I remember a board meeting where the CEO’s multi-million-dollar compensation was to be approved. He remarked that he should be paid in a manner akin to that of sports stars and entertainers. He maintained that the board needed to pay him this much so he wouldn’t go to another company. One board member leaned back in his chair and whispered to me, “Richard, it’s really tough to deal with a high performing CEO who is also demanding.”
CEO pay can be very emotional. I have been in meetings where CEOs have pounded tables, stood up and paced and, in general, have pressed boards to pay them the compensation they believe they deserve. In the words of one CEO I interviewed, he is worth “every cent” of his pay package.
CEOs also are very competitive. Because of total compensation disclosure, CEO pay has become a scorecard for CEOs to see how they are doing relative to other CEOs. It has given CEOs ammunition to negotiate with compensation committees they didn’t have when compensation was private. The quantum of CEO compensation has perhaps become less important than the scorecard, in that CEO compensation signals their worth.
An important reason CEO pay continues to rise in spite of all the reforms over the years is related to the Lake Wobegon effect—a natural human tendency to overestimate one’s capabilities. When CEO pay is set, the board picks whether the CEO should be paid “at” or “above” the average compensation of other CEOs in a similar companies. Clearly, half of CEOs must be below average, but a board will never pay their CEO below average, because it is the board that picked the CEO. If the board has a below-average CEO, the fault is with the board. This means that the water continues to rise for all CEOs—hence Lake Wobegon.
The way CEO pay is set is structurally flawed and inherently biased toward a built-in, year-over-year 10% to 20% accretion, which is the net effect of continuously and fictionally always being above average. Peer groups are based on company performance, not individual performance, and CEO pay is therefore “back-doored” based on the performance of the company rather than the performance of the CEO. Below average CEOs are unjustly enriched by company groupings and above average performance of other CEOs, without being directly compared to them.
What is missing for setting CEO pay is individual performance comparisons among CEOs based on generally accepted performance metrics. CEO performance should be compared, not companies. If a CEO is ranked 480 out of 500 Fortune 500 CEOs, and threatens to leave, it will be clear what options that person really has.
But who will change the system?
Government regulation is not the answer and has probably contributed to the problem, as now fully disclosed CEO pay has become a scorecard for competitive CEOs who think they’re better than other CEOs. Compensation consultants have also contributed to the problem, proffering “peer group data” as the basis of their wares for the last several decades. Boards are reluctant to change the flawed system, nor can they. Ditto for shareholders.
If there is dissatisfaction with the disparity between CEO pay and that of the average worker, the very system of how CEO pay is established itself needs to change. If you’re digging yourself into a hole, the first thing you do is to stop digging.