The Compensation Consultant’s Critique

James Surowiecki recently published an excellent column in the New Yorker on why various reform attempts (such as say-on-pay, paying directors mostly in stock, increased disclosure on pay, and the shift to independent directors) have failed to curb CEO compensation.

Surowiecki identified two causes:  the perception that selecting the CEO is critical to the company’s future and the belief that paying the CEO based on the company’s performance will improve the company’s bottom line.  He sketched out a persuasive argument that both these beliefs are myth, and that the rise in pay is largely due to the increasing emphasis on the importance of corporate leadership and the shift to performance pay (especially stock options).

I agree strongly with both points.  This will not come as a surprise to regular readers of this blog or to those who have read my book, Indispensable and Other Myths:  Why the CEO Pay Experiment Failed and How to Fix It (University of California Press 2014).    Surowiecki interviewed me (and read Indispensable) before writing the column, and he quoted me several times.

Compensation consultant Marc Hodak posted a sharply-worded critique of the column in his blog recently.  (Hat tip to Stephen Bainbridge at  The post’s rather strident tone is regrettable, but Hodak’s core argument is one compensation consultants and other defenders of the current system often make, so I think it deserves a reply.

I should note at the outset that I reject the temptation to dismiss Hodak’s arguments on the theory that his role as a compensation consultant provides a powerful incentive to justify the current system.  Upton Sinclair observed, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”  But Hodak’s arguments should stand or fall on their own merit, and not because of some ad hominem attack.

Hodak dismisses my argument that it is hard for boards to predict in advance which of several similarly-credentialed finalists will most help the company by asserting, “It would no doubt upset my client directors to think of all the time and energy they have spent fretting about the quality of their top management is pretty much wasted.”  He then adds, “Seriously, to call this an ‘academic’ finding reinforces all the worst connotations of that term.”  Nowhere does he discuss any of the studies I cite in Indispensable that support my finding, nor does he cite any contrary studies (although there are some, which I discuss in the book).  His only argument is that his client directors would be disturbed to think they were misguided.  The best face I can put on his argument is this:  if smart people are investing lots of time and money in an idea, the idea must be right.

There is something intuitively appealing about this appeal to authority – it’s one I hear all the time – but it’s hardly evidence.  Smart people have invested lots of time and money into all sorts of ideas that turned out to be wrong.  In the 1960s, smart people invested a lot of money pursuing the idea that public companies should join together into large conglomerations to better leverage managerial expertise and provide one-stop-shopping for investors looking to diversify.  In the 1980s, smart people invested more money breaking up those same conglomerates.  In the late 1990s, smart people believed the internet would grow at an astronomical rate, justifying stratospheric valuations for companies that were not yet earning a profit, and they invested their money accordingly (until the crash came).  In the early 2000s, smart people invested lots of money in financial instruments whose value depended on a housing market that would never stop rising in price.  We know how that one turned out, too.

The point is not that smart, rich people always make mistakes, or even that they often do so.  These examples just demonstrate that it’s far from unheard of for lots of rich, smart, sophisticated folks to all believe the same fallacy, and to invest accordingly.  It’s therefore far from sufficient to point to the behavior of this group as conclusive evidence of empirical validity.  We need to test propositions with actual empirical studies that look at how companies perform under different conditions.  As I document in my book, the weight of the empirical research demonstrates that CEOs do not, on average, have much impact on enormous, well-established, companies.  Some CEOs do (in both positive and negative directions), but on average, we should not expect the CEO a company hires to have much of an effect.  And there is not yet a reliable way to tell ex ante whether a board is hiring a future superstar, a future disaster, or just a caretaker.

Hodak goes on to point out that even if, as Gabaix and Landier claim in their study, the best CEO will only add .016% to the market capitalization of a company when compared to the 250th best, that would still make paying a CEO $15 million a bargain.  That was, of course, precisely Gabaix and Landier’s point.  They are defenders of the current CEO pay system, and this was the very argument they made in their paper.  I critiqued their study on a number of grounds in Indispensable, but the point Surowiecki was highlighting was simply that if the talent differences are actually that small, boards cannot reasonably be expected to discern them and be sure the company is hiring #1 and not #250.  Hodak does not address this point, nor does he discuss any of the other critiques of this study I raised in my book, such as the study’s deeply problematic assumption that all companies are looking for CEOs with the identical skill set.

To undermine Jacquart and Armstrong’s work (a paper that found that higher pay fails to promote better performance and that incentive pay encourages unethical behavior), Hodak again resorts to the “rich, smart people can’t be wrong” argument.  He writes, “So, all those directors with all those years of collective experience have been wasting not only immense amounts of time, but also all that money based on a mistaken believe in the power of incentives. Wow.” He also asserts this “may be one of the worst studies on executive compensation in recent years” without even hinting at why he holds this belief.  The closest he comes is his statement that the authors conflate pay-for-recruiting with pay-for-performance, but he provides no evidence that they do any such thing.

The remainder of the post attacks a straw man.  Surowiecki says that whether or not compensation committees can accurately predict CEO performance, they are willing to spend extra money to get the person they think will do the best job for the company.  His point is that well-meaning boards who believe CEO leadership is critical and that they can discern which CEO candidate will best run the company might very reasonably pay a premium to get the best person.  The problem is not that boards are “lazy, stupid or corrupt,” as Hodak mischaracterizes Surowiecki as implying, but that they are mistaken on the two points discussed above:  that CEOs of large, established companies typically have a major impact on performance and that performance pay induces CEOs to work harder and smarter.  Nor is Surowiecki’s point that boards believe that simply paying CEOs more will induce better performance.  His point (and mine) is that boards believe that conditioning additional pay on performance will result in better performance.  That is the entire rationale behind performance pay.  If Hodak does not believe this is true, then we have little to argue about; he can join Surowiecki and me in understanding that performance pay is an extravagant waste of corporate resources.



  1. Since you were kind enough to respond to my note, permit me to reply with a few points:

    1. I’m sorry if you felt my treatment of your contribution to Mr. Surowiecki was a bit rough. I did not intend any disrespect. I just felt it appropriate to convey how far I felt his conclusions were stretched in my 600 words.

    2. I am well aware of the studies that have been done in the area of management incentives. I was writing a blog post, not a research paper. If you want to see my research papers, kindly check out my SSRN page.

    3. My appeal was not to authority, but to experience. And not just the experience of a cadre of directors operating in a bubble, but of directors operating throughout the history of corporations around the world. The illusion you are suggesting is not just widespread, but universal in space and time. I suppose illusions can sometimes be that way, but extraordinary claims demand considerable proof. For the record, directors do not believe that they can finely distinguish among the best candidates with any degree of certainty. They believe they can do it just well enough that their input is meaningful. And they don’t have to be much better than a coin toss in each instance for their overall effect to undermine your thesis. A grain on the scales can drive evolution. That was one of Surowiecki’s points in his book, which I thought made his article rather ironic.

    4. I’m sure I have not seen all the studies, but I have studied the issue of managerial impact in sufficient detail over enough years to know how difficult it would be to specify a model that can isolate something as uncertain as discerning the quality of management. I am skeptical that anyone has statistically significant results on this point (including, by the way, Gabaix and Landier, who I think did a pretty good job.) And I have seen some very clever models.

    5. But I will allow that I have not seen them all.

    6. I won’t even entertain the argument that incentives don’t work. I have personally seen the opposite, with great clarity, both in corporate practice on every scale and in the best financial and compensation data sets in the world. How would you interpret every study relating ownership and performance from McConnell and Servaes (1990) to Von Lillienfled-Toal and Ruenzi (2014) if not an incentive effect? How would you describe the diverging fortunes of communist and market-oriented societies? You might as well try to prove that the earth is flat.

    7. I did not say that Surowiecki said that boards were lazy, stupid or corrupt. (He just asserted the latter.) I said that this was the assumption of the proponents of Say-on-Pay, which failure is what Surowiecki’s article was nominally trying to explain.

    8. Between Surowiecki’s (and your) explanation based on mass delusion and mistaken ideology versus the default explanation that market is working reasonably well, as an observer I would go with Occam’s Razor on this one.

    But I am not an observer. I am the guy who sits on the side of investors trying to negotiate the best deal on the best executives to run their companies, and who knows how scarce their talent is, and what those executives can command. (And you’re quite mistaken, presumptuous really, about my interest in justifying the current system. Good consultants make their income on change.) If you think you could get these CEOs cheaper, you’re welcome to try. If you think the whole market is wrong, and has been going on two decades, that we’re in a kind of bubble market for hundreds of top executives, well, perhaps you’re much smarter than I am.

    1. Thank you for your thoughtful reply. Let me start by saying that I’m certainly aware of who you are. If I didn’t think you were someone worth engaging, I would not have replied to your post. In that light, I would very much value hearing your thoughts about the book. The conversation we’re having – while interesting – will be much more productive once you’ve had a chance to read the book thoroughly. Some of the points you made are responding to views I don’t endorse; others are points I address in the book. If you’re willing, I’d very much enjoy setting up a phone call (or a meal when you’re next in Los Angeles) so we can discuss the book in much greater depth than an exchange of blog post comments really permits.

      Very much in short-hand, then, and in anticipation of what I hope will be a much longer discussion, below are some comments in response to those of your points that seem to ask for a reply. I refer you to sections of the book with some hesitation, since they will not make as much sense in isolation, divorced from the overall flow of my argument. I very much hope, therefore, that you’ll take a careful read through the book as a whole and use the page references below just as highlights as you’re moving through the text.

      1. Thank you, I appreciate it.
      3. You might take a look at pp. 89-90 and 194-198 for my reply to this point about experience. I’m not sure what the basis is for your statement that directors don’t need to be much better than random selection for their impact to be important, especially if the talent differentials are very small. Perhaps we can discuss this more clearly by phone or in person. As to the burden of proof, please see 8, below.
      4-5. Yes, the data issue is extremely difficult for the econometric studies. I talk about this at pages 127-136. But we are not limited to econometric studies.
      6. I agree that incentives are important. That is quite different from arguing that they have the precise effect our intuitions tell us they should have. As for the ownership studies, please see pp. 168 and 244-45.
      7. I’m glad this was just a misreading on my part. I don’t think boards are corrupt either. Chapter Five is entirely devoted to this point.
      8. I agree that when intuitions about human behavior are strong, the burden of disproving them is difficult to meet as a practical matter. That is not to say that this burden is appropriate or that we should defer to our intuitions when they conflict with the empirical evidence available. As you know even better than I, the behavior that leads to the CEO results we observe is enormously complex, so we should expect empirical studies to be mixed, and they are. But the weight of the evidence is pretty clear, especially when we view the question from multiple perspectives (econometric data, broader economic data, and psychological data). I respect and appreciate your experience in this area, and I take that as an important data point. Many compensation consultants, directors, and executives would agree with you (though I have also spoken with a number who do not). (On this, much depends on how one asks the question. More on this in person if you’re interested.) But the fact that many (even most) participants in the system believe in it is not evidence the system is producing the desired results. And the participants in the system from the 1940s through the early 1970s believed in it, too, and they paid their executives almost entirely in salaries and short-term bonuses. Which set of experienced experts is right? There is a considerable advantage in studying the system empirically rather than relying on the intuitions – even the strong intuitions – of those who live in it. Oh, and if you make money on change, my book represents an excellent opportunity for you. I hope you’ll see it that way. I certainly did not mean to be presumptuous, and I apologize if I offended you.

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