Pay for performance?

Study shows reverse correlation between CEO compensation and returns to shareholders.

Among the most controversial management topics in recent years has been the issue of CEO pay -- or, more specifically, perceived CEO overpay. As many CEOs made hundreds of millions in salary and stock options over the last decade, shareholder activists began complaining that U.S. CEOs are by and large paid significantly more than their overseas counterparts. The activists cited examples to show that good management could be bought at half or even a tenth of the cost of some high-flying CEOs. In turn, the CEOs and their Wall Street defenders pointed out that most of the largest CEO salaries were the result of incentive-laden compensation plans heavy with stock options. These CEOs became rich, their argument concluded, only after they made their shareholders even richer.

And what could be more American -- and sounder management practice -- than that?

Plenty, at least according to a recent study completed by the Wharton School of the University of Pennsylvania. Researchers John E. Core, Robert W. Holthausen, and David F. Larcker took a hard look at the relationship between CEO pay and subsequent financial and stock performance by examining compensation and accounting data from the 1980s. What they found wasnt pretty, at least for CEOs hoping to finagle a larger bonus or stock package: CEO pay that was relatively higher than would have otherwise been predicted correlated with lesser financial performance. In laymans terms, the better a CEO was at negotiating his own compensation, the worse off his company was.

Why? Because, the study finds, a CEOs ability to command a premium for his services seems to depend less on his management skills than on his ability to persuade or manipulate his board of directors. Specifically, CEO compensation is higher when:


  • The CEO is also chairman of the board.
  • The board is larger.
  • The outside directors are less independent.
  • The outside directors are older and serve on more than three other boards.

On the other hand, CEO compensation is lower when:
  • A greater percentage of the board is composed of inside directors.
  • There is an external blockholder who owns at least 5% of the equity.
  • There is an internal, non-CEO board member who owns at least 5% of shares.

      CEO pay also declines, the authors say, as the CEOs ownership stake increases.

      These findings -- combined with the relatively poor performance of the firms that employed highly compensated CEOs -- suggest that board and ownership structure strongly influence both CEO pay and corporate financial performance. Weak boards composed of large numbers of older, distracted, or hostage board members (i.e., board members who represent suppliers or partners) tend to overpay and undermanage their CEOs. By contrast, strong boards -- those that boast small cadres of either attentive outside directors or watchful inside peers of the CEO -- are not so easily convinced of either the CEOs omnipotent leadership or his need for luxury. In both cases, accounting and stock-market results ultimately reflect the boards leadership (or lack thereof) rather than the CEOs.

      This is hard news for CEOs who hope to bully their boards into signing off on gold-plated 1040s. Even worse than the millions they stand to lose, however, is the reminder the study provides of two facts many top executives would like to forget: First, CEOs need bosses, too. And second, even when CEOs do succeed, it probably has less to do with their own talents than with those of the people who surround them.

      What could be more American -- or sounder management practice -- than that?

      Send e-mail messages to John Brandt at [email protected]

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