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About CEO pay

   

The prevailing ideology says that CEOs in the United States are paid so much because that’s what the market will bear. The free market is setting the level of compensation for those executives. Economically, they are “worth” that much. Our free-market economy is a meritocracy that rewards people according to their economic contribution. Hogwash!

If the free market determined CEO pay, then we would have a situation where the buyer of the managerial service - the corporation - bargains with the seller of this service - the executive - to secure the service for a certain period of time for a certain price. The corporation might put ads in the paper describing the requirements of the job. It would solicit bids from interested individuals offering that service. A representative of the company would examine and compare those bids and then negotiate with prospective sellers to secure the service at the lowest possible price. The executives might be on fixed-year contracts, with the process repeated at regular intervals. That is an illustration of how a free market might set executive pay.

Of course, it doesn’t work that way. Politics is a factor. The chief executive officer is normally good friends with members of the board of directors on which he serves. He may even have nominated some persons to the board. Executive pay is nomally recommended to the board by a compensation committee consisting of senior board members. Pay is set by looking at what “peers” receive by a process known as “competitive benchmarking”.

How does it work? The compensation committee draws up a list of companies that are comparable to the committee's company in some way. It may be a competitor in the same industry or cater to the same type of customer or even be a company that committee members “admire”. The the committee decides to offer a compensation that is slightly higher than what prevails among the peer groups. A study found that in 99.5% of cases the compensation package was more generous - the theory being, I think, that to attract this talent the company had to offer something better than what its supposed competitors might offer.

What this system does, of course, is to rachet up the level of CEO pay. The CEO of a “comparable firm” can then use data from its own competitors to justify even higher salaries for him.The median level of pay steadily increases.

The selection of firms on the peer list is critical. When committee members arbitarily pick a firm because, say, it is one whose performance they admire, they are giving the CEO in question a pay raise in response to another's performance.

In the case of a CEO with a hairdressing firm, the "peers" included Starbucks coffee, which had three to four times its revenue, as well as H & R Block, which had 1.5 times the annual revenue. The hairdressing CEO’s base pay rose by 19%, and his bonus by 118%, in a year when corporate profits fell by 24%.

When executive compensation is set by such means, the committee can claim to have used an objective method in setting the rate. It can claim that the process is market-driven. However, stockholders are starting to become alarmed by the secrecy of the process. In 2006, the SEC required that public companies disclose the names of firms they use on their peer list and describe how the list was selected.

I think that CEO pay amounts to a crisis that needs to be addressed by even stronger measures. If corporations are a creature of the state, then the state has a right to appoint at least some of the board members. If the pay problem continues, I would propose that a majority of persons on corporate compensation committees be either representatives of government, or of employees, or of other of the firm’s major stakeholders. It’s time to debunk the myth that the free market determines executive pay. In reality, some high-paid executives are looting their own firms.

 

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