Discussion # 5 - Do CEO's Deserve their Pay?

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Do CEOs Deserve Their Pay?

The myths that drive the CEO pay bonanza.

According to the most recent report of the Economic

Policy Institute, the average CEO-to-worker pay

ratio in the United States has gone down from

286-to-1 (in 2015) to 271-to-1 (in 2016). This number

may disappoint many top executives who were

hoping to see it return to its peak of 383-to-1,

achieved in 2000. But in spite of this “bad” news, it’s

clear that CEOs will not receive a pauper’s wage.

Looking at these figures, it appears that nobody

heeded the warnings of management sage Peter

Drucker who determined that the proper ratio

between a chief executive’s pay and that of the

average worker should be around 20-to-1 (as it was

in 1965). Drucker believed that larger discrepancies

would bring about morale problems within the

workforce. As things stand now, many CEOs earn

more in a single workday that the average worker

makes in an entire year.

In many respects, extremely large CEO

compensation packages are problematic. The

practice over-emphasises the impact of a single

individual and undervalues the contributions of

other employees to the success of a company. What

make these ratios even more troublesome are

studies that show that companies with high CEO-to-

worker pay ratios have lower shareholder returns

than companies with lower ratios.

The myths behind CEO mega pay

I would argue that extremely high salaries for CEOs

are abetted by the following myths.

Myth 1: CEOs need high pay to motivate them to

exceptional performance.

If CEOs were not paid so well, they would not work

as hard. Thus, for the benefit of the corporation, it’s

essential to offer them generous incentive packages.

Reality: High achieving CEOs will work hard whatever

they are paid.

Given our understanding of human motivation, the

kinds of people interested in the corporate game

tend to be high achievers. And most CEO-types fall

into this category. From my experience working

with these people, they will work hard regardless

of salary. Companies that give CEOs grandiose pay

packages are wasting resources that could be put to

better use. It’s very unlikely that cutting CEOs’ pay

would affect the bottom line.

Myth 2: Large CEO salaries reflect market demands

for a CEO’s unique skills and contribution to the

bottom line.

According to this argument, talented CEOs possess

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impressive but very scarce leadership skills.

Generous pay packages merely represent the

market forces of supply and demand. If there was an

oversupply of people with such unique qualities,

market forces would bring their salaries down.

Furthermore, they deserve high levels of

compensation given their ability to withstand the

enormous pressure they are under to create

exceptional results for the corporation.

Reality: CEOs are not that exceptional and it's almost

impossible to measure their singular contribution to

the bottom line.

What may be a downer to some is the fact that most

CEOs aren’t that exceptional. Rare are those who

have the impact of a Steve Jobs or a Bill Gates.

Although they may imagine that their skills are in

scarce supply, many are quite ordinary, fallible

human beings who have only a limited impact on

their companies. To replace them is not an

impossible task. After all, every year, worldwide,

business schools crank out hundreds of thousands of

MBAs, many with sights on a CEO’s office. In

addition, no matter how talented, CEOs cannot run

their companies alone. Other qualified people are

needed to make it happen. Given economic

upswings and downswings, it’s very hard to

determine the exact value a single CEO creates or

destroys. A company’s success is always the result

of a team effort.

The greed spiral

In order to understand why extremely high CEO pay

persists and why people continue to buy into the

illusion that they are getting their money’s worth, we

need to look at a number of systemic issues and

dynamics that drive the cult of the CEO.

In the CEO mega compensation game, peer

comparisons play a central role. Both the board’s

compensation committee and prospective CEOs are

taking advantage of the “above average effect”.

When determining the size of salaries, members of

the board assume that a prospective CEO must be

above average and make remuneration

comparisons accordingly. Similarly, in bargaining

for their pay, CEOs will not suggest that they are

below average. All of them want to be paid more

than the median.

Board members may fear that if they don’t

compensate CEOs according to the upper quartile

of the compensation scale, they could lose them.

They may worry that their CEO will be “poached”.

These social comparison processes, however, when

repeated year after year, have a dramatic,

inflationary effect on pay packages.

To put even more oil on this inflationary

compensation fire, many head hunters base their

own fees on what a prospective CEO will be paid.

And as they are operating in a highly irrational

market, they have considerable leeway to jack up

the pay package. Furthermore, the remuneration of

most compensation consultants is based on a

formula tied to their prospect’s pay package. When

we combine all these escalating pressures with the

fact that many board members often do not fully

understand the convoluted pay structures designed

by these consultants, it’s no wonder that there has

been such inflation in compensation.

Given the existing pay bonanza, it is fair to say that

many CEOs have lost their capacity for fair

judgment when making a case for their own

compensation, acting more like mercenaries than

genuine leaders. They are reluctant to recognise

that an excessive compensation package has

negative implications. For instance, it destroys the

sense of community that a high-performing

organisation needs. It demoralises people and may

even motivate some to leave. Although some CEOs

may acknowledge the downsides of exorbitant pay

packages (as they prefer to keep their pay secret),

greed is one of the deadly sins most difficult to

overcome.

Keeping the compensation game within

boundaries

Unfortunately, self-policing by the CEO community

is quite unlikely. Countervailing pressures will be

necessary to keep CEO compensation packages

within limits.

For a start, board members need to push back

against the “above average effect” and not be

tempted to make comparisons with outliers. They

also should be very wary of excessively

complicated compensation schemes which make it

easier for opportunists to rig the system. All too

frequently, these convoluted pay constructions turn

CEOs into financial engineers – focused on ways to

impact compensations formula instead of investing

in the company’s future. Board members need to

face the unpleasant truth that compensation

packages can be “gamed” in such a way to boost a

company’s short-term earnings. For example, the

emphasis on stock options and restricted stock

grants invites manipulation.

Compensation packages should be designed with a

focus on the company’s long-term health, taking the

various stakeholders into consideration. For

example, we can see how the German tradition of

worker representation on the board serves as an

antidote to excessive compensation.

Publicly releasing information about top executive

compensation is one way to offset excessive

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salaries. Another suggestion is a shareholder vote

on top executives’ compensation packages. The

same approach can be used concerning shareholder

approval on all share buybacks which are also an

invitation to manipulate compensation when it is tied

to share price. (Often, in taking such actions the

price of the shares is pushed up without actually

investing in the company’s capital, R&D or the

development of its people.)

Clawback provisions could also reduce the

temptation to manage for the short-term. They force

executives to return compensation that – at a later

stage – turned out to be calculated incorrectly.

Another way to fight against excessive

compensation is taking a hard look at how a

company deals with existing tax codes.

Compensation decisions are often attempts at

finding “creative” ways to manoeuvre through a

maze of tax regulations. In this case, the government

needs to play an important role. For example,

implementing higher marginal income tax rates at

the very top would have a dampening effect on

large compensation packages.

Furthermore, in many countries, the way stock

options are taxed could be revisited. Lastly, a rather

innovative measure to prevent pay packages from

spiralling out of control would be to set high

corporate tax rates for firms that have very high

CEO-to-worker compensation ratios.

These various recommendations may not be

received warmly, as many people view the CEO

compensation game as an important bulwark of

capitalism. Although this may be true, inflated CEO

pay scales are also a sign of impending rot. While

capitalism has many positives (in light of the

alternatives), free market ideas in unrestrained

forms have serious dysfunctional effects on society.

Unbridled capitalism only contributes to social

unrest. Therefore, it’s timely that the next generation

of CEOs thinks more creatively about the challenges

corporations face in building sustainable

businesses. And a good start to this is creating fair

compensation systems.

Manfred Kets de Vries is the Distinguished Clinical

Professor of Leadership Development &

Organisational Change at INSEAD and the Raoul de

Vitry d'Avaucourt Chaired Professor of Leadership

Development, Emeritus. He is the Founder of

INSEAD's Global Leadership Centre and the

Programme Director of The Challenge of

Leadership, one of INSEAD’s top Executive

Development Programmes.

Professor Kets de Vries is also the Scientific Director of

the Executive Master in Coaching and Consulting for

Change (EMCCC). His most recent books are: You

Will Meet a Tall, Dark Stranger: Executive

Coaching Challenges; Telling Fairy Tales in the

Boardroom: How to Make Sure Your

Organisation Lives Happily Ever After;

and Riding the Leadership Rollercoaster: An

Observer’s Guide.

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