VOL. 26, NO. 1
SPRING 2013
BENEFITS LAW
JOURNAL
From the Editor
How Much Should the Boss Earn?
Boards Should First Determine PAR
C
omplaining about overpaid CEOs has become a national pastime,
fueled by screeching headlines about pliant boards that have
allowed avaricious, rent-seeking senior executives to grab an everincreasing slice of corporate earnings, to the detriment of shareholders and society alike.
Is that fair? Certainly, the average chief executive of a major US
company takes home a huge chunk of change: median pay for
Fortune 500 CEOs in 2010 was $8.5 million. But focusing on the longterm reward to shareholders, there is plenty of evidence that most of
those paychecks were well-earned.
The debate over CEO pay is nicely framed by two recent opposing
papers by well-known academics.
In “Executive Superstars, Peer Groups and Over-Compensation,”
Charles Elson and Craig Ferrere of the University of Delaware posit
that even high-performing executives are overpaid. They cite a dramatic rise in CEO compensation over the past three decades, despite
the greater independence and improved governance among corporate
boards. Rejecting the rationale that companies must compete for a very
limited pool of highly skilled executives in a free market, they counter
that most executives possess “firm-specific knowledge and skills” that
are not easily transferable to other companies. Executives and employers therefore have a huge mutual investment—a skill set and knowledge base honed over years of training and effort—that tempers the
usual laws of supply and demand. In fact, Elson and Ferrere conclude,
because a “star” manager is actually far more valuable to his or her
current employer than to any other company, he or she is unlikely to
have much opportunity to jump ship for more money.
From the Editor
For those reasons, Elson and Ferrer believe that when a rising
corporate star is elevated to CEO, a moderate bump in total compensation should be sufficient for continued motivation and reward.
They point out that a major goal in setting CEO pay is (or should be,
according to the authors) totally unrelated to the individual executive.
The level of pay needs to be sufficiently enticing to motivate junior
executives to develop the firm-specific skills needed to rise to the top,
but not so outrageously high as to discourage the other still-valued
senior executives who didn’t make it to the highest rung.
Elson and Ferrere blame excessive CEO pay on the use of peer
group benchmarking as a competitive yardstick. Even a reasonable
and representative group of peer companies will eventually inflate
compensation, because a pay increase to any individual in the peer
group—a bonus, equity grant, or whatever—automatically increases
the peer group average. When it comes time for another board to set
its own CEO’s pay, the higher average prompts a bump in targeted
pay, further raising the group’s average. The pattern is only exacerbated when boards benchmark their CEO’s pay above the 50th
percentile—the much-maligned Lake Wobegon effect.
At the other end of the spectrum, Steven Kaplan of the University
of Chicago’s Booth School of Business maintains that CEOs are generally fairly paid, but that we need to rethink how we look at corporate rewards. He points out the flaws in Elson and Ferrer’s type of
analysis, having long argued publicly that adjusting for inflation, CEO
compensation in 2010 was actually similar to 1998 levels and lower
than the peak reached in 2000. Overall, Kaplan says median inflationadjusted CEO pay has actually declined 46 percent since 2001, most
notably during the Great Recession. During the same period, he adds,
public companies on average have become more profitable, generated more cash, and boasted stronger balance sheets.
Perhaps Kaplan’s keenest observation is that at companies whose
CEOs rank in the top quartile of pay, stock returns were on average
60 percent greater than other firms over the preceding three years.
Similarly, CEOs who ranked at the bottom 20 percent in pay scale
generally came from companies that underperformed the market by
20 percent. Most significantly underperforming CEOs ultimately were
routinely (and quickly) fired, as shown by declining CEO tenure over
the past decade.
Isn’t that how pay-for-performance is supposed to work?
Ironically, the relatively rapid escalation of CEO pay levels from
the mid-1990s through 2001 can be blamed in part on Congress’s misguided attempts to regulate pay levels. In 1993, IRC Section 162(m)
was added to the Tax Code, eliminating public companies’ ability to
deduct non-performance-based compensation above $1 million paid
to the CEO and his or her four top compadres. As it happens, stock
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VOL. 26, NO. 1, SPRING 2013
From the Editor
options with a strike price of fair market value on grant are considered performance-based, and accounting rules at the time (since
changed) didn’t treat options as a compensation expense. It’s no surprise that companies steadily shifted the bulk of executive pay into
ever larger option grants. When a long bull stock market drove the
value of these options sky high, executive pay levels soared as well.
Still, if CEOs are being appropriately rewarded for strong performance and penalized for poor results, it doesn’t answer the question
“How much is enough?” The use of peer groups gives boards a competitive starting point for setting pay levels, but the challenge remains
to determine how to align pay to company performance. This analysis
is extremely difficult, involving art as much as science. Boards should
exclude factors outside of management’s control (e.g., natural disasters or a surplus of natural resources). Moreover, it should be remembered that sometimes the most important feat for a CEO is to avoid
making major mistakes—a disastrous acquisition, failing to recognize
a poorly designed product.
America’s original national pastime offers some lessons on how boards
can make better use of peer group metrics and subjective analyses in
designing and calibrating pay programs. Baseball executives have developed a measure of player value based on WAR: wins above replacement. It uses a complex formula to measure a player’s hitting, fielding,
base running, and other statistics to arrive at how many additional team
wins the player is likely to add over the season over a top-level minor
league player. The more added wins, the more valuable the player.
The value-added approach is beginning to take off. Patterson
Associates, the London office of compensation consulting firm Pearl
Meyer & Partners, recently introduced an analysis that provides a simple, compelling measure of the pay/performance link. The “Patterson
Index” calculates the total shareholder value added for every £1 paid
to the CEO over rolling four-year periods, including share gains/losses, dividends, and share buybacks. (Full disclosure: my wife works
for PM&P, although not as a consultant.)
Building on this approach, we’d like to see the wonks of the comp
world develop a measurement of how much “profit above a replacement” (PAR) executive a CEO adds. Obviously, no one index will be
foolproof or can replace the insight of an independent board. Still,
it seems clear that the issue isn’t how much the boss is paid, but
how much value he or she adds to shareholders. Executives who are
above PAR should be so rewarded.
David E. Morse
Editor-in-Chief
K & L Gates LLP
New York, NY
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VOL. 26, NO. 1, SPRING 2013
Copyright © 2013 CCH Incorporated. All Rights Reserved.
Reprinted from Benefits Law Journal Spring 2013, Volume 26,
Number 1, pages 1–3, with permission from Aspen Publishers,
Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437,
www.aspenpublishers.com