code of conduct for consultants—independently developed and enforced—that includes consequences for breach, similar to regimes that lawyers and accountants have. John Tory was in the audience and endorsed my notion of industry leadership before government regulation. Regulation tends to have unintended consequences, and industry leadership is far superior to the former. Industry leadership unfortunately is not happening and is unlikely given vested interests. We have seen the consequences of inaction in the U.K.