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20 January 2020
How many people have strong opinions about most hot topics in corporate governance— staggered boards, proxy advisory firms or dual-class share structure? In Pay for Performance… But Not Too Much Pay: The American Public's View of CEO Pay, from the Rock Center for Corporate Governance at Stanford, the authors take a look at a corporate governance subject on which everyone seems to have an opinion—CEO pay—and the public's perceptions about it. While academics may be arguing about labor market efficiency, much of the public takes a more intuitive or pragmatic approach: "the issue of CEO pay boils down to a personal assessment of whether any executive deserves to be paid so much money." The authors' conclusion from the survey: "the disconnect between observed pay levels and the public's view of pay is stark." Overall, the survey results were quite fascinating.
The authors consider these questions:
- "To the American public, how should pay vary with size and performance?
- Under what circumstances do CEOs deserve higher pay, and in those cases, how much higher should it be?
- When value is created, how much of that value should be paid as compensation, and what are the implications given the incredible size and market valuation of America's largest companies?"
The paper was based on a survey conducted in October 2019 by the Rock Center of "3,078 individuals—nationally representative by gender, age, race, political affiliation, household income, and state residence—to understand the views that Americans have on CEO compensation." The authors considered public opinion to be important because of its influence on the tax, economic and regulatory policies that affect executive incentives and, ultimately, U.S. productivity.
Pay vary with size? Not surprisingly, the authors found that 86% of those surveyed, regardless of political party or income, believe that public company CEOs are overpaid. In more detail, the breakdown was 92% Democrat and 81% Republican—not a huge spread in any event. And that seemed to be generally true throughout the survey—the spreads between Democrat and Republican were actually much smaller than you might expect. And that percentage is relatively flat compared to survey data from 2016 (83%).
But obviously, CEO pay varies significantly, depending on company size, profitability and organizational complexity. The authors observed that median CEO total compensation among the S&P 500 was $12 million, but (I hesitate to say "only") $4.1 million among the Russell 3000. And even within the Russell 3000, there is significant variability, from $13.3 million at the 90th percentile to $1 million at the 10th percentile, reflecting a 13-times pay increase relative to a 25-times increase in company size.
How much higher? While "typical" Americans believe that CEO pay should depend on company size, the authors note, they don't believe that it should vary to the extent that it actually does—that is they tend to believe the CEO of a much larger company should receive comp that is closer to 50% higher than the CEO of a smaller company: only 4% of respondents believe that the CEO of a company with 1,000 times greater revenue should receive even 10 times more comp than the CEO of a smaller company; the percentage was 7% if the larger company had 1,000 times the number of stores, reflecting greater operational complexity. According to the authors, respondents had somewhat more favorable views when they were given actual numbers. For example, "when told that the average large company in the U.S. earned $2 billion in profit last year and its CEO was paid $12 million, only 70 percent believe CEOs are overpaid—a 16-point improvement over the unprompted question…. When told the average large company has a market value of $45 billion and its CEO accumulated $50 million in company stock over their career, 72 percent say CEOs are overpaid." The authors ask whether there is "a point at which CEO pay should simply stop increasing? Or does the basic economic principle of value sharing continue to apply no matter the scale of the company?"
In this essay in the Harvard Business Review, two academics contend that performance-based pay for CEOs makes absolutely no sense: research on incentives and motivation suggests that the nature of a CEO's work is unsuited to performance-based pay. Moreover, "performance-based pay can actually have dangerous outcomes for companies that implement it." Why not, they propose, pay top executives a fixed salary only? The global economic crisis of 2008 led many to question whether large bonuses and stock options were motivations behind the overly risky behavior and short-term strategies that many argue triggered that crisis. But the answer that most often resulted was to structure the compensation "differently so that the variable component motivates the right behaviors." Instead of changing the measures, these two academics "argue in favor of abolishing pay-for-performance for top managers altogether." One of their main arguments was that contingent pay actually works only for routine tasks. Research has shown that, while performance-based pay works well for routine tasks, the types of work performed by CEOs are typically not routine; performance-related incentives, the authors argue, are actually "detrimental when the [task] is not standard and requires creativity." Where innovative, non-standard solutions were needed or learning was required, research "results showed that a large percentage of variable pay hurt performance." Why would that be? In this interview from the Washington Post, one of the authors explains that the research shows that "for humans in general, performance-related pay often backfires. That seems slightly counterintuitive. But if a very large component of someone's pay is dependent on performance —and hence there's a lot at stake—people seem to freeze." (See this PubCo post.) As discussed in this PubCo post, a New Yorker columnist concurs with the contention that performance pay does not really work for CEOs because the types of tasks that a CEO performs, such as deep analysis or creative problem solving, are typically not susceptible to performance incentives: "paying someone ten million dollars isn't going to make that person more creative or smarter. One recent study… puts it bluntly: 'Higher pay fails to promote better performance.'" In addition, the argument goes, performance is often tied to goals that CEOs don't really control, like stock price (see this PubCo post and this news brief.)
When is pay more merited? In addition, the authors found that, even if companies were the same size and in the same industry, 54% would pay the CEO more for a company that was growing and hiring U.S. employees than if the company were shrinking and imposing layoffs; 31% would pay the same amount. And 64% would pay founder-CEOs more than "professional CEOs" who are promoted to the job.
Who should be compensated for value creation? This is one of the most interesting questions. The authors cite earlier research showing that "CEO pay increases approximately $0.3 for every $100 change in shareholder wealth, but the public believes it should increase only $0.05 for that same change." One rationale the authors suggest is that the public applies the type of scale to CEOs as is applied across the "bottom and middle of most organizations, where promotions are compensated with 10 percent, 15 percent, and 20 percent raises, rather than the economic practices that we witness at the top of organizations where compensation scales significantly with size and profitability." But an alternative theory is that the public believes that CEOs aren't really responsible for that much of the value creation at their companies. To support that argument, the authors offered this hypothetical:
"when given a hypothetical situation of a CEO who creates $100 million in value through his or her management, respondents are willing to share $10 million, or 10 percent of this value in compensation (median response). However, when asked about a company that is simply worth $100 million more at the end of the year than at the beginning of the year, respondents are willing to give only $500,000 as compensation, implying that CEOs are responsible for only 5 percent of value creation."
The authors report that the research on this question "is very mixed," with earlier studies suggesting that CEOs were responsible for anywhere from 4% to 36% of company performance. Tellingly, however, directors, who, after all, determine comp levels, tend to "estimate that CEOs are responsible for 40 percent of performance." The authors ask whether the views of the public are wrong if they do not attribute to CEOs significant responsibility for value creation and company performance? Or whether the corporate directors who approve the amount of executive comp are wrong?
In September, the Council of Institutional Investors announced its new policy on executive comp. To address the widening gap in compensation between workers and executives, CII recommends that the Comp Committee take into consideration employee compensation throughout the company as a reference point for setting executive pay, consistent with the company's strategic objectives. In addition, CII cautions against overreliance on benchmarking to peer practices, which can lead to escalating executive comp. Understanding what peers are doing is one thing, but copying their pay practices is quite another, especially if performance of those peers is markedly different. (See this PubCo post.)
Should CEOs always be paid the most? Almost 2/3 (62%) of respondents said that CEOs should be the highest paid persons in the company, but that didn't hold true where another "employee" was a movie star or star athlete: "only 43 percent believe the CEO of a movie studio should make more than $10 million per year if an important actor at that movie production company makes $10 million per year; and only 40 percent believe the CEO of a sports team should make more than $10 million if an important athlete on that team makes $10 million per year."
Is it just dumb luck? According to the survey, 39% attribute CEOs' accession to that role to working harder than others, 32% to luck and 61% to connections; only 8% disagreed with the last point.
What's so bad about perks? Apparently not much. Surprisingly, 70% thought it was "always or sometimes appropriate" to provide a private jet for work travel, normally considered one of the more controversial perks; 30% said never. Also relatively acceptable were a company-provided private car, personal financial advisor, personal security and supplemental pension. Viewed as the least appropriate were guaranteed severance and membership in a local country club.
Does charity help? Apparently not much. If CEOs agree to leave most of their accumulated wealth to charity, 34% view them as good role models for others and 27% think that they may have strong feelings about certain issues, such as the environment, but many had more cynical views: 31% thought that they were just trying to reduce their taxes, 30% thought they probably had already given most of their money to families and 25% attributed the motivation to reputational improvement. The authors ask whether "the negative views of CEO pay [are] driven in part by a broader skepticism or lack of esteem for CEOs? Or do high pay levels themselves contribute to lower regard for CEOs?"
For further information on this topic please contact Cydney Posner at Cooley LLP by telephone (+1 415 693 2000) or email (email@example.com). The Cooley LLP website can be accessed at www.cooley.com.
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