Profits Without Honor: The Sad Truth About CEO Compensation

04/14/2015 09:53 am ET | Updated Jun 12, 2015

"For what shall it profit a man, if he shall gain the whole world and lose his own soul?"(Mark 8:36). The answer: In terms of CEO compensation at major American businesses in the 21st century, everything.

That's because in the corporate world today souls don't count. What does count is shareholder value. Or, put more bluntly, how that value can be manipulated to push executive pay into the stratosphere.

William Lazonick, professor of economics of the University of Massachusetts Lowell, documents the perverse nature and approach being taken to inflate CEO compensation in his top prize McKinsey award-winning article in the September 2014 issue of the Harvard Business Review (HBR).

Professor Lazonick reports that

"In 2012, the 500 highest paid executives named in proxy statements of U.S. public companies received, on average $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company's shares, open market buybacks automatically lift its stock price even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets."

He goes on to point out that "...over the past two decades major U.S. companies have tended to do buybacks in bull markets and cut back on them, often sharply in bear markets. They buy high and, if they sell at all sell, low. Research...shows that companies that do buybacks never resell the shares at higher prices."

Professor Lazonick is not alone in his description and criticism of these egregious practices.

Douglas Skinner, accounting professor at the University of Chicago, in a July 2014 article for FiveThirtyEight highlights that beginning in 2001, "...firms are now paying out relative to investments about twice as much as ever before." He concludes, "...this mania for buyouts is taking place when the market is at record highs, in part to try and juice earnings to sustain these valuations. Not to be a doomsayer, but it is hard to see how all of this ends well."

But, in the short and near term, it does end well -very well that is for a very small group. They are the shareholders who get dividends and even more-so the executives who get rewarded primarily based upon stock price. The question arises should stock performance be the overriding metric for assessing CEO performance.

Apparently so, according to a November 2014 HBR article titled, "The Best Performing CEOs in the World" that identifies the 100 chief executives who performed most effectively in "increasing shareholder return and market capitalization in the long term" (since the time they took office until April 30, 2014).

Not so quickly! Maybe one shouldn't rush to judgment or payment using this performance measure alone, however.

As Adi Ignatius, author of the "Best CEO's" article observes,

"We acknowledge, of course, that being a good CEO is about far more than just investment performance....And investors certainly aren't the only stakeholders that need tending to; the best run companies connect effectively with customers, employees, and the communities where they operate."

Those other stakeholders may need "tending to" but it's still the shareholders and most notably the CEO himself (there were no females on HBR's list) who gets the lion's share of attention and reaps the bounty from successful stock performance. That's especially true here in the United States.

The median pay for U.S. CEO's on HBR's list was $12.1 million as opposed to $6.4 million for non U.S. CEO's. According to Professor Lazonick, "...the compensation of top U.S. executives has doubled or tripled since the first half of the 1990's, when it was widely viewed as excessive." In 2012, the ratio between the average pay of American CEOs to the average pay of American workers was 354:1. In Germany the executive to worker ratio was 147:1 and in Japan it was 67:1.

Are American CEO's worth that much more than their employees, their international counterparts - or, than they were approximately two decades ago? Possibly - but it seems highly unlikely.

We attribute the aggrandizement of CEO pay to what we call the 3-C's of executive compensation: compensable factors, competitive benchmarking, and corporate boards.

Establishing a CEO's compensation package usually begins by defining compensable factors - the driving force for those factors at present is stock value and growth in market valuation. The size of the package is set by benchmarking against other businesses in similar industries. Finally, the package is normally approved by the board which frequently includes current or retired CEO's from other businesses who have had comparable packages.

Put it all together and it is a formula for CEO compensation nirvana. And, while the CEOs luxuriate in a personal nirvana, the other stakeholders - including even shareholders in some instances - suffer in the financial nether-worlds below.

As importantly, money that could have been invested in research and development, product improvement and service enhancement is distributed to a select few rather than used to build a bigger and better business that benefits many.

This has serious negative consequences for those in and around the business and for the overall American economy as well. That is why Professor Skinner cautions,

"The bottom line is that market pressures - investors' insatiable desires for ever larger dividends and buybacks - are forcing large U.S. companies, which are vital to our economy, to pay out more cash than ever before, raising questions about where their future earnings - and ultimately, the U.S.'s overall economic growth will come from."

Professor Lazonick takes it one step further admonishing, "If the U.S. is to achieve growth that distributes income equitably and provides stable employment, government and business leaders must take steps to bring both stock buybacks and executive pay under control. The nation's economic health depends on it."

Professor Lazonick recommends three steps to redress this situation:

1. Put an end to open-market buybacks.
2. Rein in stock-based pay.
3. Transform the boards that determine executive compensation.

We endorse all of the professor's recommendations. We would add to them a fourth: Implement a balanced scorecard approach to executive compensation.

In 1992, Robert S. Kaplan and David P. Norton introduced the "balanced scorecard" methodology comprised of performance measures from four perspectives: Financial, Customer, Internal Business, and Innovation and Learning as a means for driving organizational performance and causing managers and executives to concentrate on a "handful of measures" that are most critical.

For a while, the balanced scorecard approach was the hot management fad throughout the corporate world. Its luster has since faded somewhat.

Now, in this new era of executive compensation run amuck, the balanced scorecard has been replaced with an unbalanced one. The single factor that matters most in too many businesses is moving the financial needle to pad the executive's pocketbook.

Implementing an executive compensation approach based on Kaplan and Norton's four perspectives - to which we would add the employee's perspective - would correct this myopia. It would broaden the CEOs' focus and reward them for managing and leading the business rather than simply extracting value from it through feats of financial legerdemain and keeping increasingly larger pieces of the compensation pie for themselves.

In the famous old Smith Barney ads that began running in 1979, British actor John Houseman proclaimed, "They make money the old fashioned way. They earn it."

If the approach to executive compensation and corporate reward practices were reformed, that could be said about American CEOs and businesses going forward. They would be making profits with honor. This would be good for them and for the American worker and economy as well.

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