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Wednesday 14 April 2010

CEO Pay – Because They’re Worth It?

Poor Chief Executives

In the United States CEO pay dropped by an average of 2% in 2009. Still, ordinary workers needn’t shed too many tears as the average total compensation for an S&P500 CEO hovered around the $11 million mark. Perhaps more significant is the gap between the average CEO’s and the average worker’s pay. From CEO’s earning 42 times more than employees in 1980 this soared to a factor of 525 in 2000 before declining to a still eye-watering 319 times in 2009. Here in the UK we find a similar discrepancy between the boardroom and the shop floor.

This doesn’t automatically mean that CEO’s are overpaid, although there’s no evidence either way that they’re providing 319 times more value than their underlings. Indeed, it’s hard to see how you could ever disentangle the various causes and effects to determine this. What we can do, however, is look under the covers at why CEO rewards may be so high: and, as you might expect, it looks like this is less to do with performance and more to do with psychology.

Perverse Incentives (Again)

The founder of JP Morgan, John Pierpoint Morgan, once argued that a company’s leader should earn no more than twenty times that of his employees, a rule of thumb only slightly tarnished by the fact that it was one that JP himself completely ignored. Of course, the real argument is whether better paid CEOs lead to better performance where it really matters. That’s in the earnings statement, if you’re interested.

Bergstresser and Philippon looked at this in more detail in CEO Incentives and Earnings Management, wondering if in companies where CEO compensation is heavily biased towards earnings related elements such as stock options, there’s greater evidence of earnings manipulation. It’s an unworthy thought, of course, that CEO remuneration packages could induce the leaders of companies to direct our great corporations to behave to maximise the value of their take home pay at the cost of the shareholders that they represent.

So, of course, that’s more or less exactly what was found. Attempting to align senior management with the interests of shareholders through remuneration packages seems to have incentivised them instead to find ways of maximising their take-home pay regardless of the longer term effects on the corporations they’re the temporary custodians of. It’s a key lesson – all incentives are perverse, CEO’s are especially motivated by incentives: therefore CEO’s are especially likely to pervert incentives.

Linking Executive Pay To Earnings

Although the numbers suggest that executive pay has always been linked to company performance this relationship was virtually formalised in the 1990’s. Significant increases in executive stock options were deliberately engineered in order to more tightly align the interests of a company’s managers with those of its shareholders. This, in turn, may have encouraged managers to manipulate stock prices by exercising their discretion in reporting earnings. For example, the researchers point to Xerox, Waste Management, Tyco and Enron as companies whose executives exercised significant amounts of options even as the companies were illegally inflating earnings. More generally they:
“... find evidence that more ‘incentivized’ CEOs—those whose overall compensation is more sensitive to company share prices—lead companies with higher levels of earnings management. These CEOs appear to more aggressively use discretionary components of earnings to affect their firms’ reported performance. In addition, CEOs exercise unusually large amounts of options and sell unusually large quantities of their firms’ shares during years where accruals make up a large part of their firms’ reported earnings.”
Manipulation, Not Management

Separately a report from the comptroller of New York State found that between 1995 and 2002, just as companies were tying executive compensation to earnings, the number of companies that needed to announce changes to earnings bounced from 44 to 240. Conclusive it’s not, suggestive it is: that the apparently superior alignment of executive and shareholder returns offered by earnings related executive remuneration packages may be, at least partially, down to the executives forcing the issue: incentivising executives to produce improves earnings doesn’t necessarily incentivise them to do so by improving performance. Manipulating accounts will have just the same effect and is often a lot easier to engineer, especially if your auditors know what’s good for their non-audit fees (see the Accounting Industry section of the NY comptroller report).

This probably isn’t especially surprising to most people and, to some extent, it’s the sort of behaviour we might want in the chief executive of our companies – we hardly want our capital being looked after by a shrinking violet who’s not prepared to stand up to suppliers, competitors, unions or any of the other myriad groups that want our earnings in their hands. However, if that’s the type of person we want protecting our interests we’d better make sure that they’re properly aligned with shareholders’ and correctly overseen.

Scary Authority Figures

To take the last of these issues first, the oversight of executive pay packages is pretty much outside of the control of shareholders. We can moan, we can name and shame, we can even vote against egregious awards but boards can generally go ahead and pay whatever they want to. To counter this Sarbanes Oxley reforms in the US required boards to utilise independent directors to staff key committees. Similar recommendations have been recommended in the UK where nearly 50% of supposedly independent directors were personally recruited by the CEO. In all cases the qualifications required to sit as an independent director are unclear.

At root the unwillingness of boards and senior officials of companies to stand up to over-powerful CEOs may stem from a simple calculation of the individuals’ interests – keep quiet and keep a job. However, there may be a more powerful behavioural driver than this which is responsible for governance problems: the problematic nature of our instinctive deference to authority.

The Milgram Experiment

The classical experiment is the Miligram Experiment – a scary experimental setup where ordinary Americans were induced to apparently electrocute innocent victims at the encouragement of an authority figure. The victims were, in fact, actors and the experiment wouldn’t be permitted today but its findings still have special resonance within psychology. Stanley Miligram’s follow-up work indicated that the participants carried on shocking because they felt a sense of loyalty and duty to the (personally unknown) experimenter. It seems that they were prepared to kill someone on the order of a stranger due to some odd drive for obedience.

Although most CEO’s don’t demand that their employees commit murder on their behalf it’s fairly obvious where this train of thought leads us. Further experiments by Miligram showed that the unthinking – or at least unquestioning – response to authority of participants could be challenged. As Morck records in Behavioral Finance in Corporate Governance:
"Milgram reports that dissenting peers, rival authorities, and absent authorities shook this subservience and reinitiated subjects’ own reasoning. Corporate governance reforms that envision independent directors (dissenting peers), non-executive chairs (alternative authority figures), and fully independent audit committees (absent authority figures) aspire to a similar effect on corporate boards – the initiation of real debate to expose poor strategies before they become fatal."
Good CEO, Good Performance ...

Despite this corporate governance over CEO’s will continue to be a problem because all powerful leaders aren’t always a problem. As Adams, Almeida and Ferreira find in Powerful CEOs and Their Impact on Corporate Performance more powerful CEOs can lead to very bad performance. However, they can also lead to very good performance.

Basically, powerful CEOs dominate boards and this dominance has a direct effect on company performance – good decisions lead to good performance and vice versa. Obvious this may seem, but it proves one point conclusively – a CEO’s decisions can make a dramatic difference to a company’s results such that if we could identify the good ones they might just be worth their huge paydays.

Know Your CEO

As for aligning corporate rewards with shareholder interests, well, that’s easier said than done. Bank executives who were, back in 2007, sitting on a powder-keg of off-balance sheet shenanigans should have, by all that’s reasonable in the world of perverse incentives, been selling all the stock they could get their hands on. Instead, as Fahlenbrach and Stulz record, they simply sat and waited for the apocalypse with the rest of us: despite having more stock and options than the most ardent advocate of shareholder alignment could possibly hope they blindly oversaw their companies into the abyss.

To which all one can say is: being aligned with shareholders is good, but understanding the business you run is better. When all else fails, look for CEOs that know their industry. Then, and only then, they may end being almost worth what we pay them.

Related Articles: The Halo Effect: What's in a Company Name?, Buyback Brouhaha, The Psychology of Dividends


  1. It’s a key lesson – all incentives are perverse, CEO’s are especially motivated by incentives: therefore CEO’s are especially likely to pervert incentives.

    I think the answer is to encourage people to seek goals other than their own financial reward. Religion used to do this for lots of people. The influence of religion has been diminished. We either need to restore the influence of religion or find some new non-religious way of encouraging people to seek goals other than their own financial reward. The entire system breaks down when too many become too focused on their own financial reward, in my assessment.


  2. Guys-
    We're on different pages. How can you say "...all incentives are perverse...". People came to this country and built the greatest wealth creating machine the world has ever known or could imagine because of the most basic incentive - they could keep what they produced.
    I'm living at a place where the smartest people on the planet are trying to figure out what I want. They are trying to figure out the music I like, the books I want to read, the car I want to drive, and the vacations I want to take. Not because they like me or know me but because of the incentives built into the free market, capitalistic system. Bill Gates is a rich man because he made my life and millions of others richer.
    This is not to say that all incentives are perfect. Obviously they are not and obviously we get unintended consences from time to time that shock us.
    Is CEO pay excessive in general? Sure it is. But I don't think its because of incentives.