Executive Pay and the Emperor's New Clothes

I read a recent article by Dan Ariely on how we measure thrift. Mr. Ariely, is the author of “Predictably Irrational” and “The Upside of Irrationality.” He is also a professor of Psychology and Behavioral Economics at Duke University. He used a simple example of how we may choose to purchase expensive premium coffee over less expensive, but still good coffee, to show how seemingly reasonable decisions can be influenced by past experience rather than current facts. In the end he questions whether some of our monetary tendencies are driven by habit instead of rational decisions (original article here). This concept can be applied to executive and equity compensation. It’s quite a leap to go from comparing cups of coffee that differ in price by $1.75 to CEO compensation that may differ by millions of dollars, but the foundation is the same. Ask yourself if you are you paying your CEO what you should, or what you think you should. Is your compensation package based on a series of small, well-meaning adjustments that when summed up can no longer be supported?  Or, is it based on easy to demonstrate facts?

Very few companies will tell you that they pay their CEO too much money.  Some will admit they pay a lot of money.  They will sometimes even admit that it is an extraordinary amount of money. In the end they will show you the data that justifies the amounts. This data seldom includes a full analysis of the skill sets required to do the job and a breakdown of the number of people that have that skill set. It almost never shows the progression of pay growth for the position at that company, or across all companies, over several years. There is very little discussion of other individuals already on staff who have a majority of the required skills and what it would take to build a full bench of talented and less expensive replacements.

We can be certain that the job of a successful CEO is difficult to fully define. It is obvious when the right person is in the position. Shareholders will support a leader like this. As their value grows, so does an easy defense for additional pay. In good times it can be difficult to filter out the companies that succeed in spite of their CEO. These CEOs can be like the Emperor in Hans Christian Andersen's story. They can ride down the street without a stitch of clothing, with the masses silent. The crowds are either afraid to say a word because of potential retribution, or simply unwilling to point out the obvious while they are personally doing well.

I find it more interesting that when times are tough, many companies are still ignoring the lumpy, exposed bodies of ineffective executives. CEO pay has generally recovered quickly from the recent downturn. A recent study in Canada calls CEO Pay “Recession Proof”. It appears that even after a collapse of historic proportions we are still unwilling to point out that some CEOs are being paid huge amounts not because they deserve it, but because some of their superior peers deserve it. I am uncertain if this is an artifact of the ethereal, or vague, nature of defining a great CEO or due to the fact that we have simply made a habit of paying certain people large amounts of money while our market data supplies a constant flow of convincing, but sometimes flawed, justification.

What I do know is that compensation professionals are the only people truly armed with the knowledge, skill and experience to determine when we are paying rationally and when we are paying based on some irrational adherence to past practices.  The question is whether people will have the courage to point out what others are ignoring, when the easier thing is to let the occasional naked CEO just ride by one more year.

You Can Self-fulfill a Prophecy, Just Ask the Right People!

Too Heavy for Any Amount of Money