Aug 12, 2014

The CEO Compensation Conundrum: What is Reasonable and Equitable?

By PFM Executive Search

Article written by Panorama Partner John Ferneborg, Jr. (The Ferneborg Group) – http://www.execsearch.com/

Since we do most of our recruiting work for chief executives, senior vice presidents, and vice presidents, we spend a lot of time working with clients developing executive compensation packages. The challenge with senior executive compensation is that you want to create a package that is competitive and attractive, but that also includes performance incentives and room for added rewards, based on success.

There is no question that executive compensation has become a touchy subject for public companies in recent years. The Economic Policy Institute reports that from 1978 to 2013, CEO compensation increased 937 percent; more than double the stock market growth. The AFL-CIO has been keeping track of the “pay gap” and calculates that the CEO-to-average worker ratio for CEOs has jumped from 46:1 in 1983 to 331:1 in 2013. Another way to look at it is for every dollar in salary the average worker earns, the CEO takes home $331. Among the Standard and Poors 500, J.C. Penney was the biggest offender, paying ill-fated former CEO Ron Johnson 1,795:1. Agilent had the lowest CEO compensation among the S&P 500 at 173:1.

To rein in galloping compensation packages, the Security and Exchange Commission has proposed an addendum to the Dodd-Frank Act. Section 952(b) would require companies to disclose the median of the annual total compensation for all employees, and the ratio of that median to the total annual compensation for the CEO. If they are approved, any such changes wouldn’t go into effect until 2015.

Company directors are making more of an effort to develop CEO compensation packages based on performance. There is a marked shift away from solely rewarding chief executives with salaries and stock options. Increasingly the trend is to tie compensation to financial performance or stock performance, and companies have to hit their goals in order to get paid. More companies are bowing to pressure from shareholders to tie executive compensation to performance.

Surprisingly, a new study from the Social Science Research Institute reveals that the more CEOs are paid, the worse the company’s performance. Scholars from the University of Cambridge, Purdue University, and the University of Cambridge studied 1,500 companies with the biggest market caps and examined CEO pay and company performance in three year increments from 1994 to 2013. The findings were that the 150 companies with the highest paid CEOs showed the worst financial performance. The researchers concluded that the cause was overconfidence on the part of the chief executives: “They ignore dis-confirming information and just think that they’re right.”

So while it would seem logical that loading CEO compensation with stock options to make sure they have “skin in the game,” the research shows that stock options are a poor motivator for CEO performance. Corporate stock price can fluctuate for any number of reasons, many times having little to do with the chief executive’s direct performance. However, basing salary on a ratio, i.e. CEO wage versus median worker wage, offers a better metric that could benefit everyone. If the company’s financial performance improves, then salaries go up across the board and everyone wins.