How Much for That CEO?

High executive pay is the result of two factors that markets have a hard time dealing with in combination: high stakes and high uncertainty.

Last year, the CEO of Goldman Sachs got paid $12 million. According to Forbes, the chief executives of the 500 largest companies in the US received on average $10.5 million each. According to the New York Times, Apple’s new CEO Tim Cook was the highest paid chief executive last year, receiving $378 million in compensation including a one-time stock award worth $376 million that extends over 10 years. Compare that with the 2010 median pay for high school teachers in the US: $53,000. Or the 2010 median pay for firefighters in the US: $45,000. Do any of these CEO numbers make sense?

Any economist can tell you that compensation is a type of price, and compensation, like any price, reflects the value the market places on an individual’s services. This is the very essence of a market system. But not all prices are created equally and compensation can be a tricky thing indeed. What matters is how easily you can measure the incremental value of something. Take plane tickets, for example. When deciding whether to pay for a direct flight versus a cheaper flight with a layover, you can look at the difference in prices, imagine roughly how much more troublesome a layover would be, and ask yourself, “Is the additional convenience worth the additional cost?” In this case, incremental value is relatively clear.

Now imagine you’re on the board of directors for a large corporation that is struggling and in need of a new CEO. Your executive search committee presents the board with several potential candidates including one particularly outstanding candidate with a strong track record of turning around similar companies in similar situations. The second best candidate has a good track record but doesn’t fit the job nearly as well. All else being equal, you would naturally choose the best candidate. That part is easy enough. But how much should you pay this new CEO?

In an ideal world, you would look at the two potential scenarios for the future of the company, one with the best candidate and one with the second best candidate, and calculate the difference in future profits. You know that generally the difference between a strong CEO and a mediocre one can mean the difference between billions of dollars in profits and bankruptcy. There is a tremendous amount at stake. But how on earth are you supposed to predict the future performance of the company under the leadership of each of these candidates?

The short answer is you can’t. So instead you have to rely on far less perfect methods for generating a compensation figure. You can look at how much other CEOs at similarly sized companies get paid. You can look at how much other executives in the same company get paid. Basically, you can benchmark. But you’re not really anchoring compensation to any concrete measure of value – you’re just basing your guess on other people’s guesses. But given the potential value at stake – let’s say tens of billions of dollars in shareholder value – even if you pay your CEO tens of millions of dollars a year, this is still a relatively small sum.

A pay for performance system may seem like a good solution to this puzzle, but there is one crucial problem. If you pay a CEO with stock options, you won’t actually be compensating the CEO for his or her incremental performance. If the company does poorly, it could be the result of forces beyond the CEO’s control including the overall economy, regulatory changes, a research breakthrough for a competitor, and so on. Just because a company does poorly doesn’t mean the CEO is worthless. What matters is incremental value – given the same circumstances, how much better would another CEO have done? – which stock prices or profitability metrics alone don’t capture.

This whole awkward pricing problem applies to so many things. It applies to fees and bonuses on Wall Street. It applies to how much top lawyers get paid. It applies to how much management consulting firms charge clients. The recipe for high pay in many of these cases is simple: high stakes and high uncertainty. You can layer in more nefarious factors such as collusion between CEOs and corporate boards, the exploitation of unsophisticated clients by Wall Street banks, the role of money in politics, and so on. But ultimately, high pay is a fact of the market system itself. Giving shareholders more direct power as the UK’s recent executive pay initiatives attempt to do or requiring corporate boards to include employees as members can only affect executive pay marginally. The only way to truly change executive pay is to interfere directly with the market.

But CEO compensation is only a small part of the issue. What about the hedge fund managers whose personal earnings make CEO pay look like a rounding error? According to Forbes, last year the top 40 highest earning hedge fund managers took home on average $330 million each, with the richest taking home $3 billion. And yet there appears to be no similar outrage. For some reason, we like to fixate on a few instances of a problem while ignoring the bigger picture. We need to step back and realize that the issue of executive pay is only a single facet of something much larger and more deeply embedded in the fundamental nature of the market system itself.

Read more in this column Kyle Chan: On Tuesday, A Day For Nation Building

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