1135
n
Liaisons and intrigues
will get you the kind of risk you’re after. Stock options lead to
risk-seeking behavior, but they’re not always the risks you’d like
CEOs to take.
Too hot to handle: explaining excessive top
management remuneration
In many countries the topic of “excessive top management
compensation” – especially for CEOs – triggers much emotion,
social outcry, and even calls to arms for politicians to nally
regulate the issue and introduce mandatory caps on salaries.
And I used to think that this was all nonsense, because the high
salaries of CEOs were simply the result of a market mechanism
and “the way it is” (and certainly none of politicians’ business).
However, the more I learn about CEO compensation, through
scientic research, and the workings of boards of directors (who
usually determine a CEO’s remuneration package) the more I
realize there is more going on than that.
First of all, there has been quite a bit of research that has tried
to show that CEO compensation is tied to rm performance.
As it turns out, it ain’t. That research has tried, has tried hard
Business Exposed114
and harder, but just could not deliver much evidence of this.
Admittedly, some studies have uncovered some minor positive
relations between pay and performance, but it wasn’t much. The
salary of the average CEO seems completely disconnected from
how well his rm is performing.
The only economic factor worth mentioning that has delivered
some consistent results explaining top management remuner-
ation – indicating a positive inuence on CEO pay – is rm size:
bigger rms pay better. Although this may be an intuitive result,
it is actually not that clear why. Why do the CEOs of big rms
earn more? Do CEOs of big rms put in more
hours? Not that I know of. Is managing a
rm with 100,000 employees that much
harder and more demanding than managing
a rm with a tenth of that number on their
payroll? Not necessarily. So what is it? I guess one could argue
that a top manager of a large rm can do more damage if he
messes up and, since large rms generally have more resources
available than smaller rms, they hire (and pay) the best. Yeah
. . . I guess that could be it . . . Although research has also shown
that, on average, large rms are not really more protable than
small ones, so I am not sure these better-paid guys actually are
any better at their jobs. But anyway, we have found one thing
that seems to explain top executive pay, so let’s not be too critical
about it but accept it with grace.
But, beyond plain size, what else determines CEO remuneration?
Well, let’s start with who determines CEO compensation. In most
countries, for public rms, that’ll be the board of directors. And,
specically, the directors that serve on the rm’s remuneration
committee (usually three to ve outside directors). And, yes,
there has been some research on these bozos.
Three professors who did research on the relation between CEO
compensation and boards of directors were Charles O’Reilly
and Graef Crystal from the University of California in Berkeley
and Brian Main from the University of St Andrews in Scotland.
They studied 105 large American companies and rst computed
‘‘
bigger firms pay
better
’’
1155
n
Liaisons and intrigues
the relation between a bunch of economic factors (such as rm
performance and rm size) and CEO remuneration. The only
thing they found was a connection between company sales
and CEO pay. In short, on average, if a rm’s sales increased by
$100 million during the CEO’s tenure, his salary would go up by
$18,000. That’s hardly impressive, now is it?
Then, Charles, Graef, and Brian did something a bit more inter-
esting. You have to realize that the directors on these committees
are usually CEOs or ex-CEOs themselves. Therefore, Charles and
his colleagues compared the salaries of these director CEOs to
the salaries of the CEOs of the companies for which they served
on the remuneration committee. There was a strong relationship
between them. An increment in the average salary of such an
outside director, say, $100,000 was associated with a jump in
salary of $51,000 for the CEO, after statistically correcting for
all the results due to the effects of rm size, protability, etc.!
Charles, Graef, and Brian argued that this association could only
be the result of some sort of psychological social comparison
process. The directors on the remuneration committee who
decide on the CEO’s salary simply determine this guy’s pay by
looking at what they themselves make at their companies. And
thus, doing this, they don’t feel hindered by irrelevant issues
such as the rm’s actual performance during the tenure of the
CEO or any other silly things like that!
And guess what, who do you think usually determines who is
invited to serve as an outside director for a rm? Any guesses?
Yep, it is generally a company’s CEO who nominates new outside
directors. But doesn’t that make it rather tempting for CEOs to
only nominate very highly paid peers to serve as directors on
their boards? You might wonder. Yes
. . . I guess it does . . .
Yes, the more highly paid the
directors who you put on your board,
the more handsomely they are likely
to reward you! Thus, their wealth
may nicely domino into your bank
‘‘
The more highly paid
the directors who you put
on your board, the more
handsomely they are likely
to reward you!
’’
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