Are CEOs really overpaid and mostly not worth it? Part 1

Posted by on Jan 10, 2012

Are the highest paid CEOs really worth what they’re being paid?

And does paying top dollar for a CEO add to the bottom line, where it really matters?

CEO compensation has come under the spotlight in recent years like never before.

Smoldering public outrage burst into a brush fire after the US government bailed out major financial institutions with more than 1 trillion dollars in taxpayer money only to see some of it doled out as bonuses to bank executives whose actions either caused the debacle or whose inaction allowed it to happen.

The discontent this has sparked now threatens to spread. It may be morphing into a level of cynicism among the general public, including employees of client organizations, that is unprecedented in our experience. But how accurate are public perceptions that CEOs are grossly overpaid and not worth it? What has caused this? And is this a strategic issue on which our clients should be acting?

The Emergence of Superstar Economics

We began observing this trend more than 30 years ago after reading Sherwin Rosen’s 1981 study in which he coined the phrase “superstar(1) economics”. Rosen set out to examine why:

“. . . relatively small numbers of people earn tremendous amounts of money and seem to dominate the fields in which they engage”.

He found that small differences in talent among those at the top in entertainment, sports, academia and business resulted in the best garnering a disproportionate share of the profits, even though the differences in talent at the top seemed very small.

Frank and Cook’s 1996 book, “The Winner Take All Society” built on Rosen’s work, noting that a few top cultural icons vastly outsell those only slightly less talented because technology makes it possible to be “everywhere at once”.

The winners are increasingly “taking it all” in business. In 1977 an elite CEO working at one of the USA’s top 100 companies earned about 50 times the wage of its average worker. Three decades later, the gap has ballooned to 1,100 times the pay of a worker on the production line. Top Canadian CEOs have benefited from the same phenomenon, though more modestly. Between 1998 and 2009, the top 100 CEOs in Canada saw pay increases 53% above the rate of inflation. Their employees enjoyed a paltry 4% over inflation during the same period.

Technology and Scale Drive Exorbitant Pay

Pay for the most sought-after executives has risen for similar reasons as it did earlier for the top athletes and entertainers. As corporations have increased in size, decisions at the top have bigger impact. Top American companies have much higher sales and profits than they did 20 years ago. Banks and funds have more assets.

Just as with athletes and entertainers, the divide between the CEOs who are super-rich and those who are merely wealthy is driven by the concentration of economic activity into fewer, bigger firms. This is largely the result of scale economies, not great differences in talent between the top dogs and the rest of the pack.

But are the pay differentials that result from superstar economics justifiable? Are the highest paid CEOs really worth what they’re being paid? And does paying top dollar for a CEO add to the bottom line, where it really matters?

The answers to this are distressing to shareholders and employees alike.

Our credibility is on the line – but so is yours

It is also distressing to us because we’ve been staunch advocates of free enterprise and free markets with the proviso that government has a role to play in protecting citizens from significant negative externalities. We’re concerned that some of our clients may see our writing about this as siding with anti-business forces. But our interest in bringing this issue forward is that we see it as a very important strategic issue.

We want to put our concern about this as succinctly as possible. When your employees begin thinking that your organization’s strategy has been cast to enrich executives at the expense of shareholders and employees, you have a serious internal strategic problem. And our discussions with employees in some of our client firms over the past year indicate that many previously sober-minded and conservative-thinking employees are leaning in that direction. Once the motivation of their leaders becomes suspect, the job of managing change suddenly becomes a lot more difficult and expensive.

Avoiding employee disenchantment is made increasingly difficult by some unpleasant data. Several empirical studies suggest that CEO pay for performance is either totally ineffective, or perhaps even worse. We mention two of many below.

In the summary of their 2009 study into the relationship between CEO incentive compensation and future stock price performance, Michael J. Cooper, Huseyin Gulen, and P. Raghavendra Rau of Purdue University concluded that:

“ . . . firms that pay their CEOs in the top ten percent of pay earn negative abnormal returns over the next five years of approximately -13%. The effect is stronger for CEOs who receive higher incentive pay relative to their peers . “

And from across the Atlantic, similar findings were examined by Britain’s High Pay Commission, which concluded:

“[Executive] Salary growth bears no relation to either market capitalisation, earnings per share (EPS) or pre-tax profit.”

“There is no or little relation between the total earnings trend and market capitalisation.”

For the statistically minded, regression analysis of changes in firms’ pre-tax profits vs. their executives’ bonuses yielded an R-squared of just .004 in the data examined by the High Pay Commission. This means that there’s essentially no relationship between increases in profits and increases in bonuses.

An important qualifier

Before continuing, we feel it’s important to differentiate between the equity returns taken by CEO-owner-founders, and the pay packets of CEOs who have been hired to operate existing companies. CEO-founders have typically risked a great deal to start their companies. Their returns are just reward for that risk. Meanwhile, hired CEOs often enjoy generous base salaries and risk only their bonuses. Downside risks like those faced by entrepreneurs are non-existent for hired CEOs unless they’ve also paid for shares in the firm. We think the equity returns realized by company owners should not be compared with the pay received by CEO managers.

There’s much more to say about this topic – too much for one article. Next week, we’ll review more of the findings from research into executive salaries.

We’ll review more evidence to see whether highly paid CEOs are putting big numbers on the bottom line, or only in their bank accounts.

And we’ll review comments from some of the top researchers into leadership and executive pay for some startling opinions about how to overcome the growing negatives associated with high CEO pay packets.

One thing is certain: CEO and executive pay is a very strategic issue that deserves our attention.

More next week.

© 2012 Knowlan Consulting Group Inc. All rights reserved. Unauthorized duplication or publication in any form, in whole or in part, is prohibited.

(1) Unlikely as it seems, the word “superstar” originated in Canada, referring to the famous hockey player Fred “Cyclone” Taylor, the star of Vancouver’s only Stanley Cup winning team.

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