Monday, December 19, 2005
Debunking the "Overpaid CEO" Myth
I came across this interesting article about CEO's not really making a substantially different wage than their employees. Apparently, the AFL-CIO has produced a pamphlet charging CEOs with making more than 431 times the average worker. Alan Reynolds dissects this charge and explains why it simply isn't true.
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Here's my take on CEO overpayment:
I have argued on my website that work is for service. Let's now take that further to the issue of CEO pay levels. I want to argue that most CEOs are massively overpaid. Most of us have a gut feeling that this is true, but we can't say why.
Here is the answer: 'work is for service of the common good, and bonuses should be paid as such'. Let me say that again: 'work is for service of the common good, and bonuses should be paid as such'.
You see, CEOs have two forms of pay. The first is a guaranteed wage. The second is a bonus, which depends on their performance during the year. I want to talk about the bonus, and show why it is so often excessive.
The CEO's bonus is usually tied to the profit performance of the company. If the company increases profit dramatically in a year, the CEO will get a big bonus. If the company decreases profit dramatically in a year, hopefully the CEO will get no bonus. (I say hopefully, because sometimes the CEO still gets a big bonus when profits have slumped!)
The CEO has at least three strategies for increasing profitability, and so for receiving large bonuses. They may be itemised as follows: Item 1: He may purchase another company, merge it with his, layoff workers, and profit through efficiency gains. Item 2: He may grow the existing company by growing sales, or decreasing expenses. Item 3: He may manage his balance sheet better, and run his company more efficiently through better use of debt, or through better use of inventory, or through better management of cashflow.
Now some of these measures serve the company/owners at the expense of others, while other measures serve all of us by making the company genuinely more efficient. CEOs should be paid for the latter and not for the former. At present, they are paid for both.
Regarding item 1: The act of merging companies in this way is usually positive for the common good. Purchasing another company and reducing the work force produces the same output at lower cost. This is usually genuine service to us all. (In saying this however, we must consider whether those laid off can find new ways to support themselves and to serve others through a new form of work.)
But the CEO does not contribute much service under this heading. All he has done is find a company which is similar to his own, and negotiated a price for buying that company, and made a profit in doing so. The point is that all the work in generating this extra profit was done by the present and past workers and owners and creditors of the two companies. Practically none of the work is done by the CEO - he has just seen a possibility of combining the hard work of a stack of different people, and he has arranged for this possibility to become reality. So the CEO does not deserve much, if any bonus for merging companies. He certainly does not deserve the millions that he is likely to be paid in present corporate practice.
Another aspect of a corporate merger for which the CEO does not deserve a big bonus is the price negotiation. You see, negotiating a good price for an acquisition does not serve the common good very greatly. The more one party gains on the price for the acquisition, the more the other party loses. Bargaining on sale price is a zero sum game. Price haggling therefore does little to serve the common good. Since bonuses should be paid according to service of the common good, the CEO deserves very little for good price negotiation. Again, this goes against cuurent market practice.
Regarding item 2: CEOs might deserve bonuses if they have helped to increase sales. But it depends how they have done it. Increasing sales serves the common good if sales are increased through efficiency gains. These gains may lead to selling a better product, to better service, or to cheaper pricing. For their contribution to such efficiency gains, CEOs should be rewarded (as also should the owners and the workers who contribute to these gains, in proportion to their contribution). However, increasing sales through gaining a monopoly, or through cartel pricing does not serve the common good, and so the CEO should not be remunerated for it. (The exception is if the CEO came up with the innovation which justly produced the monopoly). By implication, CEOs of monopoly businesses should not be excessively remunerated. CEOs should not receive bonuses unless they have contributed to efficiencies which serve the common good.
Similarly, driving down expenses may come through CEO innovation, for which the CEO might justly receive a bonus payment. Sometimes workers are being lazy, and it is right that the CEO should be paid for forcing them to work harder. However, forcing the workers to work excessive hours for no extra reward does not serve the common good, and should not lead to extra CEO bonuses.
Regarding item 3: If the CEO takes longer to pay creditors, this action does not serve the common good. Neither does hassling debtors to pay more quickly. This is simply raw self-interest, and does not deserve praise nor bonus payments.
In conclusion, this post aims to show the practical implications of the idea that 'work is for service of the common good, and bonuses should be paid as such' - Note that I do not believe all CEOs are overpaid. I'm all for genuine innovation being well rewarded. You IBM execs, all praise to your development and distribution of the PC. You have served us all massively - spend your bonuses with a clear conscience!!!
Any board member out there, take careful note! You corporate board members are responsible for the present mess, because you choose the bonus levels of our CEOs. The problem begins there, and trickles down through the upper tiers of management.
The big point again: 'work is for service of the common good, and bonuses should be paid as such'
Thanks for the post, Locke. For the most part, I tend to lean toward your train of thought. I myself, with my meager salary often reel when reading about major CEO pay.
But, I don't want to be unfair. You obviously have a sense of justice as you use the word "deserve" a lot in your post. I believe that compensation can be used as a way to reward people and encourage behavior that you want to see.
Laying off workers for the sake of showing a cost savings at the end of the year shouldn't be behavior that stakeholders/shareholders should encourage with bonuses, but negotiation, looking for (and taking advantage of) strategic opportunities, increasing efficiency, and just plain leading the company should all be things that should be rewarded.
Sometimes searching for efficiency does mean you have to lay off employees. Sometimes you do have to merge with another company in order to acquire technology or supplement the business' area of expertise. These are actions that should be rewarded.
Perhaps a solution to this would be to review the CEO's performance at the end of the year and take into consideration the actions which caused the bottom line to look more attractive. The board could vote on it and then award a bonus based on what they perceive to have created value for them.
The problem with that is good CEOs are hard to come by. They like their compensation packages to be clearly established beforehand. They also want to protect themselves.
As long as a company wants to increase profits, and a CEO can do that, then if the company wants to pay them that much money, they have the right to. In fact I would be shocked if they didn't. If the CEO doesn't perform, then they get fired.
Thanks James Hemsley for your positive comments. I liked your constructive suggestion for the way performance reviews are handled.
But James, I must say that your post puzzles me. You write as though you are disagreeing with me. Yet I agree with nearly everything you say.
I'm very much for negotiation, for strategic opportunities, for clever mergers, for good leadership. I'm not against laying off workers. Indeed, when these things are done well, I'm all for an appropriate bonus being paid to the CEO. My point is that an inappropriate bonus is usually paid.
Perhaps it is in your last paragraph that our disagreement becomes clear.
'As long as a company wants to increase profits, and a CEO can do that, then if the company wants to pay them that much money, they have the right to.'
To see the problem with your sentence, note that its logic could be applied to a slave-trading company of the 17th century.
'As long as Slave-Traders-R-Us want to increase profits, and a CEO can do that, then if Slave-Traders-R-Us want to pay them that much money, they have the right to.'
This is clearly wrong - the company might have had the legal 'right' to pay big dollars to such a CEO, but their actions were immoral. Their slave-trading was immoral, so they were immorally lining the pockets of their CEO.
I don't mean to imply that you are for slave trading, James. But you need a new defence of CEO bonuses which is not so amoral.
In fact, I think you need to join my camp - Admit that modern CEO bonuses usually overplay the CEO's contribution. Admit that these bonuses improperly ignore the means by which profit is made.
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