Is CEO compensation in line with CEO value?

In a post celebrating the (rightful) smackdown of an egregious 'golden parachute' CEO compensation plan at GlaxoSmithKline, Calpundit Kevin Drum noted that in the 90s, run of the mill corporate executives saw their compensation go through the roof:

This has happened despite the fact that, based on fairly normal criteria such as revenue and earnings growth, return on equity, etc., they don't run their companies any better than their predecessors in the 50s, 60s, or 70s. And the worst part, as the Economist mentions, is that their pay packages are almost completely risk free. Rewarding entrepreneurs for their risk is something that makes sense because they also drive a lot of economic growth, but rewarding the CEO of Disney the same way makes no sense at all.

If corporate executives want enormous pay packages, they should be willing to accept some genuine risk: low or nonexistent pay if they underperform compared to other comparable companies. If they don't want to accept this risk, they should simply be paid like any other salaried worker. But they shouldn't be allowed to do both.

I used to follow the line that the market for CEOs is expensive, and thus you have to pay a lot to attract good people, and the risk of getting a bad one is one you just have to take. But these days I've wondered more and more; it seems that the 'bad' or 'average' CEO is far more prevalent than the Bill Gates of the world (or other notable titans), yet cash is thrown at them hand over fist, generously. Why do shareholders put up with that?

In light of the recent essay on Economic Attribution Error, it may very well be that people mistake a company's behavior in a rising market to be due to the CEO, and as such shareholders (being people) erroneously compensate average CEOs as though they were responsible for the growth.

I buy that as a possible explanation. I also remember reading somewhere, however, that in the wake of the 80s' LBO mania and corporate raiders, many states made it harder and harder for raiders to take over companies, which to me seems an equivalent force in overinflating executive compensation (no more risk of being burned alive by Raiders).

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Having read all of the

Having read all of the comments on the original article, I'm hard pressed to find anything fundamental to agree with in terms of CEO compensation.

Is CEO compensation in line with CEO value?

To my mind, this isn't even a useful question, nor is talking about rewarding a CEO.

CEO compensation fundamentally serves one purpose, and one purpose only. It is a requirement to recruit and retain a CEO that will maximize shareholder value. The problem is that the maximization of shareholder value is years into an uncertain future and a CEO must be selected and his compensation level and method must be determined now.

If five CEO candidates could be compared in terms of 10 year shareholder value over 5-way multiple branched futures, the differences are highly unlikely to be moderate. It is not at all hard to imagine that one of the five CEOs will produce twice or more shareholder value than the second best, and large variations are likely to occur between the others as well.

In the present, any CEO selection process will result in a ranking of the viable candidates. While there is little likelihood that the ranking will correlate well with future results, It would seem to be a major mistake to reject the highest ranking candidate on the basis of compensation alone without very careful consideration. To do otherwise is an implicit admission of no ability to rank CEO candidates, in which case a random selection may be just as good.

The variation in results for different CEOs is likely to be far greater than variations in the compensation required to hire and retain them. There certainly are limits that different companies can afford, and there is no justification to pay much more than is required for hiring and retention. However, paying what is required for the highest ranked candidate is the only logical policy, IF the ranking procedure has any merit.

Rewarding CEOs is not a fundamental part of the equation. All compensation and methods must be forward looking. Any employee, but especially a CEO, should be expected to give a close to 100% effort independent of his compensation. Any potential employee that is thought to need a bribe to perform should not be hired in the first place.

Regards, Don