Analysts from Organizational Capital Partners (OCP) found that a company’s economic performance bears only a fleeting influence on how it pays its top employee. Performance “explains only 12 percent of variance in CEO pay,” the report says, while the other 88 cents of every dollar of difference is explained by factors that have nothing to do with how the chief executive does his job. The size of the company, its past pay levels, the industry in which it operates, and basic inflation combine to explain almost two-thirds of the variation in pay between CEOs at comparable firms.
Why are job performance and compensation so poorly linked? The OCP researchers point to underlying flaws in how companies measure performance for the purposes of executive pay and say those errors are magnified by problems with how pay packages are structured. In nine out of every 10 cases, the so-called “long-term” incentive pay component of a CEO’s compensation actually measures company performance over just a three-year window, which the researchers suggest is too short a period to effectively link pay at the top to sustainable long-term success.
Another explanation for the disconnect OCP found is that companies are systematically rigging the CEO pay system to produce ever-higher compensation at the top. The largest American companies routinely hire executive pay consultants “as a justification device for higher executive pay” rather than as the expert quality-control mechanism that investors and observers might imagine pay-setting boards to be, according to new research at Cambridge Judge Business School in the U.K.
The six-year study of more than 1,000 large American firms breaks with previous consensus among researchers that there was no evidence of compensation consultants driving executive pay upward. The median company that hires pay advisers will subsequently raise CEO pay by 7.5 percent. Companies that seek out specialist compensation consultants pay CEOs almost 10 percent more than similar firms which get pay advice as part of a broader package of business services from a consulting firm. The researchers also found that pay is significantly lower when compensation committees are controlled by corporate boards rather than hired by company managers.
The Cambridge research lends empirical weight and methodological rigor to an argument that various think tanks and corporate observers have made less formally in the past. The rise of executive compensation committees and the subsequent explosion in CEO pay dates back to the years after World War II, when the management consultant firm McKinsey & Co. began pushing the notion that CEOs were underpaid and companies would need to out-do one another to lure the best executive talent. The resulting “demand to increase and justify executive compensation became a perpetual motion machine that’s still chugging along” today, according to business journalist Duff McDonald. Similarly, the OCP analysis provides hard evidence that performance and pay have become decoupled, as non-profit analysts, academics, and business journalists have previously argued.
Taken together, the Cambridge study, OCP research, and assorted circumstantial evidence from other sources illustrate how executive compensation has helped drive income inequality to levels not seen since the era of the robber barons. Over the same three decades that wealth inequality was exploding, CEO pay rose more than 725 percent, growing more than 127 times faster than compensation for the typical worker. The same restructuring of corporate pay rules that helped unmoor CEO compensation from company performance also linked executive pay to the stock market, which helped drive inequality in part because stock-based earnings are taxed at lower rates than income.
The Dodd-Frank Wall Street reforms included a new rule requiring large financial firms to publish the ratio of CEO pay to worker pay, and companies have taken to that transparency requirement like a vampire in sunlight. First the companies pushed to weaken the rules by tinkering with how the ratio is calculated. Then, they protested that the rules are “egregious” because it will cost too much money to figure out how much less money they spend on workers than on CEOs.
That ratio is almost 300-to-1 among the largest companies, according to one study published this summer. Another illustrated why disclosure would be so valuable: Americans think that the CEO-to-worker pay ratio is just 30-to-1.
Source: thinkprogress.org/
Author: by Alan Pyke
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