“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.”
-Charles M. Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware
Over the past three decades, there has been a radical rise in CEO compensation. The typical chief executive used to make 30X what the lowest paid person at the firm made. Recently, that was as high as 400X.
A new study has an intelligent theory for why this is: Inappropriate peer benchmarking.
This form of comparison is a similar problem that Housing suffered during the 2000s real estate boom: Appraisals based not on any method of intrinsic value, but on comparables to similar homes in the region. This contributed to an upward spiral. Anytime someone overpaid for a home — a regular occurrence in an era of no doc loans and free money — it dragged nearby home prices higher as comps.
The appraisal process, as currently practiced, is misnamed. It does not actually determine a fair or intrinsic value, but rather validates mispricing when prices are spiraling. Most appraisals only contribute to bubbles forming in a loose credit, rising price environment.
We seem to have suffered the same sort of issue with executive compensation, according to a paper published this summer by Charles M. Elson and Craig K. Ferrere. The key problem is the standard practice of benchmarking pay to that of peers only exacerbates an unjustified upward spiral.
Elson and Ferrere observe:
“In setting the pay of their CEOs, boards invariably reference the pay of the executives at other enterprises in similar industries and of similar size and complexity. In what is described as “competitive benchmarking”, compensation levels are generally targeted to either the 50th, 75th, or 90th percentile. This process is alleged to provide an effective gauge of “market wages” which are necessary for executive retention. As we will describe, this conception of such a market was created purely by happenstance and based upon flawed assumptions, particularly the easy transferability of executive talent. Because of its uniform application across companies, the effects of structural flaws in its design significantly affect the level of executive compensation.”
This might explain the mechanics of the upwards executive compensation spiral, but it does not address the failures of various corporate governance that allowed it to happen. In my observations, there are 5 factors that contribute mightily to this absurdity:
1) Compensation Consultants: they mostly perform non-value based peer comparables, guaranteeing an upward spiral;
2) Crony capitalists on Boards of Directors who are unusually friendly to the CEOs who placed them there; Compensation Committees of Corp Boards are unusuall deferential to these consultants. All this does is give the Board cover on the issue.
3) Stock option grants get an absurdly favorable tax treatment. This amounts to a massive transfer of wealth from shareholders to insiders.
4) Faulty theories of market efficiency: Assumes incorrectly that shareholders can track this. Consider a 20 stock portfolio — that likely has between 160 – 240 board members. Individual investors cannot possibly keep up with all of those Directors.
5) Mutual Funds that are the primary holders of stocks are complicit with this theft of shareholder value. They need to become more activist, protect their investors.
This is an issue that demands further exploration. I plan on revisiting this issue frequently in the coming new year.
Note with this post, we introduce the category Crony Capitalists.
Executive Superstars, Peer Groups and Over-‐Compensation – Cause, Effect and Solution
Charles M. Elson and Craig K. Ferrere
University of Delaware – Weinberg Center for Corporate Governance, August 7, 2012
C.E.O.’s and the Pay-’Em-or-Lose-’Em Myth
NYT, September 22, 2012
Lavish CEO pay doesn’t work as intended: study
Martha C. White
NBC News, September 27, 2012 2:46pm