Pay on Say: CEO Compensation

The Pay Disclosure norms in the US recently made it mandatory for corporates to declare the ratio of CEO pay to the median wage of the rest of the employees. This has predictably given rise to a flurry of consulting/advisory activity around interpreting the exact definition of the median (dramatic eye-roll – last time I checked this was a statistical construct which has been around forever), the precise definition of pay elements (OK, this might be legit, no eye-roll here), and several others. Click-bait header aside, this matter calls for due thought and consideration.

The story thus far: In classical finance and economics, the highest return usually went to the most prominent risk taker. The owner of the business would employ own capital in the market, take the full responsibility of failure in the form of spent money with no returns, pay labour upfront and consequently earn the lion’s share of the profits or losses as the case may be.

Present Context: With the establishment of professional organizations with an external Board of Directors, and a CEO to run the company under the overall supervision of the Board, this element of “skin in the game” has completely disappeared.

The Board-governed structure of CEO incentives and earnings is like a distant aunt twice removed trying to discipline her remote cousin’s child, while she is remunerated by the child’s trust fund

It is fraught with obvious conflicts of interest – the Board is appointed and paid by the company, the company, in turn, is run by the CEO where the success of the company is hinged on the CEO, and thus the vicious cycle. Add to this the fact, that the performance of a public company is defined almost always solely as TSR (Total Shareholder Return) and the shareholders are an amorphous mass, rarely more than a number interpreted and measured by the same Board. To compound it all, the CEO, unless equipped with a high sense of moral obligation to his role is encouraged to behave more and more like a standard employee. What part of the company’s success can be his problem if the numbers are flexible, and company performance is a mere scorecard, that has to be filled, signed off by the Board, and astronomical bonuses earned? Not much skin in the game, eh?

CEO pay

So-called benchmarks: Let us examine the actual pay ratios in the market today. An Executive Remuneration think tank called Equilar has published a report that gives the median/average pay ratio of the CEO in the US, to the average employee as 1: 300 or the CEO’s pay is typically 300 times that of a junior employee. It sounds over the top, even alarming. There is also the problem with benchmarks as a baseline for decision making. So, what is a good number? Or a reasonable pay ratio? I00, 200 or 300 as the “average” calls out? As long as ten other companies are doing the same, it is probably okay to go with the norm. That is the essence of benchmarks, and we sometimes go along with it.

How do we value the work that a CEO as the supreme leader of the organization performs? How can we possibly compensate him for the tremendous responsibility he carries on his shoulders – of these critical constituencies of shareholders, employees, and clients?

In whispers: As you think more about it, you begin to realize that s/he is bestowed with almost superhuman qualities, and in doing so, the mundane question of how much to pay him, and how do we govern it, is almost sacrilege. In fact, this particular quality of ‘hush-hushism’ is highly palpable in senior leadership meetings; there is virtually an embarrassing quality to the process of deciding on CEO compensation. We can only pay Superman in Kryptonite, right? What, no Kryptonite?! Let a million shares do the trick!

An outlier: There are exceptions, however. Allow me to present my favourite CEO (someone I have never met but deeply admire, based on what I read about him and his leadership principles). To illustrate my point, I quote from an interview of his that appeared in the Nov 2015 issue of HBR. It is a compelling story.

“Ask chief executives why their companies are performing so well, and they’ll typically credit a brilliant strategy coupled with hard-nosed, diligent execution.

But when you ask Lars Sørensen of Novo Nordisk what forces propelled him to the top of HBR’s 2015 ranking of the best-performing CEOs in the world, he cites something very different: luck!

HBR: What happens to your business if diabetes is eventually cured?

After I became CEO, in 2000, I predicted we would cure diabetes in 15 years. We’re still 15 years away. But that is the big goal. I tell my employees, “If we wind up curing diabetes, and it destroys a big part of our business, we can be proud, and you can get a job anywhere. We’ll have worked on the greatest social service of any pharmaceutical company, and that would be a phenomenal thing.”

HBR: Would you tell other CEOs to ignore those short-term pressures?

As a U.S. CEO, you cannot ignore responsibilities to shareholders. You can say, “I’m going to increase shareholder value over 15 years, so hang on with me—it’s going to be a little tight the next couple of years.” But unless you have block ownership and can convince shareholders they’re going to be richer in 15 years than if they sell the stock now, then someone will walk in with a successful offer to buy the company, because you’re not performing. The only way to change this, if society wants to change it, is to see pension funds behave differently with their investments.”

HBR: Scandinavian CEOs are paid much less than U.S. CEOs. Does that influence how you lead?

I saw that in last year’s list of best-performing CEOs, I was one of the lowest paid. My pay is a reflection of our company’s desire to have internal cohesion. When we make decisions, the employees should be part of the journey and should know they’re not just filling my pockets. And even though I’m one of the lowest-paid people in your whole cohort, I still earn more in a year than a blue-collar worker makes in his lifetime.

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HBR: Is it easier to lead when the pay gap between the CEO and workers is smaller?

Yes. There are other things that distance executives from the employees, too, like whether executives use private jets. At Novo Nordisk, we don’t, even though we’re a big company. That would send a signal to my subordinates that my time is more valuable than theirs. You could argue that it is in some ways, but philosophically it puts a gap between us. I’m not fond of that.”

To summarise: Isn’t he a dream? This is where the CEO Pay Disclosure norm makes a whole lot of sense. It provides much needed and complex compensation data available in a simple, easy to understand metric for employees and shareholders to form an informed view on their company’s performance, their pay in relation, and the CEO’s incentives to perform. “Internal cohesion” is a lovely phrase that we can borrow, to understand where and how we are going wrong with creating wide disparities and possibly correct them.

High performing CEOs can indeed be supermen in many ways,  or wonder women as the case may be. They are brilliant, ambitious, visionary, driven and a whole lot of other adjectives that make them who they are – leaders of other bright and hardworking men and women. However, that in itself should not be enough to command pay premiums in multiples of 100. There has to be more. Much more.

 

Contributed by a Total Rewards expert from the ITeS industry. 

 

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