Rising CEO pay has been an issue since 1977 when Peter Drucker suggested that CEO pay should be no more than 25 times average worker pay (a figure he later updated to 20:1 in 1985). Anything beyond that, he claims, will make it “difficult to foster the kind of teamwork that most businesses require to succeed.”
Today, such a ratio would be laughable for most corporations. For example, Starbucks CEO Howard Shultz earns a salary of about $22 million, which would put the average worker pay at $1.1 million. It certainly would be nice to be a barista under that arrangement, but for Starbucks, that simply isn't realistic. So the only way to meet this ratio is for Starbucks to reduce their CEO's pay. The problem with doing this, however, is that it limits the pool of CEOs from which to recruit simply because the average worker in the company is paid a lower salary. For this reason, the ratio has been largely ignored as unrealistic idealism.
But that doesn't mean the rising CEO pay isn't an issue. In the advent of the financial crisis, a resurgence of attention has focused on CEO pay, specifically bonus structures as a potential cause of the corporate climate that lead to the crisis. This article will take an in depth look at why the issue of CEO pay and proposed solutions result in such a complex and polarizing debate.
Why is it a problem?
A quick look at the numbers: CEO pay has risen 1000% in the past 40 years while the average production worker's pay remains relatively unchanged. In fact, in 2010 CEO pay rose about 30% and again in 2011 thanks to the resurgence of the stock market. But even if you believe that it's a growing societal problem, income inequality isn't necessarily the issue at hand. Even if CEO pay is a major contributing factor.
Rather, the real issue at hand is that the incentives for CEOs have become grossly out of touch with the value they add to the company as a single employee. And perhaps worse yet, a structure of said incentives leads to the kind of risk-heavy business activity that brought the entire system to the brink of financial disaster as well as corporate policy that favors stock value at the expense of worker compensation and consumers.
Performance bonuses vs. principal-agent problem
One of the major problems smack in the middle of the CEO pay debate is with bonuses. But big bonus payouts for CEOs are the way they are for one major reason: The principal-agent problem. Essentially, any employee of a company is paid for their work, but because the fruits of their labor are enjoyed by the company and its owners/shareholders — rather than the employee themselves — each employee has little incentive to work hard. Performance-based incentives (like stock options) align shareholder/company interests with that of the worker, in this case: the CEO.
This type of incentive is particularly popular for CEOs in order to align their financial interest with that of the value of stock. As a result, the CEO is only paid the bonus if the company and its stockholder see benefit as well (a win-win situation). But if the CEO fails to meet agreed upon goals, the company needn't pay the bonus.
The irony, it seems, is that government policy during the Clinton administration (in 1993) designed to reign in CEO pay led to an increase in performance based bonuses as they were exempt from a law that made salaries above $1 million ineligible for a tax deduction as a business expense. Not 10 years later, the Bush tax cuts further fostered this trend as many stock option bonuses can be taxed favorably as capital gains rather than income as long as they were held for at least one year.
Criticisms of performance based incentives
And while in theory, performance bonuses seem to be a win-win payment structure for both investors and CEOs, there are plenty of reasons this doesn't work out so well for everyone else. First, and perhaps most importantly, it creates incentives for short-term gain and other high risk investments; losses that the CEO themselves aren't invested. Worst case scenario for the CEO: guaranteed salary and/or severance. For everyone else: the complete collapse of our financial system.
Secondly, and perhaps the most egregious examples of the greed this type of incentive creates is when profits/bonuses come at the cost of the employees. CEOs who make drastic and perhaps frantic cuts to employee benefits (or employees in general) in order achieve bonuses for themselves. It seems when you align the interests of stock owners and CEOs the biggest loser is everyone else in the organization, particularly in hard times. While there's nothing wrong with an organization running at maximum efficiency, this creates a climate for keeping worker pay at an absolute minimum in order to maximize the benefit of a few. And when there is nothing more to take from employees, the next loser trends toward consumer value.
Another criticism of bonuses for CEOs is studies that have shown that for tasks that take even a rudimentary level of cognitive skill, monetary incentives don't improve performance. In fact, performance actually decreases. So while these incentives may help align decision making interests for the most part, they probably don't do much to improve CEO actual performance as an employee. As a result, CEO bonuses more often than not have more to do with a company's previous position, direction and performance or perhaps a bit of luck rather than level of performance or competence of their CEO.
Pay without performance
Even beyond bonuses and performance based incentives, CEOs are living beyond their market value according to a book published by Lucian Bubchuk and Jesse Fried called Pay without performance. If you are interested in further reading, it's probably the most important book that tackles the subject. In it, they show empirical evidence that CEO pay isn't being regulated by “market forces” as many opponents of regulation claim. They show how the corporate structure and governance allows CEOs to dictate their own pay. When the interests of a top CEO prospect aligns with that of important board members and decision makers (particularly those appointed by the CEO themselves), little can stop them from essentially writing their own checks. So even when shareholder and CEO interests are aligned, the CEO wins at the expense of the shareholder.
No simple solutions
Regardless of how strongly you feel about the issue of rising CEO pay, the fact remains: there is no simple solution. Small improvements and regulations like transparency of pay and shareholder say in payment structures of CEOs may be a step in the right direction, but don't do much to solve the underlying problem. Caps or limits detract from market forces, competition and recruitment. Taking pay decisions out of the hands of the corporate structure giving it to government and/or courts seems like just another opportunity for corruption of other such mishandling. Even changing the tax policy to create disincentives for high CEO pay will likely have unintended consequences, promote tax evasion, and potentially stunt economic growth.
History has already showed us that past attempts to take a stance and regulate CEO pay has failed. At the very least, the unintended consequence shifted the trend in an undesirable way. So even if you agree this is a problem that requires our attention, you must also agree any solution will require eloquent care.
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