Are CEOs really overpaid and mostly not worth it? Part 3

Posted by on Jan 23, 2012

Recap

In Parts 1 and 2 of this topic, we reviewed studies and opinions on executive pay. We found that the research shows:

  • CEO pay has grown faster than the capitalization or profits of the companies they head, and
  • this is most likely the result of measurement difficulties and remuneration policies that may be skewed by self-interest.

This week we’ll conclude by answering the key strategic question “what should companies do about it”.  Our answer may surprise you.

What the data does – and doesn’t – tell us

As with nearly all population statistics, the pay received by roughly half of all CEOs falls below the average. The data shows that CEOs at the top of the scale are overpaid, but that doesn’t mean all CEOs are. It also doesn’t mean all highly paid CEOs aren’t worth the money.   It says that performance bonuses generally don’t work as intended, and that part of the reason is the moral hazards they create.

Looking at the ways it is being interpreted by the general public and employees, however, it appears these nuances have been lost. The public reaction indicates that the combination of moral hazard and excessive, undeserved pay has created a toxic environment.  CEOs are being found guilty by association in the court of public opinion, and are in danger of losing the credibility to lead and inspire, even when their conduct has been above reproach.

The case for incentives is crumbling

The Economist magazine opined in the 1990s that no matter how carefully performance incentives were designed, CEOs would always find ways to “fiddle the system”; but excused it by saying that this was preferable to having CEOs who weren’t smart enough to do so.

What The Economist apparently didn’t consider was whether these bonuses actually worked. At the time, there was little research to indicate the real effect of executive bonuses. But the evidence that has become available since the mid 1990s paints a different picture than what most imagined back then.

We’ve spent many hours in the past few months reading what leading business thinkers have been saying about CEO pay and bonuses.  Frankly, we were shocked by some of what we found.

In his November 2009 Wall Street Journal opinion piece, McGill University’s Henry Mintzberg (32nd on the Harvard Business Review’s list of the World’s top 50 management thinkers) wrote bluntly:

“The failings of the current system—and the executives who live by it—are painfully obvious. Although these executives like to think of themselves as leaders, when it comes to their pay practices, many of them haven’t been demonstrating leadership at all. Instead they’ve been acting like gamblers—except that the games they play are hopelessly rigged in their favor.”

The system simply can’t be fixed. Executive bonuses—especially in the form of stock and option grants—represent the most prominent form of legal corruption that has been undermining our large corporations and bringing down the global economy.

In his 2008 book, Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn From the NFL, Roger Martin, Dean of the Rotman School of Management (U of T), and 6th on HBR’s World’s top 50 management thinkers, explained the problem no less bluntly:

“(CEOs) receive incentive compensation to which the rational response is to game the system. And since they spend most of their time trading value around rather than building it, they lose perspective on how to contribute to society through their work. Customers become marks to be exploited, employees become disposable cogs, and relationships become only a means to the end of winning a zero-sum game.”

In Martin’s view, many CEOs end up defaulting to managing stock analysts’ expectations about their companies, perhaps because this has more influence on share value in the short term than any other action at their disposal.

This led, for example, to downsizing at many profitable companies in the years prior to the 2008 financial crisis, not because of real redundancies, but because they weren’t meeting Wall Street’s expectations. That is neither good leadership nor good management, and it may have actually harmed the long term interests of the shareholders.

With everything we’ve learned about Wall Street analysts in the past few years, does anyone still believe we should be managing on the basis of their judgements?

So what should companies do about it?

Our focus for the past 18 years has been almost exclusively on strategy. It’s not our intention to venture into detailed discussions about compensation policy.  But we think there’s strategic action companies should take to avoid the problems discussed in this 3-part article.

Of course, the response to any issue should be proportional to the size and nature of the opportunity or threat it presents.  We think this is a serious strategic issue, worthy of our clients’ attention, for two reasons.

First, the moral hazard created by inappropriate incentives corrupts some to steer their organizations primarily for personal gain, not for the company’s benefit.

Second, the highly public furor created by the many egregious examples of blatant greed has smeared all CEOs – including the many who have always worked steadfastly in their organizations’ interests.  The same measurement difficulties that mask what CEOs have contributed to their firms’ success make it equally hard to know from the outside which ones are doing a great job.

With that in mind, let’s review what 2 Canadian luminaries, Henry Mintzberg and Roger Martin, have recommended.

Mintzberg argues that CEO bonuses should be scrapped completely.

“These days, it seems, there is no shortage of recommendations for fixing the way bonuses are paid to executives at big public companies. Well, I have my own recommendation: Scrap the whole thing. Don’t pay any bonuses. Nothing.

This may sound extreme. But when you look at the way the compensation game is played—and the assumptions that are made by those who want to reform it—you can come to no other conclusion. . . .  Get rid of them and we will all be better off for it.”

Mintzberg’s comments have been called provocative by some, and echoed by others. Still others have written that eliminating performance-based bonuses introduces another moral hazard – the temptation to take the easy way out when better results may be possible if greater effort is applied.

But this has to be weighed against the motivation to take excessive risk when not only are CEOs protected against bankruptcy for taking very bad decisions – they would still collect their considerable salaries and severance packages if the decisions were so bad that they were fired.

Roger Martin called for something that is at once simple, yet radical.  He advocates a shift of CEO focus away from shareholder value and back to customers.

His rationale is that companies which make serving and delighting their customers their highest priority should do very well in the market that matters the most – the one in which customers decide whether or not to buy a company’s products and services.  We think that will take care of the other market – the equities market that prices companies’ shares on the basis of future expectations.

We offer three recommendations that parallel ideas contributed by Mintzberg and Martin.

1. Following on Martin’s point, we think it’s essential for companies to get back to the basics set out by Peter Drucker more than 60 years ago when he wrote “the purpose of a business is to create a customer”.

This requires putting the emphasis back on creating exceptionally clear and attractive value propositions, and aligning everything in the organization (including executive incentives) to communicate and deliver this value at every customer touch point.

We believe this focus has strayed at some organizations in the past decade as a result of the focus on shareholder wealth in combination with inappropriate CEO performance incentives.  For example, a CEO could decide to gut the company to reduce costs to exceed Wall Street analysts’ expectations, and to earn a big bonus for increasing the share price.  There is a time lag between cuts in service and the resulting decline in customer satisfaction, ultimately leading to customer defection. In the interim, though, the CEO may profit handsomely from this action.

We do not mean to suggest that all cost-cutting and productivity improvement efforts are bad. Quite the contrary.  Productivity improvement and cost cutting can improve reliability, standardization and quality in some cases. But when an organization cuts its ability to generate the value customers care about, it may be cutting its own throat.

The adoption of the Balanced Scorecard may have deflected some companies away from the primary importance of customers. After all, for-profit companies typically have “shareholder value” as the ultimate outcome at the top of their strategy map.  But we have always cautioned clients who appeared to focus to excessively on shareholder value that having more of the right customers, and a growing proportion who are delighted, is the key to shareholder value. Many of our clients have never let this slip from the top of their priority list, and we think their results demonstrate its importance. If this is not the strongest point in your company’s strategy, we believe you have urgent work to do.

2. Those companies in which CEOs are currently paid more than 20% of their total compensation in bonuses of any kind should carefully examine their incentive systems for hidden moral hazards. The dismal record of performance incentives reviewed in Parts 1 and 2 undoubtedly overshadow examples of companies that have got their incentive contracts right. But who is to know which ones? We would take it as a given that performance incentives contain moral hazards or at least misdirect managerial effort until it has been proven to the contrary.

3. Even if not required by law, organizations should consider adopting standards for enhanced disclosure of executive compensation.

Finally, we’ll close this three part series with Henry Mintzberg’s startling advice to organizations hiring a new CEO.

Dismiss out of hand, without one second’s hesitation, any candidate for a CEO position who seeks a compensation package that would single him or her way out from everyone else in the company. In fact, terminate discussions immediately at the mere mention of the word “bonus.”

These prove the candidate has no business running a business of co-operating human beings. (Should this person not comprehend, cite his or her mention a few moments earlier of the importance of “teamwork,” and how “people are a company’s greatest asset.”)

This proposal will save tons of money and send a positive signal to everyone else in the company for a change, and the firm might just end up with a CEO who is a real leader. Imagine that.

Mintzberg made this compelling point in a Bloomberg interview in August 2009:

“American enterprise, so admired around the globe, was not built by currently fashionable “heroic” leadership but with leaders tangibly engaged in managing—and without today’s bonuses, I might add.”

It is possible that a lot of what’s gone wrong in US businesses during the past 20 years has its roots in CEO incentives.

Post-script: Readers’ comments on parts 1 and 2

We’ll respond to two comments we received on Parts 1 and 2 of this topic:

  • That CEOs’ pay must be appropriate since it is determined by the market; and
  • That since CEO incentive plans are carefully set by Boards, CEOs should not be second-guessing them.

Is CEO pay appropriate because it’s determined by the market?

Our answer is “no” for two reasons.

First, market benchmarks used to set CEO salaries are skewed by the process that sets them.  In many cases, compensation committee members have an indirect interest in increasing CEO salaries because some of them stand to benefit from general increases in executive compensation. This part of the market mechanism is flawed.

Second, companies with the most highly-paid CEOs are performing worse, on average, than those with lower paid CEOs. And excessive pay for the top 10% distorts the market benchmarks used for setting other CEO salaries.

Are CEOs duty-bound to follow the lead set by the bonus structure, even if they think it may hurt the company?

We’ve discussed this with senior executives many times over the years.  Some have said it’s an executive’s duty to pursue incentive targets without question since they represent the Board’s clear and deliberate decisions about priorities.

We disagree.  If following a board directive would likely cause loss of life or serious financial harm to the company, a Board would expect a CEO to avoid immediate harm, and then to inform them so they could reconsider. Boards hire experienced senior executives for their judgment, not simply to follow orders.

Further, most executives would be aghast if their subordinates blindly adhered to policy in the face of a previously unforeseen risk that threatened to damage the company.

Finally, we don’t believe most executives would remain silent if performance incentives were both very difficult to achieve and also damaging to the organization.

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


Share