Fair CEO Compensation
Recently I came across this article on CEO compensation in Slate by Ray Fisman. It’s a very interesting article, and the position Fisman takes, that CEOs and compensation committees usually do not enter into undue intrigue and backhand politics, is probably accurate.
Most compensation and nomination committees do take their jobs very seriously, and try to emerge with compensation packages that make sense. But the challenge they have faced and the challenge society continues to face is that of peer comparison. Fisman concludes that the solution is to link CEO pay with the success of the company. The biggest problem with this is the question of what we mean by ‘success’.
I see two challenges. The first challenge with peer comparison is that in a mature market, where short-term success is the most important factor, it can be a daunting task for a CEO to achieve financial success. Therefore, the few who were successful became the benchmark, and then the benchmark became the median, and on this basis CEO pay was driven up by an inflated peer comparison.
The second challenge: how do we value success? That’s the real problem. In the past, executive success was determined by a turn of the (twentieth) century American formula, linking to the financial performance of a company. The rapid growth of markets at the time made this valuation formula make sense, though it no longer works in our mature markets (though the old formula still makes sense for China given its rapid growth).
So we had a shareholder philosophy at a time of rapid market growth being the fundamental philosophical determinant of executive compensation. A century later, how can you do that?
Since western markets began to mature after World War II, I believe many CEOs (whether intentionally or not) have been ensuring their boards are filled with directors or friends who come from the network, people who do not challenge the fundamental assumptions that the CEO brings concerning success.
In a time of mature markets, shareholder success can only be driven by a few short-term tactics: primarily the sale and acquisition of assets and the artificial repositioning of shares to increase share price.
So we have had an unfortunate situation spring up since the 1970s: increasing CEO pay, decreasing investment in communities and research, and decreasing long-term employment sustainability in the name of increasing short-term shareholder value.
And then all that blew up with the financial crisis. So with all this in mind, how does society move forward? Fisman basically states that we should not do away with peer comparison, which I believe is true, but he then doesn’t define what success should mean for the future.
Climbing out of the current financial crisis will not inherently stimulate growth. Growth will require a far longer-term outlook, with a lot more sustainability criteria built in. We are beginning to witness this in the US through several of Obama’s measures, including green policy incentives, the closing of tax havens, and investment in people.
A more nuanced understanding of corporate success will become increasingly important in establishing fair executive compensation. Nomination committees will need to ensure that the CEO they hire doesn’t just have a track record of business success; he or she will also need to be aware of critical global issues. Nomination committees will need to ensure that the CEO understands the full reach and depth of the corporation’s responsibilities, and will need to know how green any potential CEO will be.
To give an example of the direction I think we’re going: the most green hotel in the world is the Proximity Hotel (http://www.proximityhotel.com/) in Greensboro, North Carolina, USA. The hotel doesn’t just look after its own energy needs; it also feeds back into the regional energy grid. If its owner, Dennis Quaintance (http://www.nicholas.duke.edu/thegreengrok/dennisquaintance), should retire, and the hotel group (which also includes the luxurious O.Henry Hotel (http://www.ohenryhotel.com/)) needed to find a new CEO, it would undoubtedly need to include green awareness as an essential criterion for selection.
Another sustainability issue that CEOs will need to understand is pensions. People have different needs as they get older. The CEO and board will need to decide whether an employee’s pension pack should include not just healthcare but also education and training, so an individual can be prepared for a new career in his/her 50s or 60s.
These sorts of sustainability criteria are unclear at the moment and will need to be sorted out in the future, but it won’t be easy. Increasing shareholder value is still a company’s most important task—is there room for sustainability criteria to be integrated such that it is a key component of shareholder value success?
I believe there is, but it will be important for companies to be truly fair, equitable and conscious of community concerns. In a stakeholder-orientated society, perception is as important as reality, and it’s easy for companies to only seem to be conscious of community concerns.
Understanding the hard and soft quantitative and qualitative, financial and non-financial criteria for corporate success will be critical to determining proper CEO compensation. Peer comparison for CEO compensation will have to remain, however compensation committees should be much more rigorous in their deliberations concerning the criteria for CEO compensation and also the reality of how a particular CEO has performed. I believe that we’re likely to see compensation committees increasingly coming up with packages unique to a CEO and the organisation itself. This is a major shift, and it will involve being far more open, firm, and critical of a CEO. This traditionally has not been the case in the US, and has only partly been the case in the UK.
If you consider that the compensation and nomination committees are subcommittees of the board, and often the board isn’t challenging the CEO, one can’t expect the compensation committee to do so. The reality of boardroom behaviour needs to change and enter new territory, where a great deal more will depend on the independent, transparent nature of boards.
