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.
This is a bunch of words strung together to make it sound like each CEO worked for free for thousands of hours to earn his ultimate reward. Piffle. If the pay was based on real performance measures, few people would object. But when the pay is based on stock price, the incentive is to destroy the long term profitability of the company in exchange for a slightly higher quarterly profit.
The idea that the poor CEOs had to endure years of office politics and backstabbing to work their way up the corporate ladder is similarly bogus. They chose the career perfectly aware that dedication and hard work didn’t count as much as luck and blame-shifting.
The idea that the equity firms establish CEO pay in a competitive market is old-fashioned. It just so happens that THOSE aren’t the companies we are complaining about. We are complaining about the ones where interlocking directors allow the CEO to pick his own board, and then name his own salary in exchange for an identical return favor. This is like letting the pigs run the farm just because all the farms around you are run by pigs.
The old adage was that CEO pay was high because they took all the risk. But when a CEO is exposed as corrupt, the termination bonus is so high that it removes every potential element of risk. Many termination agreements appear to have been written with the mean-spirited intent to punish the company for being so bold as to question to king.
In my job, if I am wrong year after year, I get fired. I don’t get use of the company jet, I just get paid for whatever vacation time I saved up. Unless there is some element of personal responsibility for CEO behavior, there is no way you can convince me that their guilded lifestyles are justified.
— Dave · Dec 18, 05:25 PM · #
Dave:
Believe it or not, I am sympathetic to your point of view on this.
Think about how somebody would practically break up the cozy little world of mutual back-scratching that you describe. Here’s what I’d do: raise enough capital to buy a small public company, fire the incompetent executives that run it, replace them with superior management with better incentives and watch the performance of the company improve. I’d then sell the company for more than I paid for it, pay off the guys who invested the money in the deal and keep a large profit for myself. Then I’d use that track record plus some of my profits to raise even more money, buy a larger company to make yet more money. I’d do this over and over again and become quite rich. Of course, I’ve just described the rise of the private equity industry.
It is, in fact, just this world of a market for corporate control and pay-for-performance that is driving the increasing separation of pay for the winners vs. losers across the economy. Yes, there are many egregious cases of very, very lucky idiots standing in the right place at the right time (I could tell you many such stories), but on the whole this is the dynamic that is pushing radical de-averaging of compensation.
The irony is that the solution to the problem of poor executive management that you describe has been a key contributor the problem of rising inequality.
— Jim Manzi · Dec 18, 05:45 PM · #
Dave/Jim:
It’s also worth pointing out that this business about rules being different inside the club than outside is not limited to the CEOs of public companies.
On Wall Street, the guy who loses $5 million gets fired. The guy who loses $500 million (through legitimate trading, not through fraud) starts his own hedge fund. Because anyone with the stones to lose $500 million is a serious player.
— Noah Millman · Dec 18, 10:10 PM · #
Noah:
Yes, that’s true in the world of technology as well. The best possible credential for getting VC funding for your start-up is having already led a successful start-up. The second best is having led a failed start-up. There is no third best credential.
— Jim Manzi · Dec 18, 10:23 PM · #
I still feel, Jim, that you are dancing around the central point for many of us. Hundreds and hundreds of millions of dollars have been paid out to fired executives who not only performed poorly, but performed at an almost absurdly incompetent level, in some cases. And yet they make more than any ten, any hundred of us will make in our lifetimes.
I mean, look— when you are a fiscal liberal, you are constantly lectured by fiscal conservatives about “the system” and how elegant and efficient it is. And one of the best parts of it, we are told, is that it rewards competence and ability. Yet those same fiscal conservatives participate in, and cheerlead for, a system that produces these kind of results.
— Freddie · Dec 19, 01:51 AM · #
Freddie!
Welcome – I had a little bet with myself on whether you would participate in this thread, and I’m glad to see that I’ve won. As always, your comments are interesting and eloquent.
I’ll go you one further before addressing your comment directly. Even if all wealth was earned based on some common-sense definition of merit, there is still an amount of economic inequality that I think is inherently bad for a society. In my view, the contemporary US is close to or past that point now.
In terms of your comment, markets are both imperfect and reward contribution as defined by those who are doling out the money. “Contribution” in this sense normally has only a very partial relationship with what most people (me included) think of as “value” or “worth”.
The classic story of the CEO who was hired and then canned two years later, but pocketed some insane amount of money upon termination is not, in my view, a huge indictment. At the time the guy was hired, the Board had to make a prediction as to the likely probability distribution of value-added the guy would provide, and the CEO negotiated to get the best deal possible for himself. That is the source of the payout on the back-end. No prediction is perfect, and with enough CEO hires in such an environment, there will be some forecasting errors. Even if we posit that some of these hires were done by incompetent or lax Boards, this is still just the kind of imperfection which all systems will have. (It doesn’t make people any less bitter when they see it happen, though.)
The point of my post, and it’s related to an earlier post about proposals to tax hedge fund carry as ordinary income, is that the problem is much bigger than CEO pay – it’s the impact of radical de-averaging of compensation across the economy. Now, I believe that this is better than the alternative of stagnation and low growth in the face of rising international competition, but it does create a huge problem of rising inequality as a by-product of our national approach to globalization.
This paragraph is where I’m supposed to summarize my prescription for how to deal with this problem, but I don’t have one.
— Jim Manzi · Dec 19, 04:02 AM · #
College football coaches are a good example. Yes, some coaches may have the ability to influence the athletic director and board of trustees in untoward ways.
However, many of the highest salaries are pure open-market deals — the college is desperate to win games, there is a tremendous amount of money at stake, and it imagines that a particular coach can produce results.
The fact that Charlie Weiss got paid a gazillion dollars to stink up Notre Dame doesn’t show that the market has failed, or that legislation is required to rein in head coach salaries – it just shows that ND made a bad bet. All things being equal, it’s smart for ND to offer their coach millions of dollars per year – even if they sometimes get a bad coach, they will still, on average, get a better coach than if they were paying less.
— J Mann · Dec 19, 09:14 PM · #
“All things being equal, it’s smart for ND to offer their coach millions of dollars per year – even if they sometimes get a bad coach, they will still, on average, get a better coach than if they were paying less.”
That’s an empirical claim, and I’d have to see numbers to believe it.
— Freddie · Dec 19, 09:38 PM · #
Freddie, seriously? You really don’t believe you get better coaches, all other things being equal, with a $5 million/year budget than with a $500,000/year budget?
An empirical study of college coaching would be difficult because of counfounding factors – even if I showed you that payroll correllated with success, you would just argue that I hadn’t shown you that payroll caused success.
In general, if you accept that (1) a significant fraction of the most talented coaches make their decision between the various opportunities offered to them by which job offers them more money; and (2) there is some ability to recognize which coaches are more talented, at least in part, then the schools that offer more money will tend to get more talented coaches than the schools that don’t.
On the other hand, if either (1) athletic directors were completely incapable of determining which coaches tended to be better than others or (2) the better coaches were completely unmotivated by money in making their career decisions, then you would be right that having a bigger payroll wouldn’t be likely to correlate with hiring better talent.
— J Mann · Dec 19, 11:07 PM · #