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 BENEFITS LAW JOURNAL 2 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 BENEFITS LAW JOURNAL 3 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