The problem of rising CEO pay

Competition between companies for the best executive talent is fuelling a rapid increase in CEO pay levels -and causing huge resentment among shareholders and the public.

by HBS Working Knowledge
Last Updated: 23 Jul 2013

Perceptions of corporate greed are further damaging the image of businesses already struggling to overcome the negative perceptions generated by recent corporate scandals -and there is no easy solution to the problem.

CEO pay levels are increasingly a source of concern for the board members of US companies, according to Jay Lorsch, Louis Kirstein Professor of Human Relations at the Harvard Business School.

The long-term trend in the US has been for CEO pay to rise along with the pay of other executives, and it is now twice as much as that of CEOs in major European countries.

Lorsch points to a recent study by the National Bureau of Economic Research indicating that the increase in pay of senior executives has been a major source of the rising inequality of wages in the US. Criticisms of CEO pay have two main themes, Lorsch says: it is too high, and it is not related to company performance.

But the reasons behind high levels of CEO pay are complex and difficult to overcome, argues Lorsch. The most significant of these is that board compensation committees face pressure to keep raising CEO pay. This is partly because of fear of losing an adequate CEO.

To make sure this does not happen, compensation committees rely on surveys by consultants about CEO pay in similar companies but without regard to company performance.

These surveys report compensation by quartiles - and most companies want to place their CEO in the upper quartile. As a result, says Lorsch, CEOs are like the children of Lake Wobegone - all are above average.

Another upward pressure comes when boards are trying to attract a new CEO from outside the company. This often means not only high pay, including incentives for performance, but also guaranteed "goodbye" payments if things do not work out.

The main brake on rising CEO pay levels is concern among directors about shareholder reaction to excess compensation, but often this is weak. Shareholders are a changing and amorphous group to the directors, while the CEO is real and has an office down the hallway. Unsurprisingly, upward pressure usually wins out.

But Lorsch suggests a few steps compensation committees can take to keep CEO pay levels in check. The first is to recognise that consultants' surveys are flawed and are a huge source of the problem. Directors should insist on surveys that reflect company performance.

Second, it is helpful to gauge CEO pay in relation to what the next echelon of management is being paid, thus placing the focus on internal quality. Finally, compensation committees should focus more on what shareholders will accept - ignoring shareholder concerns will continue to exacerbate an already serious problem, Lorsch says.

Source: HBS Working Knowledge

Reviewed by: Nick Loney

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