At the same time as governments in Europe and around the world are imposing austerity measures and reducing social benefits, CEO compensation has risen dramatically. And the golden parachutes awarded to CEOs who left under a cloud of poor performance or scandals, are unfathomable to many. Often, media backlash and public anger trigger legislation.
Professors Alexandra Niessen Ruenzi and Ernst Maug of the University of Mannheim, Business School and Michel de Fabiani, Remuneration and Governance Committee, Valeo provide us with their insights on the subject.
CEO pay and how boards react
CEO pay has increased in the absolute and has increased far more than the Standard & Poor Index. Moreover, the spread between what CEOs are paid and what other workers earn has also increased dramatically. Two theories explain the gap between CEO and other employee remuneration:
Optimal contracting: The view of classical economics is that high compensation results as companies enter into contracts in order to attract and retain qualified CEOs. This theory holds that that there is a shortage of capable leaders with the necessary general management skills, causing the price of those skills to increase. The theory also indicates that the best paid CEOs are those who manage the largest firms.
Extract rent: Under this theory, termed the managerial power approach, CEOs leverage their situation to extract the highest possible rent. This theory indicates that neither firm size nor skills explains the huge increases in compensation.
On reaction to CEO pay, Professor Ruenzi states that shareholders do care about compensation, as evidenced by rising share prices when boards adopt sound compensation plans and negative reactions when golden parachutes are adopted. The discussion around say-on-pay provisions has gained a great deal of attention, but these provisions do not exist in many countries and indeed, have not made a difference in executive compensation.
When it comes to public attitudes, much of the public is concerned about income inequality. 75% of the population believes that executive compensation is too high and it is often this public anger that triggers legislation. In boardrooms, such public attitudes are taken into account and can play a role in determining the composition of pay. In the 1990s, salary was a hot button, so boards limited salaries. In 1993, the issue was stock options. More recently, there has been anger about bonuses. In each instance, the board changed the components of executive compensation, but not the level.
Directors must link CEO pay to performance
Michel de Fabiani contends that there is no “right” level of CEO compensation. The reality is that firms must pay appropriately in order to attract and retain CEOs and other executives that are expected to lead increasingly global, increasingly complex companies. The issue is when there is no correlation between an individual’s pay and company performance. Pay is most problematic when a person leaves a company and still receives a significant payout. To help improve the compensation equation, Michel de Fabiani suggests the following axes for development:
- Benchmarks: Firms should benchmark the compensation of CEOs against firms in comparable situations.
- Alignment of incentives: Often incentives are not aligned with performance, and as a result a CEO is paid well even
when his firm doesn’t perform well. Directors should therefore consider making elements of
compensation variable so they are linked to performance.
- A package of tools: Boards need to pick from a package of tools including salary, bonus, stock options and more.
The precise tools should be based on the company’s situation.
- Selecting performance criteria: Precise performance targets need to be established and communicated and it is important that these criteria are linked with company strategy. Also, instead of absolute criteria, performance needs to be looked at in relative terms versus the industry.
- Medium and long term: While annual bonuses may be appropriate, directors should include medium- and long-term
Food for thought:
- To what extent should employment contracts explicitly include social/societal incentives (employee satisfaction, etc.)?
- To what extent are stakeholders’ interests already reflected in the long-term incentives of your organisation (share value, etc.)?
- To what extent would including social/societal incentives undermine the focus of CEOs?
Article drawn from the Council on Business & Society Paris Forum, Corporate Governance and Leadership. Collated and edited by Prof. Patricia Charléty, ESSEC Business School
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