It's time to rethink CEO pay, but not in the way you imagine.
Yes, CEO pay is extreme. Some might even call it excessive. And from a social equity perspective, I might agree.
But that's not the only — and probably not even the most important — reason that we should reconsider how we remunerate those who sit at the top of the corporate tree.
CEO pay has really skyrocketed in the last couple of decades. Not surprisingly, it corresponds nicely with the rise of 'compensation consultants' who are only too happy to tell boards that they should be paying more… because there's no better way to get a referral than to make sure you have a happy client.
And the process of comparison is broken. Imagine that wages were set only by comparison to the average wage. The bottom half would argue they needed to be paid more, because they were below average. And when that ambit claim was successful, guess what? The average rises. Which puts another group below average, so they argue for a payrise. Which – you guessed it – further increases the average.
It's a game of corporate leapfrog, where everyone gets richer – except those who pay the bills.
But that's still not the biggest problem.
In their haste to 'align the interests' of shareholders and their employees (the directors and management), boards have adopted an approach that is all so simple — and seemingly foolproof: CEO bonuses these days are mostly tied to TSR, or Total Shareholder Return.
On the surface that makes sense: a CEO only benefits when he or she makes shareholders rich. If the share price goes from, say, $10 to $15, then shareholders have made a 50% return. And, the theory goes, the CEO who was responsible for that value creation should then be rewarded. Logical right?
Not so fast.
Here's a couple of thought experiments:
I'm the CEO of an oil company, and the price of black gold falls 50%. My profits dive, despite me improving safety, cutting costs and investing for future growth. The share price plunges 80%. No bonus for me.
Now let's say I'm CEO of an iron ore company when the price of the commodity goes from $40 per tonne to over $100. I'm making a fortune, I don't bother trying to improve the business, and our safety record takes a dive. But the share price triples, and I buy myself a 6-bedroom holiday mansion on the coast with my bonus.
The CEO bonus (or lack thereof) was aligned with the share price movements, but do they reflect my skill, effort and broader results? Or is it just luck?
Let's try a few more:
The new CEO takes over just after her predecessor spent a fortune on growth initiatives that are just about to pay off, despite no new efforts from the incoming executive.
A CEO doesn't improve profits, but goes on a PR offensive, inflating the share price to record highs… then gets his bonus and leaves before the share price halves when the market realises it was all talk.
Or this one: What about a (hypothetical) financial services CEO who presides over a cultural morass of poor incentives, wrongdoing, weak internal audits and a heap of other sad and sorry examples, yet gets his or her bonus and resigns, leaving the successor to clean up the mess?
That could never happen, right?
Yes, we think we want CEOs who prosper only when shareholders prosper. But, as you can see, that doesn't always make sense.
What we really want – or should want – is to pay a CEO for the value she adds to the business, not on the basis of short-term share price movements. That's the real way you align management decisions and long-term shareholder value.
Foolish takeaway
So what might it look like?
No CEO is going to appoint me as their compensation consultant, of course, because, well, I'm going to look after the interests of shareholders. But here's what I'd do.
First, reduce base pay. I'm happy to pay out bonuses – even large bonuses – but they have to earn it.
Second, all bonuses would be paid out in five yearly instalments, over the following five years, and only if the company continued to perform. That way the CEOs are incentivised to make this year great, but not at the expense of next year and the year after. And they're incentivised to make sure their successor is well chosen and well trained.
And lastly, make it payable on controllable metrics. So rather than the oil price, on safety, and the cost of per-barrel extraction, for example. In a less cyclical business, on return on incremental equity – meaning that growth is only incentivised if there's an improvement in shareholder returns, not for its own sake.
Oh, and the bonus gets clawed back if the company is subject to adverse legal findings. You'd be amazed what that'll do for focus and culture.
