Good OP. Too bad the first few repliers didn’t bother to read it.
My answer is that the value of CEOs can be measured by performance of the company relative to others over the long term. A CEO whose stock goes up 25% over the year may not be so great of the average stock price of his industry segment goes up 30% in the same period. The basis of comparison has to be carefully chosen also. It appears that some compensation committees choose poorly managed companies as the baseline, which makes even a mediocre CEO’s performance look good.
I think the need for long term thinking is obvious at the moment. In all, I don’t think there is any way of doing this except after the results are in.
As Strassia said, the comparison to athletes is a good one.
I’ve read somewhere (don’t ya just love that phrase?) that boards often set CEO and executive salaries like this:
Board Member 1: We need to set the compensation for Bob
Board Member 2: He’s done a good job. We’re a great company!
Board Member 3: Do we want an average CEO or an above average CEO
All: Above Average!
Board Member 4: Is Bob an average guy or above average?
All: Above Average!
BM 1: Should we give Bob an average wage or an above average wage?
All: Above Average! We strive for excellence, not averageness!
BM 2: Great - let’s give bob a 30% raise to make him above average. That will show everyone we’re an above average company that strives for excellence.
The next company does the same thing. Only now the “average” CEO wage has gone up. They have to give their CEO a raise to make him above average. All the companies are now in a race to pay their CEO’s more to make sure they have an “above average” CEO.
This wage inflation is the result of people looking at the “average” and thinking that they want to be above the average.
The CEOs that were chosen by “the system” (the boards, the market, etc) to lead the huge financial companies must have been the best of the best. They must have had enormous respect among their peers and a great track record.
And yet, these CEOs ran their companies into the ground. These are huge multi-billion dollar 100-year-old companies, and they managed to run them into the ground.
Therefore, one of the following options applies
The CEOs lacked the talent/ability to run these companies.
This would imply that the system is not good at knowing who the “best of the best”. The system is broken.
The CEOs saw this coming, but they chose to run these companies into the ground, because of all the hundreds of millions of dollars they made in the process from bonuses.
If this is indeed the case, then either the boards are useless in preventing the CEO’s greed from destroying the company, or they did not care, since they made mega millions in the process too. In either case, the system is broken.
Nobody could have seen this coming, so the CEOs are not to blame
It’s not true that nobody saw this coming. There were many “doomsayers” that predicted that the complex financial instruments that were being invented would bring chaos. So, the CEOs should have been at least as smart as these guys to see this coming. Since they are paid hundreds of millions of dollars to run these companies, they better know the industry and where it’s headed better than anyone else.
If the CEOs didn’t see this coming, they did not know the industry and where it’s headed better than anyone else, so again, the system of selecting CEOs is broken.
Is there any other way to explain how these CEOs were able to drive their huge corporations into the ground?
Because, all of the above scenarios seem to point to the fact that the system is not good at selecting the best of the best to run these companies.
So, if we can’t know a-priori if a person will be a great CEO, if highly-paid CEOs are just as likely to ruin a company as to help it, why pay them millions and millions?
On some levels, it is. But to make it more accurate, we would need a system in athletics where the althletes themselves controlled the stats that were released to the public.
The trouble with the defenders of the current structure is that they rely on market rationality, and in particular the role of the stock market as an information provider. If you think that role is compromised by the fact that the necessary data to play such a role is essentially provided by people with an incentive to distort it, then the system is much less rosy.
To be sure. I’d take the job of most rock stars or sports stars too…just for the chicks if nothing else. Problem being I’d be unqualified.
Ah, but I was forgetting…CEO’s are unqualified boobs who actually bring no value to the companies and are hired and over paid due to the good ole boys club. Probably sports stars and others of that ilk are equally unqualified, so perhaps I could just step in. I’d charge a lot less for my services, that’s for sure…
Because a low-paid CEO is almost guaranteed to ruin the company.
It’s like that 4 box chart they show in economics classes. Between you and your competitors there are 4 possibilities
1 - Your CEO is highly paid, Their CEOs are highly paid - level playing field
2 - Your CEO is low paid, Their CEOs are low paid - level playing field
3 - Your CEO is low paid, Their CEOs are highly paid - they will get the best and most talented CEOs
4 - Your CEO is highly paid, Their CEOs are low paid - you will get the best and most talented CEO
Your company will wind up with no strategic advantage by paying less for a CEO, outside of saving a tiny percentage of your profit on his salary. Maybe you do wind up with a brilliant guy who is a true game changer, and he’ll ditch your company as soon as possible to cash in at one of your competitors, leaving your scrambling for another cheap CEO.
Trouble is, Cheesesteak, your prisoner’s dilemma box is based on an assumption that if you pay more, you will get a better CEO. It might be possible to presume better CEO candidates want more money, but it is not true to say, necessarily, that it is possible to determine when hiring who is the better candidate. In fact, this informational problem creates a whole new game theory possibility - that as a candidate for CEO, you should request a higher salary than you deserve, because it sends the message that you are a good CEO. And once you get on the gravy train, its tough to be thrown off.
Indeed, I hate the current method of hiring people. I work as a programmer and you know you get a list of names, count out the number of applicants, roll a die, and just have to take the person it lands on and hope. But darn it, they usually don’t work out or even know anything about programming.
I wish someone would invent some sort of system for taking a look at candidates, their experience and success/loss history, and a method for determining their goals, methods, and style. If only there was a way to know who you’re hiring besides throwing dice!
We could…call it something like…dunno, an “interview” with maybe some sort of pre-created document that listed out key data…a “resume”, man we’re on to something here, I know it!
I have been the one to set CEO pay (as a compensation consultant working for the compensation committee of the Board of Directors).
Here is how the pay was set:
Step 1: Peer review. What are the CEO’s peers making? Peers are determined by the peer group listed in the proxy in the Total Return to Shareholders’ performance table. Some debate occurs regarding other possible peer firms. Since I billed by the hour, I was happy to add a ton of peers to the analysis.
Step 3: Collect peer financial performance data, and client performance data. Run all numbers.
Step 4: Discuss with the BOD what matters. Do they want to directly reward long-term total return to shareholders (TRS)? Do they want to reward TRS if it matches the market, if it exceeds the market, if he beats his peer group? Are their other measures? Do they also want to reward revenue growth, new stores, same store sales, profit margins, market share?
Step 5: Design a multi-faceted compensation plan that takes all of that into account, present it, sell it to the management team, collect check.
The problem with stock option plans is that some firms would effectively reward for not even keeping up with the market (if your stock goes up 5%, the market goes up 10% - you still make money). Better plans are ones that grant restricted stock based on acheiving other set goals (using things like an EVA model to keep it strategic). Nail the revenue numbers, get dX thousand shares of restricted stock. You are incented to nail your numbers, and you are still compensated based on company performance. The restrictions ensure that you will always leave some money on the table if you leave.
First, no one said the CEOs would work for the “greater good”, so that is a strawman.
Second, regarding prestige being a motivator, of course it is. Even in the “great socialist experiment” you mention, it’s the low-level low-prestige workers who did not do as good a job, because they didn’t give a damn. But you can bet that people in the highest echelons worked hard for the prestige of being in the Polit Bureau.
Or, for an example closer to today, there are many people who stay in academia, which is paid less than industry, because of the prestige from doing research and showing everyone in their field how smart they are.
Sure it is if you are measuring speed on 100m. But can you measure how they actually play? How many athletes with huge contracts have ended up with mediocre careers? Or injured in their first season? The point is two fold: It is hard to predict what actual effect a CEO or athlete will have for a variety o reasons and because of the small pool of candidates and the perception of large gains (think how much affect a Michael Jordan or a Steve Jobs have had), the average price has gone up as everyone seeks the next big thing.
No CEO is going to accept a compensation package that depends on 10 year results. Many CEOs don’t even stay that long.
So how do we stop the cycle? If companies have to put more and more resources into executive compensation just to compete with each other, how do we stop it short of letting the system get so top heavy it collapses.
But your point brings out exactly what is wrong with CEO pay.
If you hire an expensive programmer, they will very very likely be much better than a cheap programmer. There is very little likelihood that you hire a programmer with an impressive resume, with a long track record, and who does very well on the interview, but then goes on to be a total fuckup and destroy the project he is working on. (Well, at least that’s the case in my line of work, so I assume it’s similar for programmers)
But, in many many highly publicized cases, CEOs are brought on board with amazing resumes and yet they clearly fuck up. It’s not that the situation was so bad that even they couldn’t help the company. The decisions of the CEOs directly had an adverse effect on the company.
So, it makes sense to pay a lot of money for a great programmer, because there is little risk that they will screw up the company and he will highly likely add value to the company, and it doesn’t make sense to pay a great CEO a lot of money, because there is a significant risk that they will not be good for the company.
To look at it another way, look at the valuation of an investment. If it has a low risk and low rate of return, you value it low (like programmers). If it has low risk and high rate of return, you value it high. But, if it has high risk and high rate of return (like CEOs), then if the risk is sufficiently high compared to the return, you still value it low.
It seems to me, based on observations of CEO performance, that, even though the potential returns are huge, the probability that they will screw the company is just as high as the probability that they will bring about those returns, so the risk is high, and so the pay should not be that high.
That’s like saying that because the odds of Mike Tyson winning versus Muhammad Ali are about even, you shouldn’t bother trying to get Tyson, and just go with Joe Sixpack since he’s just as likely as anyone else to beat Ali.
I.e. even if the odds of failing is 50%, that’s only when you’ve got someone who is in that class of running. You put someone unqualified in there and it’s not going to be a battle at all.
Let’s assume for a moment that all CEOs got their compensation reset to $500,000 max as of January 2007. It’s now 2009, you’re on the board of Office Max, and your company is circling the drain. Do you offer Staples’ CEO $1 million to join your company, and try to turn it around? That dude is knocking it out of the park, kicking your company’s ass 12 ways to Sunday. If you’re Staples, do you let him go, or offer him $2 million to stay?
If you try to stay on the cheap, CEOs with “proven” talent are going to jump ship, and there will be numerous takers, desperate companies who need help. They may not ultimately help, but there are billions of dollars at stake if you screw up, you don’t want cheapness to be the reason your company died.
I dunno, ask Iacocca. He took a dollar a year from Chrysler for awhile. Really, some people are motivated by the fact they want to do THAT job, and are rewarded by the act of doing it. For them, if body and soul are comfortably kept together by the compensation, then it is adequate. Oddly enough, these are the people who I find are most likely to do a good job when no one is looking.
I’m not so angry about the size of the compensation that CEOs receive. Many of them do seem to be seriously out of whack relative to the compensation that the average worker receives. That would be less of a problem if the size of that compensation were relative to the overall success of the company, rather than a guaranteed payout.
Let me just link to the perfect solution fallacy. No one is saying that there aren’t poorly performing CEOs and that companies don’t mess up and hire the wrong guy or pay him too much or whatever, but there is no perfect solution. Market forces and oversight be experienced professionals isn’t going to be perfect. But peer review isn’t a perfect solution to verifying the accuracy of scientific research. The United States Congress isn’t always going to make the wisest and most profound and forethinking decisions.
Sweeping statements of the “evil” or “fallibility” of these systems is entirely ignoring centuries of success across hundreds of thousands of businesses of all sizes. If you have a better idea for achieving better oversight, that’s one thing, but complaining about how much someone is getting paid in the free market just comes across as sour grapes and there’s no real reason to think otherwise.
Thinking that the overseers aren’t doing their job when I can go and take you to any one of millions of stores and malls and supermarkets across the nation and show you perfectly crafted, regular, factory created items for sale on every shelf that are guaranteed to be restocked just as fast as they’re needed, and that I can go back 50 years or a hundred years and show you the same thing rather shows that overall businesses work to accomplish what they’re supposed to. You can’t say that they’re running amok when 80% of all order and regularity in our daily lives is created by these entities. This just doesn’t take a lot of effort to notice, I would generally think.