Toward an Innovative CEO Compensation Package
By Mel Miller
There are four functions of management: planning, organizing, controlling, and leading. The first three are self-explanatory, but leading involves motivating others. Motivation is the subject of this blog and many other articles. Specifically, I want to explore whether the techniques utilized to motivate base-level employees and managers are effective for Chief Executive Officers (CEO's) of major corporations.
Why the concern regarding CEO pay? The advocacy organization, As You Sow, has documented the growth of CEO compensation, which is up an amazing 997% over the past 36 years. As You Sow has performed the valuable service of making investors aware of CEOs who are the most overpaid relative to the performance of their company stock. While not a new problem, it definitely is more of an issue today than ever before.
CEO compensation critics were hopeful when in 1993 federal securities regulators began forcing companies to disclose top executive pay and benefits information. The system was out of control and the hope was that once pay was transparent, boards would be hesitant to grant executives outrageous salaries and benefits. According to Dan Ariely, a professor of Psychology and Behavioral Economics at Duke University and a leading expert in the field of motivation, in 1976 the average CEO was paid 36 times as much as the average worker; by 1993, the average CEO was paid 131 times as much.
But the new rules did not slow the growing gap between CEO pay and that of the average worker; not at all. Once CEO pay was public information, comparisons were easy. No CEO felt s/he should be paid below average. Behavioral economists call this concept "relativity" and it is at the heart of the problem. I call it the "Lake Woebegon Effect" – "a human tendency of overestimating our own abilities, achievements, and performance."
There is a very good reason why the vast majority of companies have rules against sharing worker compensation. It can lead to wage inflation as comparisons are made and workers request increases to match their counterparts. CEO's are no different. Now, it is easy for CEOs to compare their compensation to fellow CEOs who they may feel are inferior, even though they are being paid more.
Boards of Directors are also caught up in the relativity tornado funnel which is causing CEO compensation to spiral ever upward. Boards do not want to hire a below average CEO. All too often, boards decide to pay a new CEO more than the publicized average for the industry in which the company competes. Hiring a compensation consultant provides the board with both statistical support and cover because it is merely implementing the consultant's compensation recommendation. But the result is still the same: CEO pay continues to rocket upward.
In an opinion survey conducted by Professors Heidrick and Struggles of Stanford University, only 16% of Americans said CEO's deserve what they receive, while 70% of directors and 85% of CEO's said CEO's deserve the compensation they receive. A huge disconnect. Even President Donald Trump told the CBS program Face the Nation in September of 2015 that CEO pay was a "total and complete joke."
Critics do not find the growing discrepancy between CEO pay and the average worker a "joke." Since 1993, within S&P 500 companies, CEO compensation as compared to the average worker has grown to approximately 369 times. This means that in one day the average CEO of a large public company "earns" the same amount that the average worker makes in a year.
The average worker data is difficult to obtain while CEO compensation is public information. Yet, as part of the Dodd-Frank reform bill the ratio of CEO pay to median worker pay will be required to be disclosed starting in 2017 – unless the new Trump administration and Republican Congress decide to change the rules.
I recognize that human beings are unique and that no one motivational technique is universally successful, but I wonder what the most effective method of motivating workers who perform routine repetitive tasks might be…?
Professor Ariely and his colleagues have shown that variable pay is a strong performance enhancer for individuals who perform routine tasks. The fact that the job is routine and not creative is key. Often called piece rate, performance of routine tasks can be enhanced by paying more for greater output.
I once worked in a factory that manufactured rear axles for the Ford Econoline vans. Every job in the factory had a quota and workers were paid a "bonus" for exceeding the quota. For a married college student in desperate need of tuition and food money, this pay system definitely enhanced my performance. After performing routine repetitive work for just one summer, I returned to graduate school, brain-dead, but with sufficient money in the bank. It was a valuable lesson; I learned that in the short run I could be motivated by money and that I was not cut out for routine tasks.
Piece rate incentives are only effective in enhancing performance if the tasks are routine and do not require creativity. Obviously, a CEO's work is not routine. CEO's need to be innovative, be open to change, and able to generate new solutions to complex problems. The current system is the opposite of piece rate. It is a combination of a fixed salary and a performance-based bonus.
The current system evolved because of criticism from investors regarding the lack of stock ownership on the part of CEOs and top executives in the firms they managed. The argument went like this: If the CEO's compensation was performance linked, then the stockholders should benefit as the CEO benefits. Compensation consultants pushed the variable pay concept and developed various performance measures. In fact, it's now common practice for 60% to 80% of CEO pay to be tied to performance. Sounds like a plausible argument to make such a large percentage of total compensation variable. But is it?
"I have no idea why I was offered a contract with a bonus in it," said John Cryan, CEO of Deutsche Bank, when first hired, "because I promise you I will not work any harder or any less hard in any year, in any day because someone is going to pay me more or less."
This is true for the majority of CEO's and top management. I remember making a similar statement to the CEO of Heartland Financial where I was Executive Vice-President. I was working as hard as possible, therefore, the 30% variable portion of my total compensation package was not an effective motivator.
In fact, according to professors Dan Cable and Freek Vermeulen of the London Business School in the Harvard Business Review article linked above, variable pay for CEO's can actually be "dangerous."
Cable and Verneulen cite five reasons CEOs and top management should be compensated on a fixed salary basis.
First, contingent pay only works for routine tasks, not tasks that are not standard and require creativity.
Second, fixating on performance can weaken performance. Several studies have shown that when employees frame their goals around learning (i.e., developing a particular competence; acquiring a new set of skills; mastering a new situation) it improves their performance when compared with employees who frame their work around performance outcomes.
Third, intrinsic motivation crowds out extrinsic motivation. The authors state that when people feel intrinsically motivated, they do things because they inherently want to, for their satisfaction and sense of achievement. A meta-analysis of 128 independent studies confirmed that when people are extrinsically motivated, they do things because they expect to receive bigger rewards.
Fourth, contingent pay can lead to cooking the books. Financial engineering can generate short-term stock benefits at the expense of long-term value. I wonder if there would be fewer stock buy-backs if fewer CEO bonuses were not so commonly linked to stock performance in the short-run.
Finally, all measurement systems are flawed. So true. I remember during the Financial Crisis that I achieved the highest performance level for the bank bond portfolios, and yet I did not receive my bonus because our plan stated that the holding company had to achieve a minimum return on assets and equity. While I remained intrinsically motivated, it still hurt. Some boards of directors, in an effort to rectify this type of injustice, have a small discretionary fund, which they can allocate to these "unique" situations. Nice idea, but I question how much knowledge the board has of day-to-day operations.
Unfortunately, boards of directors are often seduced by the easiest compensation solution. It's not difficult to find examples in the financial press of a CEO heading a company that had a miserable performance year, and yet the board overrides the performance system and grants the CEO a huge bonus. The report, 100 Most Overpaid CEOs, published annually by As You Sow offers numerous examples.
In summary, the uniquely American problem of excessively high CEO compensation has only gotten worse since information on CEO compensation was required to be made public. Piece-rate incentive pay is ineffective as a motivator for CEOs and top management teams. The danger of a high allocation of total compensation being derived from variable performance-based systems is generally counter-productive.
What system might work better? In my perfect world, CEO compensation plans would limit variable performance-based compensation to 10% of total compensation. And the 10% would be limited to stock grants only. I feel it is necessary to have a small portion of compensation in line with the wishes of the stockholders. At least 90% of total CEO compensation would be a fixed salary.
I would require all stock grants to vest on a ten-year schedule, and the agreements that govern the grants would include a five-year "clawback" provision. The board would be required to seek compensation reimbursement if the CEO or the company is found to be in violation of any SEC rules or even any actions which hurt the reputation of the company. If the board does not take action, the stockholders at their annual meeting would be able to force the board to act by obtaining 25% vote in favor of such action.
But in my perfect world, there would be a limit on the CEO compensation. I would limit the CEO total compensation to no more than twenty times the median income of the rest of the employees. Boards of directors wanting to raise the fixed salary of the CEOs would first have to consider the entire workforce. Make sense…?
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Posted: February 13, 2017