Why Are CEOs So Underpaid?

Megan McArdle raises that hardy perennial question, why is CEO pay so high? If we are discussing CEOs of large public companies, I have a different question: why is it so low?

The world of American business has changed enormously in the last 30 years, and the practical implications of this for compensation in the upper reaches of the economy are staggering. The median Forbes 500 CEO, i.e., the 250th highest paid CEO among the 500 biggest U.S. public companies, made about $6.6 million in total compensation (salary, bonuses, stock options, etc.) in 2006, and has 5-year total compensation of about $14 million. His name is Andrew Liveris and he leads Dow Chemical, a company with an enterprise value of about $50 billion. A successful technology entrepreneur who builds a company 1/100th this size will make much, much more than this. Successful senior partners in leading strategy consulting and corporate law firms today make about $1 to $2 million per year – and all they have to do is be smart and willing to endure the pain of a horrible lifestyle. A senior investment banker makes more: Last year the average partner at Goldman Sachs made more than $5 million. The take-home pay of a partner in a good private equity firm or hedge fund makes all of these numbers seem like lunch money. The 400th highest paid public-company CEO in America makes about $2.6 million per year, but the 400th richest American is a billionaire.

Imagine that you are smart, motivated by money and just entering the workforce. Given that senior management is a specialized field, and usually requires decades of development, you normally have to commit to such a corporate career for many years before you know how it turns out, and you have, at best, partial control over the outcome. A very large number of people go to work for a Fortune 500 company every year, and there is one CEO at any time. Even if you assume that CEO tenure is only a few years, you realistically will have no more than one or two such openings at the relevant point in your career. No matter how talented and hard-working, you are extremely unlikely to become the CEO. Compensation falls off rapidly below CEO, and is typically well below $1 million per year for the 10th highest-paid executive at a public company. It’s a terrible odds-adjusted proposition if the other alternatives discussed are available to you. How many times in the last 30 years do you think someone offered a job in the analyst program at Goldman has turned it down for the management trainee program at General Motors?

There are several other factors driving the rapid recent increase in CEO pay: the deployment of new technologies, the growth in the size of the average public company, the increasing concentration of power in the CEO role, changes in tax policy, and so forth. Changes in some of these factors could theoretically reduce the pay gap between the CEO and the average worker. But seen in the context of the relevant job market, a few million dollars of annual income as the low-odds pot of gold at the end of the rainbow is probably insufficient to attract the best talent for the job into the career on the front-end. This is why the best CEOs (or at least those rationally predicted to the best job before hiring) can command such a huge premium over the average.

Public company CEO compensation is a voodoo doll issue. The data is available by regulation, so people write articles about it. If anything, the political pressure this creates probably suppresses compensation below what it would be in a private company market. Don’t think so? – then why do the smartest owners with the most limited agency problems, namely major private equity firms, pay such enormous compensation to successful CEOs.

If I sound cavalier about all this, I’m not. I believe that growing income and wealth inequality is a very serious long-term issue for the United States. Focusing on public company CEO pay in isolation just frames the problem far too narrowly.