[Vision2020] C.E.O.’s and the Pay-’Em-or-Lose-’Em Myth

[Art Deco]

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September 22, 2012
C.E.O.’s and the Pay-’Em-or-Lose-’Em Myth By GRETCHEN
MORGENSON<http://topics.nytimes.com/top/reference/timestopics/people/m/gretchen_morgenson/index.html>

CORPORATIONS are forever defending big executive paydays. If we don’t pay
up, the argument goes, our sharpest minds will jump to our rivals.

Now, there are good reasons for rewarding top executives. The decisions
they make are so crucial to their companies that the priority should be to
hire competent people rather than scrimp on pay.

But a study released last week pretty much drives a stake through that old
“pay ’em or lose ’em” line — what you might call the brain-drain defense.
It also debunks the idea that companies must keep up with the Joneses by
constantly comparing their executives’ compensation with that of similar
companies.

This peer-group benchmark — how executive
pay<http://topics.nytimes.com/top/reference/timestopics/subjects/e/executive_pay/index.html?inline=nyt-classifier>at
one company stacks up against pay at another — is a big driver of
ever-rising compensation. Boards say it helps them set pay based on what
the market will bear.

Well, maybe not.

New research<http://irrcinstitute.org/pdf/Executive-Superstars-Peer-Benchmarking-Study.pdf>by
Charles M. Elson, director of the John
L. Weinberg Center for Corporate Governance
<http://sites.udel.edu/wccg/>at the University
of Delaware<http://topics.nytimes.com/top/reference/timestopics/organizations/u/university_of_delaware/index.html?inline=nyt-org>,
and Craig K. Ferrere, one of its Edgar S. Woolard fellows, begins by
attacking this conventional wisdom. Mr. Elson and Mr. Ferrere conclude,
contrary to the prevailing line, that chief executives can’t readily
transfer their skills from one company to another. In other words, the
argument that C.E.O.’s will leave if they aren’t compensated well, perhaps
even lavishly, is bogus. Using the peer-group benchmark only pushes pay up
and up.

“It’s a false paradox,” Mr. Elson said in an interview last week. “The peer
group is based on the theory of transferability of talent. But we found
that C.E.O. skills are very firm-specific. C.E.O.’s don’t move very often,
but when they do, they’re flops.”

Executive pay has come under scrutiny — and criticism — in recent years, in
part because so many ordinary Americans are struggling in a difficult
economy. Companies have pushed back, often pointing to the peer-group
benchmark. But that benchmark has had a pronounced effect on pay levels
across corporate America. As the Delaware study notes, one company’s
showering of rewards on its executives affects executive pay at every one
of its peers.

In annual proxy statements, compensation committees of corporate boards
tell shareholders which companies they placed in their peer groups and why.
Last year, for example, I.B.M. said it began by including all companies in
the technology industry with annual revenue of more than $15 billion. But
it also added companies in other industries with revenue of at least $40
billion and “a global complexity similar to I.B.M.,” the company said. The
result was that 28 companies were in the group, including AT&T, Ford and
Pfizer.

Peer groups have come under attack
periodically<http://select.nytimes.com/gst/abstract.html?res=FB0D10F8385A0C758EDDA80994DE404482>,
especially when they appear to inflate pay.

In 2003, a firestorm erupted over the peer group chosen by the board of the
New York Stock Exchange to compute a $140 million payday for Richard A.
Grasso, its former chairman. Even though the Big Board was then a nonprofit
organization, the board’s peer group included highly profitable investment
banks and huge financial institutions. Benchmarking against companies that
are much larger and more complex has the effect of increasing pay, experts
say.

But even when peer groups are compiled prudently, the Delaware study
contends, they are deeply flawed measures. “Whether the excess compensation
is awarded for merit or otherwise,” the authors wrote, “a talented
individual who is paid on a scale deserving of their abilities should not,
through the peer group mechanism, be allowed to bolster the pay of less
able executives.”

Importantly, the study disputes the notion that executive pay today is a
result of an efficient bidding process for finding and retaining a scarce
and valuable commodity: managerial talent. “In essence, this process
creates a model of a competitive market for executives where it otherwise
does not exist,” the authors wrote. “Through the operation of a market, it
is argued, wages are bid up to an executive’s outside opportunities.”

But there is little evidence, according to Mr. Elson and Mr. Ferrere, that
a hot market exists for interchangeable chief executives. First, they note
numerous academic studies indicating that C.E.O.’s selected from within a
company perform better than outsiders, especially in the creation of
long-term shareholder value.

“There is no conclusive empirical evidence that outside succession leads to
more favorable corporate performance, or even that good performance at one
company can accurately predict success at another,” the authors conclude.
“In short, executive skills cannot pass the most basic test of generality:
transferability.”

TO be sure, this flies in the face of the widely held view that skilled
managers have become generalists and are therefore far more interchangeable
than in previous years. Proponents of this thesis argue that top managers
today can accumulate a broad knowledge of economics, finance and management
science, giving them the ability to manage any type of company effectively.
Technological advancements also give chief executives access to untold
amounts of data about a particular company that in previous times would
have taken years to amass and synthesize, this view holds.

But the data on actual C.E.O. moves raises questions about just how
portable C.E.O. skills really are. The Delaware paper cites several studies
indicating that relatively few chief executives land new top jobs
elsewhere. One study, a 2011 analysis of roughly 1,800 C.E.O. successions
from 1993 to 2005, found that less than 2 percent had been public-company
chief executives before their new jobs.

“It appears that the threat to go elsewhere is muted for a sitting C.E.O.,”
the authors concluded. “Particularly for the large firms comprising the S.&
P. 500, C.E.O.’s are rarely traded in any market for their talents.”

Nevertheless, the notion persists that chief executives and their skills
are transferable — and that they will walk if their pay doesn’t keep
rising.

This, Mr. Elson and Mr. Ferrere argue, has given rise to a new type of
captured corporate director. “Rather than being beholden to management and
thus ineffective in negotiating pay because of a lack of arm’s-length
bargaining, boards are now often seen as captive to the market,” the two
wrote.

Because that market is largely based upon the questionable use of peer
groups, the authors contend that those interested in changing executive pay
practices should begin by junking these benchmarks. “Instead,” the authors
said, “the independent and shareholder-conscious compensation committee
must develop internally consistent standards of pay based on the individual
nature of the organization concerned, its particular competitive
environment and its internal dynamics.”

Directors may not like the extra work. Shareholders should insist on it.

“Everyone wants a formula and peer grouping is part of that,” said Jon
Lukomnik, executive director at the Investor Responsibility Research Center
Institute <http://www.irrcinstitute.org/>, which financed the Delaware
study. “We need objective measures but we also need to understand their
limitations.”


-- 
Art Deco (Wayne A. Fox)
art.deco.studios at gmail.com
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