Ethics in CEO Compensation

Here’s a smart & balanced piece on executive compensation by Ray Fisman, writing for Slate: Comparison Shopping: The real reason CEO compensation got out of hand.

The popular (and populist) perception is that of America’s CEOs greedily rubbing their hands together as they approve their own paychecks, and there certainly has been some of that. Others argue that in most cases CEOs are richly compensated because they’re so good at what they do.

Several recent studies stake out a middle ground, assuming that CEOs are neither villains nor business masterminds. These studies argue that the seemingly innocuous practice of benchmarking pay against other companies’ CEOs may be to blame…

I heartily recommend reading that entire article. It’s enlightening. And it’s enlightening on an issue about which many of us have strong opinions. And opinions without understanding are useless, perhaps dangerous.

I think there are 4 factors that go into explaining public outrage at executive compensation.

1) Corporations sometimes screw up, in which case any executive compensation, never mind 6-figure compensation, seems outrageous. (If you think “sometimes” is an understatement, you’re falling prey to the same fallacy that leads people to believe, falsely, that plane crashes are common.)

2) Executives sometimes are paid too much — too much, that is, by any standard other than cronyism. That is, sometimes Executive Compensation Committees make bad decisions, in some cases because they’re insufficiently independent of the CEO.

3) Many people hate the rich. And many (not all) corporate CEOs are rich. Hating them leads naturally enough to believing they don’t deserve what they have. (This typically involves a philosophically controversial assumption that justice in the distribution of wealth is a matter of how much we each end up with, rather than how we each got what we have.)

4) Most of us don’t understand enough basic economics. I include myself in that category. (So read this book.) One consequence of this is that many people don’t know that there just is no other, well-worked out theory of the value of labour beyond “What The Market Will Bear.” (The notion of benchmarking CEO salary based on what other relevantly-similar companies are paying is part of figuring out just how much the market will bear.) Even the notion of tying salary to performance leaves open the question of how much reward for how much performance of what kind. Also, this helps explain why reason #1 above can be a mistake: base salary is related to expected performance: it’s a gamble, based on what the company expects the CEO to be able to do. Failure on the part of the CEO doesn’t necessarily mean the salary was unjustified in the first place.

All that being said, the salary-ratcheting phenomenon discussed in Fisman’s article strikes me as a genuine problem, because the feedback loop implies a kind of self-fulfilling prophesy regarding what, in fact, the market will bear. And if CEO compensation looks, to corporations, like it’s rooted in a reliable methodology, it will tend to trump, and hence squeeze, other, less-readily quantifiable, corporate objectives.

4 comments so far

  1. Doug Cornelius on

    Chris –

    I liked how it was summarized as “The Lake Wobegon Effect” where everyone is above average.

    http://www.compliancebuilding.com/2009/01/21/ceo-pay-and-the-lake-wobegon-effect/

  2. Jeff on

    It would be interesting to compare the psychological factors at play in determining CEO pay to those at play in determining other workers’ pay.

    Presumably other workers’ pay is determined in part by comparison — benchmarking, or whatever we call it. There doesn’t seem to have been a ratcheting-up effect here, to judge by the increase in the ratio of CEO to worker pay. But why not?

    To borrow from the article: Don’t executives (who set workers’ pay) “like to think they have above-average workers?” Like boards and CEOs, executives and workers “still have to face one another at future meetings . . .”

    One guess: there is a perception that CEOs matter enormously to the firm’s success, whereas workers are more or less interchangeable. So it is important to spend whatever it takes to get the “right” CEO, or perhaps more importantly, to signal to Wall Street that one has the right CEO. (If you don’t pay him much, he can’t be very good, eh?)

    Now whether this perception is true is another story . . .

    Jeff M.

  3. Chris MacDonald on

    Jeff:

    Thanks for your comment. I suspect you’re right about the difference: in many industries, most labour is essentially a commodity. Which is not to say that it’s unskilled, just that there is lots of it available. So there’s a much clearer market price.

    It *is* a nice empirical question: what do CEOs who pay workers $8/hr think of their employees, compared to ones who pay $9/hr?

    Chris.

  4. Jérôme on

    I found an interesting article regarding CEO’s salary.

    Taking the RISK out of RISK and the TALENT out of TALENT

    http://www.uniglobalunion.org/Blogs/20to1.nsf/


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