Are CEOs Overpaid?
by Stephany Schings, Communications Specialist
SIOP Members Discuss Factors That Determine CEO Pay
Amidst the current economic turmoil, the debate over CEO pay has intensified. Now more than ever, the propriety of large salaries and bonuses for CEOs is leading people to ask, “Are CEOs overpaid?”
This question is an important one right now, said Jerald Greenberg,
SIOP Fellow, senior psychologist at RAND Corporation and a member of the panel discussion “Are CEOs Overpaid?” to take place at this year’s SIOP annual conference
. The panel, which takes place 10:30 a.m. to noon April 2, in Grand Ballroom A at the Sheraton Hotel, includes four experts in justice, compensation, and employee motivation.
“This topic is vitally relevant right now,” Greenberg said. “As resources become scarce, we become increasingly careful about how to spend them. So, if a CEO's salary appears to be wasted, people become concerned about it.”
SIOP Member Brian O’Leary, who will moderate the conference panel discussion, said a key question in the debate is the root of high CEO pay.
“The question is, ‘Why are CEOs being rewarded at a level that doesn’t seem to be commensurate to their contributions to the organization, especially in cases where they are running failing organizations?’” said O’Leary, a professor of industrial-organizational psychology at the University of Tennessee at Chattanooga. “I’m not saying CEOs don’t work hard, but if you’re in a publicly held corporation, particularly if you’re not the owner, why are you getting paid so much? There are arguments to both sides.”
Fellow panelist and retired SIOP Fellow Edwin Locke knows which side he is on. According to Locke, there is no set level of pay that is “fair” or that would make a CEO “overpaid.”
“There is a certain philosophical fallacy people have when talking about this,” he said. “I call it the intrinsic theory of pay. Some people think there is an intrinsic amount of pay that is correct for a job. The problem is, there’s no such thing.”
Locke, theDean’s professor of Leadership and Business (emeritus) at the University of Maryland, was a professor of management and psychology for 34 years at Maryland. Instead of thinking in terms of “is a certain amount of pay too much,” he said, you need to look at the market.
“There’s no way you can stay divorced from the market. It’s a market-driven phenomenon,” he explained. “Fair is really, at least at the time of hiring, what the market price is. What’s the intrinsic value of a baseball player? What the fans are willing to pay to see a ball game.”
However, the market for CEOs doesn’t always work the way the normal marketplace works, argues fellow panelist Albert Cannella.
“That statement is much more correct if CEO salaries were established in a marketplace where there’s a lot of buying and selling going on,” said Cannella, Koerner Chair of Strategy in the Department of Management at the A.B. Freeman School of Business at Tulane University. “That would arguably be the case if CEOs changed companies frequently, and we could observe a lot of CEOs leaving their current positions for other CEO positions at higher salaries. In fact, however, this is extremely rare. The evidence suggests that CEO salaries arise from private—i.e., covert—processes that they have significant control over.”
For example, Cannella said, actors and entertainers like Madonna are paid through a market. Actors and entertainers’ salaries are tied to the value they create or are expected to create. In the case of CEO’s, he explained, we get away from this notion because it is very hard to identify the specific value they create or destroy. CEOs also have much more control over their salaries through their social influence over the directors who set their pay levels.
“A singer like Madonna has to sell albums to make income,” Cannella explained. “It is a transaction-based system that is forward looking. The deal a singer gets from a record company is directly proportional to estimates of the number of albums or records he or she is expected to yield. If that doesn’t pan out, then the singer will not be as highly sought after in the future and won’t get as good a deal from the record company. On the other hand, you have a bank that goes bankrupt and gets sold to another bank and in the process gives $8 billion in bonuses; that’s just nuts, and it has nothing to do with the concept of bonuses going to those who create value and help move the company forward.”
Locke said that type of accountability to value is what should be present in determining a CEO’s salary.
“I would not say executives with high pay are overpaid just because they are paid highly,” Locke said. “I think when they keep getting raises despite the fact that the company’s doing badly, then they are getting paid too much. I think if you are not making good, genuine profit increases, then you should not get a good bonus.”
Greenberg agreed. CEOs should be paid highly for success and not for failure, he said.
“Like people in any other position, some are overpaid, some are underpaid, and some are fairly paid,” he explained. “Years ago, for example, Jack Welch was paid a great deal of money, but he led General Electric to unprecedented growth of many times its initial value. He worked miracles, and nobody thought he was overpaid. If anything, he was a bargain. By contrast, few would argue that paying hundreds of millions of dollars to the CEOs of failed banks is anything short of outrageous. Add to this the arrogance of giving themselves huge bonuses and masterminding wasteful spending in the form of lavish expenditures for personal jets and it's not at all surprising that people are furious.”
However, Locke said, you need to be sure success is both long and short term.
“You have to balance out the long-term and the short-term performance,” he said. “If the CEO makes a lot of money for the company in the short term but the company eventually fails because they made poor investments or something, then that would be a negative long-term performance. On the other hand if you fail in the short term, there is no long term.
“It's important to focus on long-term as well as immediate outcomes,” he said. “And, of course, ethical performance must be taken into account as well. If this isn't done, unethical but short-term profitable results may occur. You get what you reward and you reward what you measure, so it's important to base a pay system for CEOs on outcomes of greatest interest to the company.”
However, measuring the outcomes of a CEO’s work isn’t always that easy, Cannella said.
“Are they worth it? That’s where I think we have a bigger problem,” he said. “What exactly did the CEO accomplish over the year? What value creation can be attributed to him or her? That’s very difficult to figure out. You can make a similar statement about any management position, but the other managers aren’t being paid millions of dollars a year.”
Cannella said one of the factors leading to extremely high CEO salaries are the CEOs who exert a huge influence over the boards of their organizations and, thus, over their own salaries.
“Boards don’t have to agree to these contracts in the first place, but they do. A lot is done in the honeymoon of hiring the CEO when everyone feels great about the person.”
As the CEO continues to lead the company, Cannella explained, the CEO’s often exhibit “ingratiation behavior,” in which they try to curry favor with the board, giving them more power.
“I think many CEOs are simply taking advantage of their circumstances and their power,” he said. “Certainly CEOs have a large influence over their own remuneration. If there are outsiders who own a large chunk of the company, then the CEO’s influence is much less. The longer the CEO is in place, the more power he has for the most part.”
CEOs also garner power from the fact that there are relatively few CEOs in the workforce.
“Part of it is also just being part of the ‘CEO Club’ puts you in this group that is paid very highly, and salary levels are a form of competition between the CEOs,” Cannella said. “In some ways, I think part of the problem is a broader social comparison problem where all CEOs and their directors – compensation committee members specifically—compare their salaries to each other and nobody wants to be in the bottom half.”
However, the fact that there are few CEOs makes high pay more justifiable, Locke explained.
“Good CEOs are extremely difficult to find. There aren’t that many and you have extremely high turnover,” Locke explained.
Locke said CEOs are difficult to find for several reasons.
“Running a company today is, in my mind, 100 times harder than running a company in 1960,” he said. “The pace of change is faster, you are working in a global market where there is more competition.”
Cannella disagrees: “Could we get someone else to do a job that those people are doing and do it as well and do it for less? I think the answer is ‘yes.’I have real problems imagining a person within an organization worth that much money. Why would that money from the company’s success belong to the CEO and not the investors who took the chance with the company? Why would some of it not belong to other investors, like employees, who also worked to bring about the success?”
Pay discrepancy has gotten a lot worse over the past few decades, he added, noting that the first study of CEO pay compared to other employees was done in 1986.
“Back then we thought CEOs were making a lot of money, Cannella said. “The CEO was making 50 to 60 times what the entry-level employee was making. Now it is hundreds of times more. CEOs are getting a much bigger piece of the pie than most others in the company, while performance is not commensurate.”
But Locke said the issue can’t be looked at in terms of the pay discrepancy between CEOs and other employees.
“There is no intrinsic amount of difference that there should be between the CEO’s salary and the other employees,” he said. “If a CEO is doing a good job, he might be the reason the company’s doing well and the reason you still have a job. For example, people like Jack Welch deserved every penny they got.”
However, Greenberg said, a large salary that doesn’t seem justified could also hurt the company.
“Pay also matters for another reason,” he said. “Wasteful spending at the top sends a strong message to employees at all levels that fiscal irresponsibility is tolerated. This also will take a toll on success.”
So what can companies do to make sure their CEOs salary hasn’t gone off the deep end? One option is to make CEO pay at least partially recallable, Cannella suggested.
“So that if the company goes bankrupt the CEO doesn’t get the last 5 years of bonuses.”
Merit-based pay is also a good concept, Locke said.
“Any organization that doesn’t tie merit to pay is in trouble because if you don’t do it the best people will leave,” he said. “The best people know who they are, and they know what they are worth.”
“CEOs paid for adding value to their firms will be motivated to do so,” Greenberg added. “Such a compensation system sends a clear message about what is most important.”
Greenberg said incentives are an important factor in performance-based pay.
“This is a great time for paying for performance. Incentives are key,” he said. “A formula that rewards executives for what they do to bring value to the company—long term, short term, and ethical goals should be met—is key. Fixed sums, such as the U.S. government's $500,000 salary to bank executives, are severe disincentives.”