Concerns about the compensation of chief executive officers and other top executives of American public companies have reached fever pitch since the financial crisis and the economic meltdown of 2009. Some observers blame the recent recession in part on the flawed compensation arrangements for the top management of major financial institutions. Nor are such concerns new. For almost 20 years, a growing chorus of voices—including some shareholders, the business media, policymakers, and academics—have been criticizing the way top managers are paid. The criticisms focus particularly on CEOs not only because they are the highest paid, but also because their compensation sets the pattern for executives beneath them.
Jay Lorsch is the Louis E. Kirstein Professor of Human Relations at Harvard Business School. This post on The Harvard Law School Forum on Corporate Governance and Financial Regulation blog is based on an article by Professor Lorsch and Professor Rakesh Khurana that first appeared in Harvard Magazine.
Like previous criticisms, the current complaints focus on two issues: executives are paid too much, and current incentive-pay schemes are flawed because the connection between executive pay and company performance is mixed at best—and at worst has led to a series of dysfunctional behaviors.
Whether executives are paid too much is highly contested. Some institutional shareholders, politicians, and the public (as measured by opinion surveys) believe that CEOs are overpaid, while other shareholders, board members, and executives themselves disagree. What cannot be disputed is that American CEOs make more money than CEOs in other countries, largely because of a greater reliance on incentive pay (see the details in the chart above). Further, American CEOs are paid increasingly large amounts relative to the average employee and their immediate subordinates. Finally, it is clear that the rise in executive pay contributes to the skewing of income distribution in the United States.
Less clear is evidence about the link between executive compensation and performance. The most comprehensive survey examining the link between CEO pay and performance found that changes in firm performance account for only 4 percent of the variance in CEO pay. [1] This may in part reflect CEOs’ ability to game the system, or even the perverse effects of incentives that promote dysfunctional behavior.
The solutions offered for the problems of excessive levels of executive pay and the need to strengthen the link between pay and performance often hit on the same themes: strengthen the independence of directors and compensation committees; increase the shareholders’ rights to elect directors and to express their views on compensation plans, to discourage gaming and align incentives more closely with the aims of the owners. It is also tempting to suggest that these problems can be solved by better compensation schemes or improved techniques to link CEO pay to stock performance.
We disagree with the premises underlying these remedies. Instead, we find that the current compensation trouble stems in large part from unexamined assumptions that have fundamentally changed the nature of executive compensation and radically shifted the way that boards, executives, and even the larger society regard the corporation and its broader purpose.
In fact, the problems of executive compensation are symptomatic of larger societal questions. They cannot be resolved without considering the purpose of executive compensation—what behaviors, attitudes, and values we are trying to motivate in our business leaders—and indeed the larger purpose of business in American society. We assert that the current approach to executive compensation is an outgrowth of a pervasive paradigm that boards, senior executives, and indeed even those of us educating future and current business leaders have adopted about the purpose of the corporation, what it means to be a business executive, and to whom and for what executives are responsible.
Click here for the entire post.
While I agree with many of the observations of Mr. Lorsch, I do not go along with the esoteric assumptions he makes. In fact, their is a simpler way to examine pay for performance and it goes to the reasons a CEO is hired and the touch-point at which the board should entertain and discuss firing the CEO.
The purpose of hiring a CEO is to obtain someone to steer the ship. The CEO’s job is to set the course of the enterprise and to exhibit his or her prowess by steering the ship along that course, responding to obstacles in the way of that course and changing parts or all of that course in enough time to keep the course true to the objectives of the owners of the ship. Leaving the seafaring idiom, the CEO sets the strategy of the company and makes sure that strategy is followed or modified to meet the owners objectives. However, a vital part of this process is communicating clearly and thoroughly to every aspect of the organization what that strategy is and to ensure that each part of the organization follows that strategy; aligns their tactics and sets their internal strategy, tactics and objectives to the CEO’s strategy.
If this stategy communication and monitering is carried out, and the organization is successful, then the CEO deserves every bit of the compensation the board and the stockholders approve. If on the other hand, close monitoring shows that any part of the organization deviates from the CEO’s strategy and is essentially operating on its own, the strategy is not being employed correctly and most likely, the organization is losing sight of its objectives, losing profit and on its way to failure. The CEO should be judged on his/her strategy and performance. If he/she cannot modify the course immediately…firing should be discussed and communication of that discussion should be circulated to all the stockholders.
When businesses fail or underperform it is directly the fault of the CEO. They are given a great deal of leaway and support to hire consultants, listen to their managers and employees, and even establish “kitchen cabinets” to bounce their ideas off before they announce their strategy to the full company. Smart CEOs take advantage of this “honeymoon” before they communicate their strategy to the rest of their ship. Unfortunately, a number of CEOs never let their strategy leave the “C” level suite.
Likewise, many CEOs make sure to communicate their objectives and strategy to every function in their organization and to receive in return how each function will carry out this strategy as it affects what they do. What this does is establish a contract between each manager and the CEO. This scenario leads to efficient and effective management…and success at every level (as defined by the CEO’s strategy).
Communication is both the lifeblood of the organization and the glue that holds it together. Where the CEO’s strategy has a problem reaching descending levels of managers and functions, the life blood is not getting through and the organization begins to die; functions run on the “I guess” basis; strategy is no longer aligned with the CEO; that function becomes rudderless or worse, a separate business doing whatever it guesses it should do. The organization’s death is forecast and a crash of that part of the ship is imminent.
Even if the CEO does communicate clearly and thoroughly, it is also encumbent upon the CEO to establish a monitoring system that will immediately report the effectiveness of the implementation of his/her strategy to the control room–the CEO–to assure that the strategy is working properly, as constructed by the CEO, and each function’s objectives are being met. Where communication as the glue that holds the organization together begins to flake and that function is going on its own or floundering, the CEO can immediately take corrective action, including firing the manager who is interrupting the channel of communication, deciding to go it alone or not effectively managing his or her staff [i.e. the "Yes, Minister" approach (as exemplified by the British sitcom of many years ago and by the way in which executive assistants dismiss ideas of their bosses as "I'll be here when he/she is gone")].
With all this said, CEO performance and pay can be effectively justified through the 4C’s: Command, Communicate, Control and Compensate.