Post No.: 0626
Fluffystealthkitten wrote about how astronomical the CEO-to-average-worker compensation ratio is in Post No.: 0604. I found it so intriguing that I wanted to know how CEO compensation packages are usually ultimately determined…
So in ‘the West’ at least, CEO compensation packages have increased from ~25x an average worker’s salary to between 250-500x over the past 40 years. Ruffly speaking, board members – as part of a compensation committee – decide how much their own senior executives should be paid (in salary, bonuses, stock-based options, deferred payments and perks), and they use their peers (other corporations that are, supposedly, similar in terms of size and complexity but don’t have to be in the same industry) as a comparison.
The executives and board members should therefore never be the same people in large companies for there’d be a conflict of interest. The CEO and Chairperson should definitely never be the same person. Nonetheless, CEOs are often friends with members of the board anyway.
Instead of CEO compensations being linked to their relative contributions compared to other workers in their own companies – they’re arbitrarily linked to what other CEOs in other companies are paid. But since every CEO is just trying to base their level of compensation on what other CEOs are getting, and because in negotiations they try to justify their own, greater, compensation packages by stating how ‘above average’ they are, and moreover that if they don’t get an above-average amount then it’d reflect upon the lack of self-belief and ambition of the company itself – it has led to this escalation of remuneration!
If every CEO, and company, believes that they are above average and therefore deserves, and should justify giving, an above-average amount of compensation, then this’ll logically constantly escalate the average CEO compensation package.
It links to how we don’t know the value of anything until we compare it with something else – which means that the value of something depends hugely on what we’re using as a benchmark; even if that benchmark is arbitrary. In this case, it’s not market-driven, for the peers used for comparison need not be in the market for or in demand of that particular CEO’s services (in part because they mightn’t even be in the same industry as the other companies used for comparison). Yet companies rationalise their method by arguing that if they don’t offer a ‘competitive’ compensation package then their CEO will go work elsewhere; even though they probably wouldn’t – at least to many of those selected peer companies because industry expertise is reasonably specialised (e.g. the skill in making a pharmaceutical company and retail company successful are different).
It’s not ‘doing work that few people can do and being in high personal demand’. Their skills aren’t so portable despite the peer groups they compare to, which is unlike when, say, an NFL quarterback moves to another NFL team. Businesses aren’t identical in structure, products, competition, regulations and operation to each other, unlike an NFL team that can only ever field up to 11 players at a time and must play to the same rules on the same kinds of pitches.
They each also rationalise any general complaints made about over-inflated CEO compensations by blaming other companies for this escalation that left them ‘no choice’ but to follow the trend. Hence the buck is passed even though each is perpetuating the problem.
Professional footballer wages escalate on an ‘I think I’m worth the same as them at another club’ basis rather than wider economic reality too, hence a giant club like FC Barcelona can have a wage bill that alone, reportedly, has exceeded 100% of total income(!)
Even bonuses awarded for meeting performance targets can be manipulated because a CEO can agree to which metrics are used and can utilise information that the board knows comparatively little about to set easy targets. ‘Creative accounting’ can be used to meet them too, like when they’re based on earnings per share (EPS). These might result in short-term gains that could hamper the company’s long-term profitability. CEO pay being tightly, directly linked with company performance should really be the norm rather than anything special, but as we can see – performance figures can be manipulated anyway.
Stock options (the option to buy a certain amount of stock in the future at a price set today) and restricted stock (stock that’ll only get assigned to the executive if certain conditions are met) are thus designed to overcome this problem since the long-term interests of a CEO must then align with those of the company. But share prices can be manipulated too, like implementing share buybacks to temporarily boost the company’s own share price, at the cost of losing that investment which could’ve helped the company in the long run. So these long-term interests can still be thwarted by short-term ones as CEOs attempt to manipulate share prices to suit their own personal self-interests.
Company takeovers are sometimes fashioned primarily for the CEO’s self-interests – there’s a strong correlation between the size of a company and a CEO’s compensation package, and the easiest way to increase company size is to buy out the competition (frequently via leveraged buyouts). This is possibly a contributing reason why over 50% of merger and takeover deals fail.
Also, if a company performs badly due to wider market/economic conditions – CEOs are usually let off the hook by directors allowing adjustments to be made to the figures to make them look more favourable to shareholders and other potential investors. It’s totally uneven though, because when the wider market/economic conditions are good – CEOs are never penalised by adjusting the figures down to make them look less favourable(!) Directors therefore make adjustments to account for rainy days but seldom for sunny days.
The same for CEO compensation generally – when the markets are buoyant, they expect a larger compensation package, but when the markets are sinking, they don’t expect a reduced one.
For the directors – serving on the board of an established company is usually far less stressful and time-consuming than working in any other position in that company, yet the pay they receive is typically at least several times more than the average worker of that company too. Board members typically collectively decide their own compensation packages, including expenses. Even when they incorporate the opinions of board members from other companies, they’re usually their friends or cronies anyway! Remember that they’re paying themselves and senior executives with shareholders’ money rather than their own money too.
Risk and uncertainty are accepted as inherent in business, which allows directors and executives to escape liability for their unprofitable decisions.
During COVID-19, while most businesses struggled – tech giants like Amazon, Apple and Meta prospered. According to the Chartered Institute of Personnel and Development (CIPD), CEO pay in 2020 for 36 of the top UK FTSE100 companies only reduced by 0.5% because bosses made merely token gestures to reduce their own compensation packages (salaries only make up a small part of those packages because there are also bonuses and other incentives). So there was little overall solidarity as many others lost their jobs. Many of these large corporations also took advantage of government grants, rates reliefs and job retention schemes when they could’ve afforded to fully keep and/or fully pay their own employees without using taxpayers’ money.
We know that pay isn’t strongly proportional to how hard a person works or how dangerous or important the work is (e.g. hospital cleaners compared to TV entertainers). But some argue that CEOs are worth their pay because the death of a CEO can cause a share price to plummet. But that could be due to anticipating the disruption such a death causes rather than losing a particular person (like even taking down a dictator causes national disruption for at least a while!) And stock trading is about speculation and a current share price isn’t the same thing as the net and long-term profitability of a company.
The correlation between performance and pay is weak especially at the top – in general, CEOs who get paid the most perform worse than CEOs who get paid less. (We also often see top division footballers on six-figure weekly wages playing lazily.) Most chief gerbils cannot really justify their huge salaries – many CEOs who’ve been paid millions have overseen the foreclosure of their companies or seen them being bailed out by taxpayers. Bosses might pay themselves handsomely even as the ship they command is sinking (as e.g. the directors at UK construction firm Carillion self-interestedly tried to do in 2018).
But we now understand that it’s not really wider market forces that decide CEO pay but compensation committees – who often include other CEOs; so there’s an element of cronyism, and frequently nepotism, too. Apart from the original founders or those who rose from within a company, it becomes a virtually closed-off little circle of already-rich people and ‘who you know, not what you know’. Along with deciding compensation packages – board members pick people from within their own circles to go into senior positions of other companies in the first place.
People with pre-existing advantages therefore don’t face enough survival pressure, and ‘the 99%’ should really have something to say about that. Woof!
Many people think we live in a world where free market capitalism is the dominant force – yet hierarchies, not markets, are how decisions are really made within corporations. Employees of a firm aren’t acting according to fluctuations in currency, stock or commodity prices – they’re acting according to their boss’s wishes. And even economist Adam Smith rejected the idea that bosses would do a good job of looking after the investments of shareholders – they’re not going to be as careful with other people’s money as they would with their own!
With command comes responsibility, but what usually happens is that, under self-regulation, when something goes wrong or a fraud has been committed – firms try to hide it or blame others to protect their reputations, or pass the buck onto others to clean it up. Regarding the ‘it’s only a few bad apples’ or ‘it’s an isolated incident’ excuse that’s often promulgated – during any failure or fraud, many CEOs will immediately look to use lower-level employees as scapegoats so that they can fire them and therefore claim that the problem is solved within their organisations. Rather than admit that there are systemic problems within the firm, or that a problem goes right to the top – a scapegoat or two will give the impression that the fuzzy deadwood has been ditched and the firm and the shareholders can confidently carry on; but really nothing has changed or the true perpetrators have not been punished.
It’s tacit that it’s the shareholders, or their proxy advisors, who indirectly (or in some places directly) decide the salaries, bonuses, etc. of senior executives and directors, by ultimately approving their boards of directors and remuneration committees – but most shareholders don’t bother to exercise their voting rights. (The number of shareholder revolts against senior executive and director pay may be growing though?) Also, either most laypeople think that CEO compensations are fair because they’re driven by the wider free markets, or what’s most true – 70-90% of shares are held or controlled by other wealthy people or financial institutions hence the votes of all the remaining individual investors who hold a few (ordinary/voting) shares of a company combined only amount to on average 10-30% of a firm in total, hence their voices are barely heard anyways. Directors and CEOs typically hold much of the shares of their own companies too.
And the retention rate of board members of even failing firms is high despite the mistakes of the CEOs they hire on the shareholders’ behalf. It’s like it’s always the football managers who get fired after a poor season rather than ever the directors of the club… who made the poor choices in hiring the wrong managers in the first place(!)