Month: March 2014

Does Performance Pay Work?

Reputability, the UK reputational risk firm, has a new blog post about an empirical study of performance pay that demonstrates that performance pay does not result in higher share prices.  The study is spot on and reinforces the points I make in my forthcoming book, Indispensable and Other Myths:  Why the CEO Pay Experiment Failed and How to Fix It (University of California Press, forthcoming 2014).  (I cite an earlier version of the study there.)  Michael J. Cooper, Huseyin Gulen, and P. Raghavendra Rau performed a careful analysis of the impact of various forms of performance pay.  They concluded that paying CEOs more — generally in the form of performance pay structures such as stock options, restricted stock, and bonuses — resulted in worse, not better share price performance.  Unsurprisingly, stock options had the strongest negative effect, while guaranteed salaries had no impact at all on stock price, positive or negative.

Cooper, et. al argue that the reason performance pay does not produce better corporate performance is that it encourages executives to make acquisitions, and acquisitions tend to be decrease companies’ value.  Reputability’s Anthony Fitzsimmons does not dispute this, but adds that the problem may be linked to the concept of “dominant” CEOs.  CEOs who are paid more than their peers may be “dominant,” and this characteristic may lead to poor management such as refusal to consider alternative viewpoints.

There is actually an extensive social science literature on why performance pay does not work for the type of high-level cognitive tasks performed by CEOs.  I analyze that literature extensively in Indispensable and can’t really do it justice in a short blog post.  (There are also other reasons not rooted in social science for the failures of performance pay, but these have more to do with the type of performance pay companies tend to use than with the concept of performance pay itself.  I discuss these other problems in the book as well.) 

One issue psychologists have honed in on is that performance pay is inherently distracting.  Think about shooting a free throw at the park,with no one you know around.  With nothing much to take your attention away, you can focus on the task at hand, sinking the ball into the basket. Then imagine trying to make that same shot with a $50,000 prize available if you hit five in a row.  Does the shot become easier or harder with a considerable sum of money on the line?  Performance pay may have a similarly distracting effect on CEOs’ ability to manage their companies.  With such a vast personal fortune on the line, to what extent can CEOs really focus on the task at hand and ignore the pecuniary consequences of success or failure?  The empirical data from studies such as Cooper, et. al‘s suggest that money is as highly distracting for CEOs as it is for the rest of us.

Apple Without Jobs — Pretty Much the Same, Says NY Times

In a penetrating review of Yukari Kane’s new book, Haunted Empire:  Apple After Steve Jobs, the New York Times’ Farhad Manjoo points out all the ways in which Apple seems to be clicking along perfectly well without its legendary former CEO Steve Jobs.  This is entirely consistent with what the empirical studies tell us about corporate leadership.  Most studies have found that — contrary to the prevailing belief that CEOs control their companies’ fate — corporate leadership accounts for a relatively small percentage of the variance in a company’s performance.  These studies grapple with a host of variables and there is a range of results, but the weight of the evidence is that on average, the identity of the particular CEO doesn’t matter very much.  This is not to say that anyone can run Apple.  These studies are comparing the performance of companies run by the type of CEOs boards typically hire; they don’t include the test case of randomly selected individuals with no business background being given the chance to run multinational corporations.  They do indicate, though, that which person with the usual — very impressive — credentials, experience and talent runs the company may not matter very much.  The most important drivers of a company’s success or failure are the external environment (both generally and within the industry) and the company’s internal resources (personnel, physical assets, intellectual property, culture, etc.).  Leadership can matter in particular cases, but it does not matter very much on average and its impact is not predictable.  All of which tends to undermine the view that companies should be paying CEOs huge sums because they create enormous value for shareholders.  Companies create enormous value for shareholders; CEOs’ role in that creation is far less certain.

Escaping the Conformity Trap

Pearl Meyer & Partners has just released their contribution to the NACD’s new Governance Challenges 2014 and Beyond report, “Escaping the Conformity Trap: Aligning Executive Pay Programs with Business and Leadership Objectives.” I love the overall theme, which is that companies should not default to cookie-cutter measures of executive performance just because their peer companies do. The report also indicates that companies shouldn’t defer to peers on the amount of pay, though this point is less prominent. I make a similar — though more sweeping — argument in my forthcoming book, Indispensable and Other Myths: Why the CEO Pay Experiment Failed, and How to Fix It. (The book should be out around the end of May.)

Unfortunately, while there’s a lot in the Pearl Meyer report that is laudable, there’s also a fair amount of rehashing of typical errors. On page 18 (the report starts on p. 17 for some reason), the report describes the growth in CEO pay of 12% from 2009-2012 in Fortune 100 firms as “comparatively conservative.” This is technically true, if by “comparatively conservative” Pearl Meyer means that there have been much steeper rises in executive pay. But the rationale seems to be different. The report points out that the market capitalization of Fortune 100 firms increased by 50% over this same period, and credits external scrutiny of CEO pay and a desire to remain within peers’ norms for restraining CEO pay.

The clear implication here is that CEO pay should rise in proportion to the company’s stock price. (The report says this more explicitly on page 19 when it says total shareholder return is often a good performance metric.) As I point out in Indispensable, this is a dangerous fallacy. CEOs do not control their companies’ stock price. They can influence price (especially in the short term), but careful empirical studies have repeatedly demonstrated that executives’ actions account for only a small percentage of share price movement. The external environment broadly — and in the industry more particularly — drive the bulk of share price movement. So why should companies peg CEO pay to the growth in share price that for the most part is independent of their actions? This sort of rhetorical move is particularly disappointing in a report whose laudable aims seems to be to move companies in precisely the opposite direction, away from easy, off-the-shelf measures like share price that fail to capture what companies should really care about.
The report also backtracks when it comes to using comparable companies to set the amount of CEO pay. Despite having at least hinted that this is a poor strategy elsewhere in the report, it states (on p. 18):

Of course, there is nothing inherently wrong with providing executives with pay opportunities that reflect market norms for comparable positions in similarly sized and oriented companies.  With well-designed long-term performance metrics and goals, establishing pay opportunities  at market median will help ensure that actual, realizable pay is appropriately positioned based on relative performance outcomes.

But there absolutely is something wrong with this. As Charles Elson and Craig Ferrere have recently demonstrated, there is no market for CEO talent. Since CEOs have little ability to move to another company, why should a company care what its competitors are paying their own CEOs? Why not try to get a bargain by paying less, if the CEO can’t get a comparable job elsewhere? Scholars have advanced plenty of rationales (which I explore in the book but don’t have room to delve into here), but none of them work very well.

Although I’m disappointed that the report does not go nearly far enough, I was heartened that a major compensation consultant is at least beginning to question the conventional wisdom. It’s a small step, but at least it’s in the right direction.




Are CEOs paid what they’re worth?

Robert Reich recently posted an article on Salon ( arguing that workers — and CEOs — are not paid what they’re worth.  Instead, workers’ pay depends on the extent of unionization in the industry, Reich says, because unions enable workers to extract a greater percentage of the joint gains of production.  CEOs are paid some 300 times more than typical workers not because they’re worth that much, Reich continues, but because they appoint the directors on the compensation committee or because boards don’t want to be perceived as having hired a second string CEO.

Reich’s broad point — that CEOs are not necessarily worth what they are paid — is quite correct.  In the details, though, Reich is entirely wrong.  He adopts two common theories of CEO pay:  the corruption theory and the advertisement theory.  Neither has strong empirical support.  The corruption theory — most closely associated with Harvard professors Bebchuk and Fried — predicts exactly the opposite of what the data shows.  CEO pay was flat in real terms during the 1940s, 1950s, and 1960s, then rose somewhat in the 1970s, climbed dramatically during the 1980s then skyrocketed during the 1990s.  CEO power over boards follows precisely the opposite pattern.  Companies began insisting on independent directors during the 1980s and by the 1990s most boards were dominated by directors from outside the company.  In other words, CEO pay was stagnant while CEO power over directors was strongest, and CEO compensation climbed fastest while CEO power was weakest.

The advertisement theory doesn’t work either. Are directors really spending millions of dollars to create a perception that their CEO is better than s/he is?  That seems like an entirely irrational use of money.  Wouldn’t it be more effective to just hire a CEO who was worth that sort of money?  And this explanation also fails to match up with the data.  If this is what motivates boards in paying their CEOs, we’d expect to see a one-way ratchet in CEO pay, with companies constantly striving to outdo one another to advertise their CEOs’ quality.  But that’s not what’s happened. For decades, CEO pay basically stood still in real terms.  More recently, in the years following the internet bubble and again during the financial crisis, CEO pay actually shrank.  That shouldn’t ever happen if boards are primarily focused on advertising their companies’ fitness when they set CEO pay.

The real problem with CEO pay is the assumption that CEO pay should be tied to corporate performance.  The empirical studies (both of actual companies and in the laboratory) show that tying CEO pay to corporate performance does not improve corporate profits.  It does, however, boost CEO pay.  During the period when CEO pay remained flat, boards used little if any performance pay (such as stock options or restricted stock).  The performance pay trend began in the late 1970s and accelerated during the 1980s, precisely when CEO pay began its dramatic rise.  Then, after the stock market crashed in 2000, the value of CEOs’ pay packages — tied, as they were, to stock prices — shrank too, then recovered with the stock market.  Ironically for Reich, then, the core reason CEO pay has risen so dramatically is precisely boards’ efforts to ensure that CEOs are worth what they’re paid.  The problem is that they’re doing it wrong.  More on that another time.