By Cydney Posner
In case you missed this article in Sunday's New York Times, Gretchen Morgenson challenges the "pay 'em or lose 'em" argument that companies often use to support ever higher CEO pay levels. Citing a recent study from the John L. Weinberg Center for Corporate Governance at the University of Delaware, the article suggests that peer group benchmarking is a problematic tool for setting CEO pay because it is based on the false premise of a vigorous external market for CEOs.
The study debunks the idea that CEOs can readily transfer their skills from one company to another, which is the underlying basis for benchmarking. The argument has been that CEOs 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." However, the study also shows 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…. Particularly for the large firms comprising the S.& P. 500, C.E.O.'s are rarely traded in any market for their talents.' " The study also notes numerous other academic studies showing that CEOs selected through internal promotion "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.'"
Compensation committees and others want the comfort of relying on objective measures and formulas, such as peer group benchmarking, but the limitations of these tools must be understood. The study's authors argue that benchmarking is "'a false paradox….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.' " The article observes that "[i]mportantly, 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…Through the operation of a market, it is argued, wages are bid up to an executive's outside opportunities.'"
The authors of the study argue that the theory that CEOs will walk if their pay does not continue to increase "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 authors wrote. That market, however, is premised on peer group benchmarking. Instead, the authors contend that "those interested in changing executive pay practices should begin by junking these benchmarks [and developing] ‘internally consistent standards of pay based on the individual nature of the organization concerned, its particular competitive environment and its internal dynamics.'"
According to the study, even if peer groups are properly constructed, benchmarking is a flawed methodology that tends to inflate compensation for those who may be less deserving, leading to a continual escalation of executive pay. The authors of the study argue that, "by basing pay primarily on external comparisons, a separate regime which was untethered from the actual wage structures of the rest of the organization was established. Over time, these disconnected systems were bound to diverge. Unfortunately, the pay of the executive has a profound effect on the incentive structure throughout the corporate hierarchy. Rising pay thus has costs far greater than the amount actually transferred to the CEOs themselves. To mitigate this problem, pay must be more consistent with internal corporate wage structures. An important step in that direction is to diminish the focus on external benchmarking."