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Ron Ashkenas Headshot

Rethinking the Assumptions Behind Executive Pay

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Cross-posted from Harvard Business Online

The gap between CEO compensation and that of the average worker continues to grow at an astounding rate. According to the Institute for Policy Studies, CEO compensation in the United States was approximately 40 times greater than that of the average worker in 1960 and is now over 400 times greater (a much larger gap than in other countries). Similarly, from 1990 to 2005 CEO compensation increased 300% (adjusted for inflation) while the pay of average workers increased only 4.3%. These figures prompted Joe Biden to remark last year that "the average CEO makes $10,000 more every day...than what the average worker makes every year."

The usual justification for the size of CEO compensation of course is that CEOs and senior executives create wealth for shareholders through their decisions and actions. Based on that rationale, many companies include substantial stock options or grants as part of the compensation process, in addition to salary and bonus, so that top executives will be incented to improve stock performance. A recent study by compensation expert Graef Crystal, reported in Bloomberg Businessweek, found that there is no relationship whatsoever between CEO compensation and shareholder returns: The compensation of some CEOs went up while their stock performance went down and vice versa.

So what's going on? Why is executive pay going up while the correlation between pay and performance is unclear? Let me suggest two explanations:

First there are more factors that influence stock price than just the performance of the CEO and C-suite team -- global economic conditions, political concerns, industry trends, investor speculation, and other dynamics all weigh heavily on the market. Therefore, stock price is probably a very poor short-term or even medium-term indicator of company success. For many companies, in fact, the creation of shareholder value may not show up for a decade or more -- and even then may be derailed along the way by short-term market disruptions. Unfortunately many (if not most) CEOs and their teams do not stay with their companies for a decade. Average CEO tenure in 2009 was seven years and may get even shorter as the economic recovery continues and more opportunities emerge. In other words, assessing CEO and C-suite performance on the basis of stock prices may not work. In fact, it may create incentives for executives to take short-term actions (such as selling the company) to boost stock price that could be detrimental to longer term value creation.

Despite the disconnect between executive performance and stock price, most senior compensation packages include large amounts of stock. The reason for this may be that CEO and senior executive compensation is based to a large extent on market comparisons rather than on objective assessments of how much value the candidate will create. Board-level compensation committees (usually including current or former CEOs from other companies) get input from executive compensation consultants (who survey the pay of other senior executives) and make determinations about what kind of pay package will be required to entice the candidate to sign on. And of course if the candidate was already highly compensated, then the new package needs to make the person "whole" and then some. The result is a spiraling escalation of executive compensation.

Employees and shareholders want to believe that their senior executives are incented to do the right things for the organization -- and that their contributions are fairly rewarded. But if executive compensation doesn't correlate with company performance, the credibility of the firm's leadership may be compromised. If so, it might be time to rethink some of the assumptions behind senior executive pay.

What are your thoughts?