CEO Pay by Performance an Urban Legend?
The point is: It’s not how much you pay but
how!
murat ulker
We are going through a difficult period with increasing competition, economic difficulties, and the pandemic that has enveloped our world. Now, August 2020, the time for budgets has arrived. It will be difficult to make valid forecasts, especially when strategies need to be updated, especially detailed plans. I wonder what will be the effect of abundance of cash, desperately pumped into the markets by governments in an economic recession worldwide? As if recession and inflation will happen simultaneously in a world economy that is getting cold?!?
Actually, I wanted to write about budgeting and implementation, but it would be better to commence this article with a different topic and then pass onto to the issue of budgets. One of the most important issues in strategic management literature, which is the aforementioned topic I will discuss, is how to determine the CEO and senior management team wages (salary + bonus). In this article, I will only talk about the CEO, but it should not be forgotten that all my views include other management teams.
In short, the payment made to a CEO according to the performance of the business under his management is called “Pay for Performance“. Now, what would you say if I told you that although this subject is so important and often discussed, the research and field studies conducted so far have not found a strong relationship between CEO performance and company performance? (1,2) There are few studies showing a relationship, and these studies also show that the effect decreases when a CEO’s risk increases or the effect disappears after two years (3,4). I couldn’t believe this. This has been researched and a relationship could not be found because they had focused on stock exchange companies aiming at short-term investor satisfaction, as that was the data available to them. However, my experience is different!
Nicholas J. Price from Dilligent Insight wrote in his article “CEO Pay and Company Performance” dated July 29, 2019, “ In past decades, the CEO’s pay wasn’t always given much attention especially in regards company’s performance. As cases of corporate fraud became public, shareholders began questioning the pay of CEOs and other high-ranking executives. Now that public companies are required to be more transparent about CEO pay and how it compares to what they pay the median employee, shareholders and others have all new sources of information with which to evaluate the equity of how companies pay their employees at all levels” (5).
Indeed, many field studies show that high CEO pay does not necessarily equate to the highest company performance! The stock option provided to CEOs does not always bring superior performance. While the option only directs the CEO towards short-term goals, his full ownership of the company shares makes him think of him/herself as “the owner of the company”. The Wall Street Journal analyzed data from MyLogIQ and Institutional Shareholder Services (ISS) in 2017 show company performances and include company CEO salaries. As a result of the analysis, they revealed basically that CEOs of companies with average performance get high wages, and good performers earn low wages. Herman Augunis of George Washington University found similar results in his research on 4,000 CEOs. Although there is no relationship between CEO salary and business performance, CEOs receive on average 10% of their wages as a cash base, and the remainder as a stock option or balance sheet bonus (equity incentive) for motivation and better management of the company (6).
Interestingly, when such a relationship between CEO Salary and Company Performance could not be established clearly, a reaction to high CEO salaries, especially in the USA, has begun in recent years and the methods of determining CEOs’ salaries have been opened to serious discussion. Of course, this also has the effect of the law requiring disclosure of how many times of the median salary the CEO salaries in public companies are. As it turned out that the median employee salary in some companies was one in 300 of the CEO salary, as such leftist activists and academics have increased the dose of questioning concerning CEO salaries (7).
The largest insider inquiry is the Peer Review in the Handbook of Board Governance,edited by Richard Leblanc, where many academics and practitioners from the United States to New Zealand, and from England to Australia participate with their writings in ‘Peer Groups: Understanding CEO Compensation and a Proposal for a New Approach” (8).
Elson and Ferrere (2016) first briefly summarize how CEO salary is determined in the industry as follows: “In setting the pay of their CEOs, boards invariably reference the pay of the executives at other enterprises in similar industries and of similar size and complexity. In what is described as ‘competitive benchmarking’ … This process is alleged to provide an effective gauge of ‘market wages’ which are necessary for executive retention.”
The authors then drop another bomb: “The CEO’s abilities are compatible with the company he works for, these skills cannot be transferred to another company!” Elson and Ferrere prove these hypotheses with the knowledge that the majority of CEOs in the US are appointed from within. They say: “CEO’s success comes from growing up within the operations of that company and having the way of functioning specific to that company!”
For example, in the S&P 500, between 2009 and 2012, there were nearly 50 CEO appointments. 75% of these CEOs are internally appointed. The reasons why Yahoo and Avon prefer external CEO appointments are the changing structure of their sectors and the dramatic changes such as restructuring of an organization due to falling sales. Again, in 2012, a group of researchers conducted research in 1500 companies based on WRSD data and found 1069 senior management displacements between 1993 and 2009. 767 of them were in a position other than CEO, and they took a position other than CEO at another company. 267 of them were in a position other than a CEO and transferred to another company as a CEO. Only 27 CEOs were transferred to another company as CEO. In other words, those who transfer to other companies as CEOs are not CEOs, but their assistants reporting to them. In 2013, The Conference Board’s CEO Succession report contains another piece of interesting data, which is that the average duration of those who have been appointed as CEOs in their companies is 15.8 years.
Based on this, the authors suggest: “There is no such general management ability to ensure success. There is no such thing as a CEO that can wave his magical hand, and presto that company will succeed. There is no such thing such as CEO market. The success of a CEO comes from the firm specific information he has accumulated in his career. Deep information specific to a company cannot be repeated in another company. Therefore, the industry comparison of the salaries is wrong. By the way, there is not only a CEO in an organization. There are management teams. And the payment to be made to the CEO is also related to the salaries of other people in the company. ”
On the other hand, Elson and Ferrere CEO do not think the payments made are unrelated to company performance. They say; “If you think the payment made to the CEO is not related to company performance, just give them a check for $1, and see how the results are affected!”. The authors contend that a top management’s remuneration structure is very important for an effective corporate culture. They determined that “the Board of Directors should really show effort and creativity in order for the wage structure to be flexible and to positively affect morale.” Board of Directors can compare wages within industry, but it should always act on its own judgment and subjective decisions. “No computer program and consultant can replace real Board of Directors experience.”
In fact, there are two important books that set the ground for similar views like Elson and Ferrere. One of them belongs to Law Professor Michael Dorff, titled: ‘Indispensable and Other Myths. (9) and the other is Steven Clifford, who has served as a journalist and manager for many years, The CEO Pay Machines: How It Trashes America and How to Stop It (10).
However, Dorff on the other hand, reveals that overpaying CEOs does not lead them to the right critical behavior, and that this kind of remuneration, mostly made up of stock transfer, never motivates CEOs.
Clifford defends his views more harshly; Continuous increase in CEO salary is a company dogma, as the CEO ages within the company, the method of determining wages becomes subjective, as a result, the board of director’s members who have no responsibility see their right to make unprofitable choices. “The industry has done bad business, but we cannot do anything about this. ‘We have to pay‘ has become the dominant thought over time, that tying the bonus to the budget does nothing but give the CEO a ‘punching bag’, so that they can only focus on their bonus and see nothing else, they can even manipulate the accounts to hold the bonus.“ He underlines that they have less bargaining power vis-à-vis CEOs because they are well-informed and the Board of Directors is not.
The reason Clifford has brought such harsh criticism is that he thinks the added value CEOs bring to companies is not clear. “The CEO guides the business, has an oversight role, but at the end of the day it is their normal duty to produce a good product and service. For this reason, it is unreasonable and unfair for a CEO to gain hundreds or even thousand times more than a typical employee,” he explains. I do not agree.
Harvard Business Review regarding payments to the CEO; since 1990, when discussions about these payments started, has not stayed far from the discussions. But an article that took a very clear stance has not been published. In fact, Jensen and Muphy’s “CEO Incentives: It’s Not How Much You Pay But How,” published in 1990 (11) was one of the first articles on this subject, and their writings remain neutral today still and I find this to be the correct attitude. After the authors point out that CEO salary is important to the success of the business, they also identify that getting rewarded correctly is important for two reasons. One is to determine which CEO behavior will be rewarded, and the other is to determine what kind of CEO the company will actually work with. Two issues to be considered are paying the right wages suitable for a CEO’s ability and establishing the best relationship between CEO behavior and the salary + bonus given. The authors advocate the establishment of a very aggressive payment method according to performance period in the 1990s. Frankly, I believe that the non-application of this aggressive “pay for performance” method and not establishing a relationship between the payments made to the CEO and the success of the company, are reasons for the debates in last 20 years. If the correct behaviors are determined clearly; CEOs definitely find creative ways to increase the financial performance of the company. I think AI Dunlop’s saying, “The Best Bargain is an expensive CEO“(12), as he wrote in his 1990 book Mean Business, still applies. You will neither pay more nor less to a CEO. A successful CEO is a source of wealth for a company, for a country, for the world. Anyway, if long-term company revenues are not associated with company profit and CEO behavior, everyone is deceiving each other. All criticisms will be correct. Paying a CEO the bargaining fee does not mean putting a company’s money into the CEO’s pocket. A talented CEO who takes the risk is rewarded. Otherwise he/she is deprived. While doing this, one-time mistakes should not be taken into account, but CEO efficiency should try to be increased with balanced metrics.
If there is no correlation between the CEO’s remuneration and company success, what is the success? A lot of research has been done on this subject, and factors such as the size of the company, operational complexity, financial strength, CEO’s power, Board’s competence, CEO’s team (human capital), CEO’s network have been found to be effective factors in its success (13). These factors are definitely effective, but I still believe that the reward system of a CEO and senior management team will make a positive contribution towards the business success when correct targets are determined and correct measurements are made.
The Covid 19 outbreak once again showed us that our budget and annual operation plans covering 3-5 years are very important elements to ensure control of our companies and ensure their success. The changes in the Covid 19 crisis once again showed us that we should be very aggressive in making a budget, making Annual Operation Plans (AOP) connected to it and monitoring it, and we should definitely associate the realization of these plans with senior management performance in an “aggressive” manner. In our case, the top management (CEO) receives initial half of his/her annual income as fixed and the other half as premium when goals are achieved, and if the ability is shown to exceed targets, this ratio reaches up to twice the fixed amount as a bonus in increasing rates. We still believe in this system. We can be flexible, but we must definitely be aggressive. It is no longer possible to make a static budget, it is necessary to move forward with corrections and with forecasts based on accurate data (Rolling Budgets). There is also the issue of harmonizing short-term goals, namely the Annual Operating Plan, with the long-term 3-5-year plans (Strategic Plan). In other words, we sometimes organize our performance-based payment plans over the years by considering 3 to 5-year strategic targets.
At this point, I would like to emphasize both from the latest article in the Harvard Business Review on the CEO payment system and the importance of making a budget in achieving company goals. Seymour Burchman’s article in Harvard Business Review, February 2020, entitled “A New Framework for Executives Compensation” (14), states it is no longer the CEOs to be accountable only to shareholders. He emphasizes that they should also work with targets towards increasingly other stakeholders. Because technology has turned many industries upside down, the disruption situation is not only about software companies, but also industrial companies. Activist social forces are gaining more and more power to influence corporate management. Therefore, CEOs need to set goals based on strategic agility, not the strategic status quo. In traditional plans (on budget) CEOs get a bonus if they hit a target for three years in a row, Burchman says, but CEOs now have to focus longer and reshape to compete. A dilemma arises here: will CEOs focus on increasing revenue or a radical transformation? Are three-year plans sufficient to achieve seasonal performances? Are budget structures that motivate CEOs flexible enough to transform quickly? Does a CEO, which focuses solely on financial results, adapt to the interests of stakeholders? How can goals with both long-term transformation and short-term strategic agility be set within an effective stakeholder ecosystem? Can we build a structure that can do the other without giving up one?
Burchman’s answer is yes, he says that if you structure the plans and budget within the framework of the mission that will motivate the CEO and senior management team, if you connect the strategic goals with the mission, you will be able to achieve short-term and long-term goals together. Because your mission is consistent. By constantly focusing on the mission, thinking about the stakeholder ecosystem and making adjustments in the annual operation plans on the road with agile decisions, you will not miss the long-term transformation and you will be ready to be reshaped continuously.
I strongly agree, this is why, at Yildiz Holding’s quarterly business review (QBR) meetings, the budget performance includes not only an exchange of actual figures, but also an analysis of the market and competition, as well as a review of our long-term strategy for the relevant quarter of the current year. But most importantly, an analysis of expected competition and market movements in the upcoming period, estimating what our numbers will be and discussing the actions will be taken.
In order for a mission to be an effective guide and to be measurable long-term, it should answer the following questions:
Who or what is our company working for?
What results should we achieve with which stakeholders to achieve this benefit?
How can we continuously improve these results to outperform competitors?
Let me give an example from us. Our mission is very clear, “Make Happy, Be Happy”. Each of our business units can put the prefix “in every bite …”, “in every sale …”, “in every transaction …” at the beginning of this.
If guided by these discourses, the stakeholder-based base of the payments of the CEO and senior management team that will be developed and reviewed every year to gain an advantage over the competition emerges. Only your mission can deliver clear benefits for customers and employees, together with stakeholders. Mission-oriented goals connect CEOs’ performance other than financial goals to other measurable goals. For example, Net Promoter Score, consumer satisfaction score, churn rate for customers. For employees: absenteeism rates, satisfaction rates, and turnover rates, over time, brand awareness, market share, return on investment by market and profitability compared to competitors can be such measurable goals.
The feature of these metrics is that it depends on the success of the work in detail. Although managers decide in favor of one of the stakeholders in the short term, these goals balance long-term sustainable performance. Alex Admans of London Business School and Rob Markey of Bain & Company emphasize the importance of striking this balance, stating that high employee satisfaction and high net promoter score success is a challenge for competitors.
In the method suggested by Burchman, the CEO and the Board of Directors set long-term goals depending on the mission. Then, the CEO’s annual bonus targets are determined. These are intermediate milestones to be completed in the annual operation plans. For example, the number of new products that get the desired market share. In the current traditional system, when the Board of Directors approve the new set of three-year targets, the three-year plans that came two years ago are still valid. This means achieving the goals for three separate sets. Instead of such period intersections, the system in which one begins and the other ends is the best, says Burchman. I call this updating, I agree with Burchman’s views. The mission-related objectives should remain constant throughout the given period, and the metrics should not stay the same and become increasingly difficult. If there is an improvement in this approach compared to competitors compared to the previous year, a bonus is earned. The Board of Directors takes a two-sided approach to resolve the short-term-long-term ruptures experienced today. It links the CEO’s long-term bonuses with the mission and balances them with short-term bonuses. Thus, CEO behavior is effectively monitored and guided. I say, short-term achievements are rewarded in annual operations plans (KPI), long-term results are rewarded based on long-term plans (LTIP). I find his proposal applicable to all kinds of company cultures. In an age of radical transformation, a Board of Directors and a CEO should focus on how the long-term bonus system works. If the Board and the CEO are stuck in three-year plans that include only financial targets, unless they move to a long-term, flexible and data-driven agile system that includes stakeholders, it will be difficult to achieve superior performance.
Note: This article, which is open source, can be cited by mentioning the author. Copyright not required.
References
(1) Barkema, H. G., & Gomez-Mejia, L. R. (1998). Managerial compensation and firm performance: A general research framework. Academy of Management Journal, 41(2), pg. 135–145.
(2) Conyon, M. J., & Peck, S. I. (1998). Board control, remuneration committees, and top management compensation. Academy of Management Journal, 41(2), pgs. 146–157.
(3) Chandra SMishra, et al. (2000), Review of Financial Economics, Spring 9 (1), pgs. 1-13.
(4) Joskow L.Paul ve Rose N.L. (1994). CEO Pay and Firm Performance: Dynamics, Aysmmetries, and Alternative Performance Measures, NBER Working Paper, No: 4976.
(5) Price J.N. (2016). CEO pay & Company Performance, Dilligent Insight.
(6) Ibid.
(7) “CEO Pay Ratios, Stats and Infographics.” PayScale, www.payscale.com/data-packages/ceo-pay.
(8) Elson M.C ve Ferrere C.K (2016), “Peer Groups: Understanding CEO Compensation and a Proposal for a New Approach”, The Handbook of Board Governance (Leblanc R., Editor), Wiley, p.463-472, 2016.
(9) Dorff, M. Indispensable and Other Myths, University of California Press, 2014.
(10)Clifford, S. (2017) The CEO Pay Machine: How IT Trashes America and How To Stop IT, Blue Rider Press.
(11) Jensen, J. M ve Murphy K.J (1990). CEO Incentives—It’s Not How Much You Pay, But How, HBR, January.
(12) Elson, C. M (2003). What’s wrong with Executive Compensation, HBR, January.
(13) Wua, H. et. Al. (2018) Politically connected CEOs, firm performance, and CEO pay, Journal of Business Research.
(14) Burchman, S. (2020) A new Framework for Executives Compensation, HBR, February.