There is a theory in corporate America that CEOs must be paid top dollar for their skills in order to keep them from constantly shopping their skills to the highest bidder. But a new study by Craig K. Ferrere and Charles M. Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, debunks that theory and shows that CEO skills are often non-transferable. Further, the study shows that one of the main factors in determining CEO pay rates, the peer-group benchmark, is woefully ineffective and drives up pay rates for less qualified CEOs.
There is no doubt that CEOs deserve to be paid well for their managerial skills. However, skyrocketing CEO pay in a time of hardship for the working man is a clear sign of economic inequality. In an interview with the New York Times last week, co-author Elson explained the problem with peer-group pay-scaling:
“It’s a false paradox. The peer group is based on the theory of transferability of talent. But we found that C.E.O. skills are very firm-specific. C.E.O.’s don’t move very often, but when they do, they’re flops.”
The use of peer groups to determine CEO pay rates sounds logic until you see just who is included in such groups. Often, much larger companies with higher revenues are used to artificially raise pay rates. NYT uses IBM as an example:
In annual proxy statements, compensation committees of corporate boards tell shareholders which companies they placed in their peer groups and why. Last year, for example, I.B.M. said it began by including all companies in the technology industry with annual revenue of more than $15 billion. But it also added companies in other industries with revenue of at least $40 billion and “a global complexity similar to I.B.M.,” the company said. The result was that 28 companies were in the group, including AT&T, Ford and Pfizer.
Ferrere and Elson contend that peer groups are inefficient at best and deeply flawed at worst:
“Whether the excess compensation is awarded for merit or otherwise, a talented individual who is paid on a scale deserving of their abilities should not, through the peer group mechanism, be allowed to bolster the pay of less able executives….
…In essence, this process creates a model of a competitive market for executives where it otherwise does not exist. Through the operation of a market, it is argued, wages are bid up to an executive’s outside opportunities.”
The fantasy of corporate America being running by interchangeable Jack Donaghy’s is just that, a fantasy. CEOs usually rise to the top of the company through hard work and dedication. Very rarely are outsiders brought in and when they do they often fail. Ferrere and Elson reference another study to support this argument.
One study, a 2011 analysis of roughly 1,800 C.E.O. successions from 1993 to 2005, found that less than 2 percent had been public-company chief executives before their new jobs.
What, if anything, can be done about skyrocketing CEO pay and the inefficient system in which it is determined? According to the authors, breaking away from the peer-group benchmark is the best start to combating the growing problem, even though they admit it is only a small part of the problem. From the paper’s conclusion:
A hard and honest focus on the company itself and the accomplishments of the executive in question by the board, rather than blithely looking externally to other organizations, will best serve the company’s and the shareholder’s interests. Through this careful focus, any potential difficulties and costs can be mitigated.
Likewise, regulators and the courts must recognize the dangers inherent in over-‐reliance on the flawed peer process by boards and adjust their approaches to the pay issue accordingly. De emphasizing the peer group process in setting pay may not prove the comprehensive cure to the overcompensation problem, but the costs of pursuing this approach are minimal and it is a good beginning.