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Over the last 30 years, CEO compensation has been one of the most debated topics in the business press. Much of this discussion has focused the ‘excessive’ levels of CEO compensation and the allegedly weak relation between CEO pay and corporate performance. The consensus view of critics is that the compensation is broken: boards are ineffective and not independent of management, and pay is both too high and disconnected from performance. If the CEO compensation system were guilty as charged, then firms would be able to reap huge gains by providing CEOs with more modest compensation packages featuring sharp incentives to improve performance. I believe that that this consensus view is enticing but has one annoying drawback -it is fundamentally incorrect. In fact, the consensus perspective may itself have contributed to one of problems it bemoans, the high monetary value of CEO compensation packages.
Nevertheless, while the large gains from compensation reform predicted by the consensus view are a mirage, modest but significant efficiencies in CEO compensation can be attained by firms that understand the rules of the CEO compensation game.
The starting point for this understanding is the simple recognition that the CEO’s compensation contract is heavily influenced by the CEO’s options in the managerial labour market and not just the characteristics of the employing firm. Whatever else a CEO compensation package must accomplish, it must first and foremost attract and retain the right candidate. Independent boards will offer ‘arm’s-length’ compensation to managers, i.e. compensation determined by firm interests and not managerial influence. If compensation is determined at arm’s length, then, at minimum, the value of this bundle of rewards offered to the CEO must at least be high enough to induce the CEO to accept employment while, at maximum, not so high as to make replacing the CEO with a rival candidate a value increasing proposition. Because CEO productivity is wrapped up with firm productivity, the gap between the upper and lower limits for arm’s-length compensation packages can be large. A CEO of a £500 million net income firm will have a much greater ability to create or destroy value than that same CEO would if he captained a £1 million firm. For this reason, it is perfectly rational for big firms to offer a big premium to attract slightly better CEOs. If the candidate CEO’s skills are specific to the firm, as might be the case for an inside candidate, bargaining between the firm and candidate CEO will determine how much of the gain to the firm which the CEO generates will be reflected in the CEO’s compensation. However, if the candidate CEO is a ‘superstar’ and the market believes that he can create excess value not just at one firm but also at other firms in the industry, then competition between firms will tend to pull the CEO’s salary up to the top of this range, as the biggest firms, which can benefit most from small percentage changes in value, compete for the CEO’s talents. These effects are the normal and expected results of the operation of the CEO labour market. Concerns for the fairness of this pattern of compensation within the remit of governments might be addressed by tax policy. However, for an individual firm attempting to optimise its CEO hiring policy, market prices simply represent a constraint.
A good CEO compensation plan
Firms should aim to work within this constraint in the most efficient fashion possible, by packaging rewards to minimise their cost to the company and while at the same time providing incentives for the CEO to fulfil corporate objectives. In short, a good CEO compensation plan should meet the following criteria:
- The plan should provide actual or potential CEOs with value sufficient to attract and retain him or her
No individual firm can control the price of CEO quality presented by the market for executive talent. However, firms can determine how much CEO quality they are willing to buy. Shareholder value will be maximised by matching the quality (and thus, sadly, the cost) of the CEO hired with productivity of the firm’s assets.
- The plan should aim to minimise CEO exposure of compensation to risks outside of the CEO’s control
Firms are typically owned by diversified shareholders. Such shareholders require a smaller premium to shoulder firm-specific risks than CEOs, whose welfare is much more closely tied to the firm’s fortune. Thus CEOs’ valuation of payments that are affected by firm-specific risks will be lower than the market value of those payments. Compensation contracts that force the CEO to ‘share the fate of stockholders’, by loading on risks beyond the CEO’s control (e.g. based on revenues when revenues are largely determined by world commodity prices and exchange rates) are a relatively expensive way to provide the value required to retain and attract CEOs. Thus, the fashionable idea that CEOs should be forced to share downside risk may lead firms to offer more expensive compensation packages, exactly the sort of ‘overgenerous’ compensation that is criticised by the consensus.
- The plan’s performance targets should be keyed to outcomes substantially under the CEO’s control
The board should identify the value drivers of the firm that the CEO can control, e.g. market share and costs, and base compensation incentives on these drivers. As firm objectives change, a vigilant board will need to recalibrate the compensation package. When determining the level of performance-related rewards in the CEO’s contract, the firm should recognise that the very labour market forces which ensure that CEO compensation is high, make job retention, even in the absence of explicit performance-based compensation, a strong motivator. If the CEO is an insider with firm-specific skills, then losing employment with the firm will generate a very significant drop in income. If the CEO is a purported superstar, then termination following poor performance, will cast doubt on his superstar status and thus have a significant adverse effect on future compensation.
- The plan sets performance targets that are at least partially attainable under expected business conditions
The business press is full of well-founded criticisms of performance targets that are unambitious. However, too ambitious targets can also be problematic. For many firms, the most crucial decisions a CEO will ever make will occur after the firm has experienced an adverse event. Such an event can make over-ambitious targets unattainable even with the best efforts of the CEO. Thus the targets may be out of play at the very point were incentives are most crucial.
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