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.